Why I am siding with the Germans on fiscal consolidation

I am going to take the German side of the argument on the euro zone’s need for fiscal consolidation. It’s not that I like wearing a hair-shirt. Hardly. It’s because the Europeans have no other choice if they are to avoid higher interest rates and/or default. Yes some countries still could fall prey to national bankruptcy. Yet, for the likes of Germany, this is not a threat if they move toward reducing deficits.

Tomorrow morning, in anticipation of the G-20 in Toronto, I will be on BBC World News TV’s GMT programme (1200 London time/0700 Washington time) to talk about the US criticism of European governments’ austerity programmes amongst other issues. As a lead-in to that appearance, I want to explain my viewpoint in this post with some help of a well-reasoned article by the German Finance Minister.

Yesterday, Wolfgang Schäuble wrote "Maligned Germany is right to cut spending" as an opinion piece in the Financial Times to defend the German position on fiscal consolidation. Below are excerpts and my deconstruction of his argument.

To the question of what caused the recent turmoil in the eurozone, there is one simple answer: excessive budget deficits in many European countries.

It comes therefore as a surprise, to me at least, that one of the most passionately debated economic issues of the day should be whether Germany is acting prematurely in reining in its deficit and thereby choking the rebound at home and in our neighbours’ markets. My response is an emphatic no.

Edward here. This is exactly right. Yields are higher on sovereign debt in Greece and Spain because investors are concerned about the state of their public finances. The Germans have low rates because they are considered the best bet within the Eurozone and one of the best sovereign credits on the planet.

Consider the raft of stimulating measures the German government adopted in late 2008 and early 2009 to stabilise the economy and mitigate the impact of the financial crisis on other sectors; not to mention our automatic stabilisers, which acted to the full, cushioning the labour market and domestic demand from the steep downturn. Some of those who are pointing fingers at Germany on Thursday hail from countries where such built-in mechanisms to tackle economic slowdowns are much weaker.

Remember Germany embraced the "we are all Keynesians now" view in 2008 and 2009. It was the Germans who began the car scrappage schemes in 2009 that everyone else copied as a way to prop up the auto sector. The Germans bailed out BayernLB, IKB, Hypo Real Estate and on. And as Schäuble correctly points out, the Germans have a robust and extensive system of automatic stabilisers which kicks in when the economy turns down. I would argue that is exactly what you want rather than relying on politicians to make these kinds of decisions in a volatile, politically-charged environment.

As we acted, we saw our budget turn from a nearly balanced position to a deficit of 5 per cent of gross domestic product. Just as it would be dangerous to remove such support abruptly, governments should not become addicted to borrowing as a quick fix to stimulate demand. Deficit spending cannot become a permanent state of affairs. We need carefully considered exit strategies.

So, the question now that the German economy has recovered is what should it do to ensure its economic future and keep the euro zone intact. Barack Obama says the Germans need to turn on the stimulus taps again to encourage private sector demand and job creation. However, the reality in Germany’s aging society is quite different from the one in America’s immigrant society. Germany has faced stagnant growth for a decade, what I call a soft depression. The country has only been able to grow its economy through holding down wages and exporting to others willing to run current account deficits. Is this about to change dramatically with Germany’s vaunted healthcare system in stress (see Zahlungsprobleme: Dritte Krankenkasse in Finanznot), with the German Social Security system’s retirement age raised to 67 and with Germans working the third shortest hours in the OECD? No – at a minimum, not over the short-to-medium term.

What Germany needs to do is cut its budget deficit in a way that doesn’t crater aggregate demand and tip the euro zone into recession, making the deficit larger. Schäuble writes that this is what the Germans are attempting to do.

Germany has such a strategy. We will launch it next year (unlike most of its European peers, Germany still has an expansionary budget in 2010) with saving measures representing less than 0.5 per cent of GDP.

These steps are not only moderate in scale, but they are also economically sensible because they will increase incentives for the jobless to find work, reduce subsidies and trim the civil service. This controlled and measured approach to reducing our deficit is hardly what one would call “slamming on the brakes”. Indeed, one of its objectives is to strengthen our growth potential. Our course could be described as one of “expansionary fiscal consolidation”.

I am more sceptical of Schäuble’s ability to pull this off. But I am not a German government official publicly defending policy. Likely, the hair shirt is coming on – worse for the Spanish and the Greeks but it’s coming for the entire euro zone.

Schäuble makes some of the arguments I made regarding demographics in his next passage. But he also adds the cultural differences between America’s inflationary bias and Germany’s deflationary bias.

Behind the calls for us to pursue a more expansionary fiscal course lie two different approaches to economic policymaking on each side of the Atlantic. While US policymakers like to focus on short-term corrective measures, we take the longer view and are, therefore, more preoccupied with the implications of excessive deficits and the dangers of high inflation.

So are German consumers. This aversion to deficits and inflationary fears, which have their roots in German history in the past century, may appear peculiar to our American friends, whose economic culture is, in part, shaped by deflationary episodes. Yet these fears are among the most potent factors of consumption and saving rates in our country. Seeking to engineer more domestic demand by raising government borrowing even further would, here at least, be counterproductive. On the contrary, restoring confidence in our ability to cut the deficit is a prerequisite for balanced and sustainable growth.

Demography is another reason why we must work harder at reducing deficits in the medium term than many others. Not only are Germans getting older, but our population is also shrinking year after year. This will make it harder for future generations to service our debts and, in time, will reduce our growth potential to about 1.5 per cent a year. Whereas the US, with its more vital demographic trends, can hope to “grow” its way out of its public debt, this is not an avenue that is open to us.

Irrespective of demographics and culture, the key here is the euro. The Germans face different constraints than do the Americans, Canadians or British. Euro zone rules are designed to prevent ‘monetizing’ euro zone debt. This makes the Germans a user of currency, subject to the same market forces to which other debtors who are currency users must submit. If the bond vigilantes come a calling, the ECB is not legally permitted to start buying long-dated government debt with printed money like the Federal Reserve. In this sense, the euro is deflationary. For euro zone members, it acts like gold does in limiting their ability to print money and let currency depreciation and inflation do the heavy lifting of reducing the real value of government debts.

Now, at the margin the ECB has started down the path to competitive currency devaluation by buying up depreciated Greek sovereign debt. But, the Germans have had their fill of this kind of thing. The Germans would rather leave the euro zone than submit to full-bore unsterilized debt monetisation. I could be wrong, but my sense is that the ECB is the one-eyed king in the land of blind money printing central banks.

In regards to austerity, I have argued that the Chancellor Angela Merkel has taken a dovish approach which has diminished her stature amongst Germany’s elites, within the governing coalition, and within her own party. However, reader Daniel points out that the average German feels that austerity as designed by the governing coalition is unfair. he writes:

The government doesn’t suffer because they supported Greece, they suffer because you really get the impression that the main job of the ruling parties is to insult each other. They have done absolutely nothing since they’re in power (ok, they did this ridiculous short selling ban), the FDP still behaves as if they were an opposition party and even the CDU and CSU can’t find a common line. Horrible.

They also lost support because over 80% of the German people think that the austerity package is not social balanced. Even the majority of the FDP members think that rich people should also pay for the crisis, but they just don’t care what people think.

Daniel also points to a German-language story in Der Spiegel which demonstrates that even Germany’s manager class support a wealth tax. Clearly, even in Germany, austerity will produce social unrest.

I would argue that Germany has no choice. It is a user of currency with an aging population and an inflation-phobic cultural history. Hair-shirt or not, austerity must come to Germany and the euro zone if it is to survive.

12 Comments
  1. Flimflamman says

    So Germany and other Eurozone nations should fight gangrene by progressively cutting larger and larger pieces from their legs? And all because they’re afraid of an injection, which is instituting fiscal union to match their monetary union.

    You say Germany has no choices, but it does; it, and the other nations in the EZ, simply refuse to take them. As you point out the core problem in the EZ is the monetary system those nations have engineered, and the only rational solution is to either fix or abandon that system. Austerity simply ignores the problem while inflicting suffering on the people; the best that can be said for it is that it is – perhaps – the least awful of the bad options that are left over once the rational, positive and humane options have been refused. Hardly something to be supported.

    Ed

    1. Edward Harrison says

      Sounds like you are arguing for a euro zone disillusion. Politically, that is a difficult road to hoe. If the Euro Zone stays in tact however, the only way forward is austerity and/or default. Stimulus is out as the sovereign debt crisis has demonstrated.

      1. Marshall Auerback says

        Euro zone dissolution is not only difficult politically. It probably
        impoverishes everybody, much like a divorce does. As is the case with most
        divorces, this one is likely to leave all participants poorer, including
        Germany, opening the door to higher transaction costs, tariffs that make imports
        more expensive, and curtailed mobility of labor and capital. European
        borders will become less porous. Germany’s manufacturers will lose the locked in
        competitive advantage they now have as every other manufacturing entity in
        Europe will likely have a much softer currency which will enable them to
        regain export competitiveness lost whilst they have been in the euro zone.
        The net result will be a more inefficient system of the kind that inspired
        the Euro in the first place. Moving away from the Euro will have some
        benefits for rich and poor countries alike, but it will be an especially
        painful blow to the continent’s less developed economies. Income inequality
        between European countries will increase, if only because poorer Euro zone
        nations can kiss their subsidies—explicit and implicit—goodbye.
        The disintegration of the Euro will only bolster the preeminence of the
        dollar in global commerce and affairs, and perhaps leave China as the only
        plausible rival to American power. The implication, unfortunately, is that
        what political unity exists on the continent would be undermined. While we
        may hope for an amicable divorce, couples can easily dissipate their wealth
        and energies in acrimony, so imagine how much harder it will be for the 16
        euro nations to agree on a plan for disentangling themselves from one
        another.

        In a message dated 6/24/2010 3:05:41 P.M. Mountain Daylight Time,
        writes:

        Edward Harrison wrote, in response to Flimflamman (unregistered):

        Sounds like you are arguing for a euro zone disillusion. Politically, that
        is a difficult road to hoe. If the Euro Zone stays in tact however, the
        only way forward is austerity and/or default. Stimulus is out as the
        sovereign debt crisis has demonstrated.

        Link to comment: http://disq.us/f290w

        1. Edward Harrison says

          I hear you, Marshall. I am a Euro-sceptic and I know you have your doubts about the design of the common currency’s institutions. But no one wants to see dissolution if only for the reasons you mentioned. There are a lot of benefits to the euro zone if it could be structured properly.

          The question should be less about dissolution and more about preventing a collapse in demand. I think Spain and Greece are done for. Double Dip Recession is coming. Portugal and Ireland are probably headed that way. The question is the Irish and Spanish banking system. The British have heavy exposure to the Irish and the Germans to the Spanish. If we see austerity and depression in Ireland and Spain, it will weaken banks throughout Europe. Without getting too apocalyptic, there are some bad scenarios out there.

          Do you have a politically palatable one to avoid this? I see the money drop (crediting billions in currency to each nation in proportion to their size) as a non-starter politically but would be interested to hear your view.

          1. Marshall Auerback says

            Yes, the politically palatable solution in the short term is having the ECB
            credit the euro nations’ bank accounts on a per capita basis (which means
            Germany is the biggest beneficiary). If you want to punish miscreants like
            Greece, you can hold back payments (this is a more credible sanction that
            the theoretical sanctions in the Stability Pact which were routinely
            violated by everybody without consequence INCLUDING GERMANY AND FRANCE.
            Functionally, this works better than simply buying up debt in the secondary market,
            as it prevents a race to the bottom whereby the ECB in effect rewards the
            biggest spenders. The latter could ultimately prove to be inflationary. I
            would also initiate a New York city or Uruguayan type of restructuring (NOT
            default) on Greece, extending maturities and reducing the rate paid, which
            could save Greece billions and probably ensure that it makes it through.
            Since there is no mark to market requirement for the European banks, there
            won’t be a cash flow/liquidity problem (so long as the credit default swaps
            are not activated, which I’m sure the Europeans would do – they’ve already
            shown they are inclined to act without compunction against CDS holders).
            The more politically radical would be a solution that Warren Mosler and I
            suggested about 2 months ago:
            _http://neweconomicperspectives.blogspot.com/2010/04/greece-can-go-it-alone.html_
            (http://neweconomicperspectives.blogspot.com/2010/04/greece-can-go-it-alone.html)

            Of course, this in effect would create a parallel currency so likely would
            prove less acceptable politically, so you’re back to option 1, which I
            don’t think is inflationary in the current context. The point is, the austerity
            program will not deliver what the Germans think it will. Given that their
            non-government sector will typically desire to net save (accumulate
            financial assets in the currency of issue) over the course of a business cycle
            this means that there will be, on average, a spending gap over the course of
            the same cycle that can only be filled by the national government. There is
            no escaping that. The more the Germans resist accommodating that via
            fiscal retrenchment, the greater will be the deficit.
            The national government has a choice – maintain full employment by ensuring
            there is no spending gap which means that the necessary deficit is defined
            by this political goal. It will be whatever is required to close the
            spending gap. However, it is also possible that the political goals may be to
            maintain some slack in the economy (persistent unemployment and
            underemployment) which means that the government deficit will be somewhat smaller and
            perhaps even, for a time, a budget surplus will be possible.
            But the second option would introduce fiscal drag (deflationary forces)
            into the economy which will ultimately cause firms to reduce production and
            income and drive the budget outcome towards increasing deficits.
            Ultimately, the spending gap is closed by the automatic stabilisers because
            falling national income ensures that that the leakages (saving, taxation
            and imports) equal the injections (investment, government spending and
            exports) so that the sectoral balances hold (being accounting constructs). But
            at that point, the economy will support lower employment levels and rising
            unemployment. The budget will also be in deficit – but in this situation,
            the deficits will be what I call “bad” deficits. Deficits driven by a
            declining economy and rising unemployment.
            So fiscal sustainability requires that the government fills the spending
            gap with “good” deficits at levels of economic activity consistent with full
            employment – which I define as 2 per cent unemployment and zero
            underemployment.
            Fiscal sustainability cannot be defined independently of full employment.
            Once the link between full employment and the conduct of fiscal policy is
            abandoned, we are effectively admitting that we do not want government to
            take responsibility of full employment (and the equity advantages that
            accompany that end) and we are abandoning everything to “the markets”. Really,
            though, Is there anything more oversold in the history of govt finance than
            the need to “restore market confidence” at the expense of the economy and to
            the great detriment of the actual people? Anytime anyone says that, you
            know they are clueless.

            In a message dated 6/24/2010 3:20:10 P.M. Mountain Daylight Time,
            writes:

            Edward Harrison wrote, in response to Marshall Auerback:

            I hear you, Marshall. I am a Euro-sceptic and I know you have your doubts
            about the design of the common currency’s institutions. But no one wants to
            see dissolution if only for the reasons you mentioned. There are a lot of
            benefits to the euro zone if it could be structured properly.

            The question should be less about dissolution and more about preventing a
            collapse in demand. I think Spain and Greece are done for. Double Dip
            Recession is coming. Portugal and Ireland are probably headed that way. The
            question is the Irish and Spanish banking system. The British have heavy
            exposure to the Irish and the Germans to the Spanish. If we see austerity and
            depression in Ireland and Spain, it will weaken banks throughout Europe.
            Without getting too apocalyptic, there are some bad scenarios out there.

            Do you have a politically palatable one to avoid this? I see the money
            drop (crediting billions in currency to each nation in proportion to their
            size) as a non-starter politically but would be interested to hear your view.

            Link to comment: http://disq.us/f2aj5

        2. Flimflamman says

          In reply to Edward.

          French banks are horribly exposed as well; pretty soon you end up with a Eurozone which consists of Germany and the Benelux countries. As you say, at this point there are several very unpleasant futures within easy reach, and I think Austerity heads toward one of them.

          Ed

      2. Flimflamman says

        Fiscal union would be my preferred option, which would – assuming reasonable structuring with no arbitrary rules; a big assumption I know – fix the roadblock to stimulus. It may not be politically palatable to many of the nations involved, but at this point there are no easy options left.

        Ed

        1. Edward Harrison says

          Right. I think a fiscal ‘agent’ is necessary. Forget about the European Monetary Fund and call it a European Harmonisation Fund whose purpose is increasing the level of automatic stabilizers across the euro zone.

          My question is how to prevent large current account imbalances as they are going to lead to tension in Europe that you don’t see in the US or Canada as an example. The Germans have a separate identity from the Greeks, so these imbalances exacerbate tensions in a downturn.

          Interested also to hear what Marshall says on this as he has been critical of this zero imbalances meme.

          1. Marshall Auerback says

            On the imbalances question, my response is quite simple: if the Germans
            don’t want to accumulate “worthless” Greek bonds, then they’ve got to buy
            Greek goods. Can’t have one without the other. Therefore, I would push for
            the idea of a strong public investment drive at least by the “surplus”
            countries so that there is sufficient growth in these countries that would
            spillover into greater exports from the GIIPS and turn around their trade
            balances. Such ideas did have some resonance but, unfortunately, even with a
            socialist finance minister in Luxembourg who might agree, it would take a lot
            more than that to convince Germany and France to give up permanently the
            Maastricht Treaty! However, things at least are moving, albeit slowly and in a
            clumsy way.

            In a message dated 6/24/2010 3:34:47 P.M. Mountain Daylight Time,
            writes:

            Edward Harrison wrote, in response to Flimflamman (unregistered):

            Right. I think a fiscal ‘agent’ is necessary. Forget about the European
            Monetary Fund and call it a European Harmonisation Fund whose purpose is
            increasing the level of automatic stabilizers across the euro zone.

            My question is how to prevent large current account imbalances as they are
            going to lead to tension in Europe that you don’t see in the US or Canada
            as an example. The Germans have a separate identity from the Greeks, so
            these imbalances exacerbate tensions in a downturn.

            Interested also to hear what Marshall says on this as he has been critical
            of this zero imbalances meme.

            Link to comment: http://disq.us/f2by7

        2. Flimflamman says

          Imbalances would lead to tensions, but those tensions can be reduced if people understand how economies work; if they understand that money isn’t being ‘taken’ from A to be given to B. Unfortunately that first requires the economists and politicians to both understand and/or act in a way that follows economic reality. And yes, MMT FTW.

          Perhaps the larger aspect of tensions though is just their reality, in so many aspects of European policy. The project Europe has been engaged in for the last several decades is fraught with tension; it’s just going to be there for decades no matter what. You can’t integrate a group of nations with diverse cultures and languages, and indeed recent histories of brutal war, without tensions. If we – and as a UK citizen in favour, in principal, of continued and increased European integration I’m part of that ‘we’ – want to make an integrated Europe work we’re just going to have to deal with those tensions. There are too many to try avoiding them.

          Ed

  2. de Graaf says

    Great piece Edward.

    You are siding with the right partyline on this one in my opinion.
    Apropriate analogy about the ECB being the last bastion of orthodoxy in a world of heretics. ;)

    The differences between the US and Germany opposites.

  3. Professor Pinch says

    Edward,

    Making good on my word, I wanted to read this and drop you a line with some quick thoughts.

    First, I agree with you the bond vigilante risk is very real for the Eurozone. If the Europeans don’t get their fiscal house in order, there will be hell to pay. Literally. The Germans are quite aware of this, but as you pointed out, even they are at risk for political/social unrest.

    Second, and I hope I’m wrong on this, but reading your comments regarding the banking system and reading things like this: http://bit.ly/cYsJht, it’s becoming clearer to me that the European banks are in bad shape and very well could get worse depending on what happens with the 442bn euro ECB facility. As you said, the name of the game is preventing a collapse in demand. Which I’m afraid, again, they’re behind the curve on.

    It’s going to be an interesting summer.

Comments are closed.

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