Five reasons Germany isn’t innocent in the Euro crisis

I actually agree with European Commissioner Olli Rehn when he says there’s no point apportioning blame for the Euro crisis – a lot of people have messed up. It can also be counterproductive. But since you can’t move for tripping over caricatures of lazy Greeks, for the sake of balance here are some reasons why Germany isn’t quite the prudent and innocent victim of dastardly southern European profligacy it is frequently painted as.

Eurozone monetary policy is tailored to suit Germany at the expense of the Greece

The Eurozone countries all share a single monetary policy, set by the European Central Bank in Frankfurt. Any policy set will necessarily be an aggregation of the interests of the member states in Europe.

But for most of the 2000s, the ECB followed a very loose monetary policy of low interest rates, which benefited the north European countries like Germany and France at the expense of Greece, Spain, and Portugal. To policymakers at the time it would have been clear these countries were at risk of overheating from the massive supply of cheap credit this was supposed to create (Any half competent national central bank would have likely set different rates.) But they still did it. Had this not been the case, it’s very likely that the private half of the debt crisis would not have been possible, or as severe.

The monetary policy problem hasn’t gone away either. If Greece had its own currency, it would at this point likely devalue it to make its exports cheaper, shrinking its trade deficit and kick-starting GDP growth. This is what Iceland has successfully done, and its what Argentina did successfully after its severe 2002 crisis. But there’s not a chance in hell of the ECB devaluing to save Greece, because it would have negative consequences for consumers in northern Europe, making their imports and foreign holidays more expensive.

The ECB refuses to use the two policy tools that could ameliorate Greece’s crisis, on the basis that they would harm Germany. This has prolonged and deepened the crisis.

Germany ‘defected’ in the prisoners’ dilemma that is the European common market

The EU is a project of regionalisation. Though multi-faceted, part of its purpose is to shield capital in European countries from competition from abroad with high external tariff barriers, while at the same time providing a large enough free trade bloc to give access to a strong pseudo-domestic market. The idea was that French farmers and German manufacturers wouldn’t have to directly compete with people willing to work for a dollar a day, only people with a similar lifestyle; and so a race to the bottom could be avoided.

But German industrial policy has been to hold down wages and undercut labour remuneration and costs compared to other European countries to make its capital more competitive:

This is a perfectly legitimate thing to do, but in one important sense it is defecting in a prisoners’ dilemma: were all the countries to collectively agree to raise workers’ living standards at the same rate, everyone would be better off. This is arguably the point of regionalising rather than globalising. German capital wouldn’t have gained that competitive edge, but it was partly that edge that led to huge trade imbalances.

You might not have a problem with this: in a market, actors compete. But if you’re okay with countries competing in a market, you have to accept the logical conclusion of markets, which is that some actors will eventually go bust.

There are two consenting parties in any financial transaction

The story of imbalances in the EU is by now well established – at its most simple, prudent German savers and lenders lent to southern European spenders, both state and private. But what was the nature of these transactions? They weren’t charity, or gift loans to an unreliable friend. They were loans by people hoping to make a profit by charging a rate of interest; they were investments. They also turned out to be bad investments.

If there was no risk of Greece defaulting then investors could have just lent Greece the money for free, but seeking to make a profit, they charged a rate of interest (now a 34% return). Charging interest is supposed to ‘price in’ the risk of default – on aggregate, if you set your interest at the right rate you’re not supposed to make a loss. Investors clearly priced the risk wrong.

For anyone genuinely committed to the principles of capitalism, the response ought to be the same as to anyone who bought some stocks or shares that then plunged in value: ‘Tough, you made a bad investment. Better luck efficiently allocating your capital next time.’ Some of the blame for the negative externalities caused by these bad investments must surely lie with the people who made the investments.

Dragging the crisis out to makes sure north European lenders don’t get hit has been expensive

Each time Greece gets another infusion of bailout cash tied to counterproductive austerity measures, the can just gets kicked down the road. The crisis isn’t permanently solved, the bailout money goes to service the mountain of debt until it runs out and another round is needed, and the forced fiscal contraction shrinks Greece’s economy further, reducing its income and ability to pay back its debt.

This has been quite obvious to many observers for a while now, so why would you do it? Because the longer it drags out, the less the impact on lenders there is. The market can price in losses, more bonds can mature, political wrangling can resolve itself, building ‘firewalls’ (bailout mechanisms) for banks. This is explicitly the Mekozy policy.

But ensuring the financial sector doesn’t get hit too hard has hurt everybody else. Every day the Euro crisis hangs over the economy is another day of rock bottom business confidence for capital in real sectors of the economy, tipping countries into recession. The bailouts themselves are very expensive and essentially massive transfers of European taxpayers’ money to non-Greek banks. And Greece itself is being pillaged beyond the point of comprehension.

These are policy decisions made disproportionately in the interests of German (and to be fair, French) lenders, but they have had significant downsides for everybody else.

Germany was actually the first country to break the Eurozone fiscal rules

This isn’t so much a cause of the crisis, though it is relevant. One of the accusations often levelled at the southern countries is they ignored fiscal rules set by the Eurozone. But Germany was just as guilty of this as anyone – in fact, Germany was actually the very first Eurozone country to break the rules of the Stability and Growth Pact: the agreed limit on yearly borrowing of no more than 3% of GDP.

Interestingly, Spain was the only country to keep the Eurozone’s deficit rule all the way up to the 2008 crisis, and even managed to keep within regulations on public debt (keep it lower than 60% of GDP) until 2010 (!) – a rule which Germany actually broke at the same time as Greece, in 2003.

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Comments

  • GGG  On February 17, 2012 at 13:52

    Summary: Putting such different societies as the north and south under a single currency is not that good an idea.

  • Ralph Musgrave  On February 18, 2012 at 13:20

    I agree that Germany is not 100% innocent, but don’t agree with “reason No.1”: that devaluing the Euro would solve any problems. A devaluation would lead to increased demand for exports from the EZ, i.e. the effect would almost certainly be to raise aggregate demand in the EZ. Assuming inflation is at the 2% target level (which it is approximately), then an increase in aggregate demand is not permissible. So devaluation is not a solution.

  • Lucas  On February 18, 2012 at 23:14

    #3 Reflects a poor understanding of how bond markets work. Bond yields are inversely proportional to bond prices and bond demand. There is not some greedy investor who sets the interest rate to an absurd rate like the 34% you mentioned, that is simply a function of everybody selling Greek bonds and not wanting to hold on to Greek debt (making bond prices fall, and yields to rise). Can you blame them?

    Further, the claim that because some German banks bought Greek bonds they are somehow complicit makes little sense. Suppose that they had not bought any Greek bonds whatsoever, that would have left a demand gap for Greek bonds in the market, leading to a higher rates for Greece to pay which likely would have left Greece even more in the hole.

    And finally, the article forgets that a huge part of the Greek crisis blowup was that Greece was essentially cooking the books about how much debt they had and what their deficits were like. The blowup came with a new government that revealed what the real numbers were. Much like in classic number-fudging scenarios such as Enron in the U.S., the investors got mauled because they were making an investment decision on misreported official information. To say, “Investors clearly priced the risk wrong” is hindsight bias at it’s most egregious.

  • Jon  On February 18, 2012 at 23:39

    I know how bonds work and never said someone had centrally set the rate at 34%, that’s your inference alone, I’m afraid.

    And supposing they had not bought any Greek bonds and yields had gone higher – that’s pricing the risk higher, and Greece would have had to borrow less. That’s what’s supposed to happen, because the risk would have been priced correctly.

    The Greek government are certainly to blame for cooking the books, as are the ratings agencies for not noticing, but I’m afraid there ought always be the supposition of a degree of imperfect information in any financial transaction, and the principle of caveat emptor is still very much relevant.

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