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.