The Eurozone crisis. Was it all bad German economics?

Simon Wren Lewis [here and here] pulls together his critique of the role of German economics in the Eurozone crisis.

The Eurozone institutions had  3 flaws.

First, the ECB was [at least initially] prevented from acting as a lender of last resort to member states governments.  Second, the Stability and Growth Pact prevented sufficiently counter-cyclical fiscal policy.  Third, monetary policy was too conservative, with too much of an emphasis on inflation control, relative to the stability of real activity, perhaps an inflation target that was too low [remember the ‘close to, but below’ wording], and these things contributing to the premature raise in interest rates in 2011.

The charge is that these institutional design problems reflected bad economics in the head of the German economic and policymaking elite.

This thesis has a lot to be said for it.  I think Simon is right that old-fashioned monetarist economics, and excessive monetary and fiscal conservatism lives on to an unfortunate degree in Germany.  [See my own tirade on this].

But I don’t think it’s the whole story.

Regarding the first ‘failing’, that of there initially being no promise to act as purchaser of sovereign bonds of last resort.   It’s debatable whether this is a failing.

The notion, debated much in the blogosphere, is that it’s desirable and credible to have the central bank promise to act as purchaser of last resort, in order to stave off market runs on sovereign bonds.  However, providing that financing has a cost.  The money creation needed will generate inflation whose costs may be recognised to be too high [expected money printing is not an efficient way to do government financing].  Following this reasoning, the promise won’t be believed.  And if it is carried out, it may be more harmful than a default.  This is why there is an attempt at a legal bar in the UK and other countries [and Germany before the Euro].  [One which I hope Simon does not suggest – in his role as contributor to the BoE remit review led by Labour’s John McDonnell – is qualified.]

And because such lender of last resort purchases are problematic, I’ve argued before that as far as the ECB is promising to roll out OMTs for Italy or Spain or France, this is a bluff.  There would be no support – rightly – for unlimited purchases on such a scale were things to come to that.

The second and third failings relate to the foregoing of strongly counter-cyclical monetary and fiscal policy in the Eurozone make-up.

In the non-German EZ member states, monetary and fiscal instability/freedom had often been a curse, and not a blessing.

Such countries had seen many episodes of high inflation, resulting from an abuse of the monetary freedoms later given up;  episodes of fragile exchange rate fixing, with no say in monetary policy at all.

They had also seen decades of less than optimal fiscal policy, with sustained over-borrowing and abuse of the fiscal freedoms craved now.

The memory of the efficacy with which monetary and fiscal freedoms were used lived on in the hefty pre-Euro spreads between German and other sovereign bonds.

In some countries – Portugal, Spain, Italy, Greece, Cyprus – this lack of monetary and fiscal discipline was symptomatic of an acute political-economic malaise.  As an outsider to this literature, I can’t do justice to it.  But an example is what Kalyvas and other political scientists term ‘clientilism’ and corruption;  the use of state resources to reward pressure groups on the left or right who had helped win the election.

These pressures arguably distorted monetary and fiscal policy, applying a too-short horizon, over-reliance on the inflation tax, and offering influential jobs in monetary and fiscal policy to political clients rather than those most competent.

The Germans’ insistence on the Eurozone’s actual design may have been a strategy to ensure that what ever caused these abuses in the past were not going to cause a problem for ECB monetary policy.

Rewinding history a little further, the Germans’ own institutional design, which they insisted be reflected in the Eurozone, is plausibly seen as a response to its own experience of how political dysfunction [which, if we want to get into a blame game, we can lay at the doors of the victorious allied powers at the end of WW1] leads to bad monetary and fiscal policy.

Concluding, Simon is right to point the finger at the economics in the heads of German policymakers.  However, the monetary and fiscal conservatism they built into the Eurozone was certainly explicable given the dysfunctional monetary past of Germany itself and other countries too.  And, who knows, perhaps even a decision that has a coherent rationale;  perhaps an enlightened New Keynesian in those pre-Euro negotiations over the design of the Eurozone might have recognised that the monetary and fiscal freedom prescribed in that framework were not as feasible as they appear in the institutions-free versions of those models.

 

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10 Responses to The Eurozone crisis. Was it all bad German economics?

  1. Barr, Malcolm says:

    Hi Tony

    I see from the below you continue to argue along the lines of this “OMT is a bluff”. Let me make another attempt to talk you out of this.

    OMT can only happen if a country has been given an ECCL. To get an ECCL requires political assent. You could argue OMT is a bluff because, when push came to shove, the Germans (or whoever) would block Italy, Spain or France from having an ECCL. Personally, I do not think that is true, but I think that is where your argument could work.

    So let’s imagine you are in an ECCL and the ECB is having to buy a lot of your short term debt because markets still do not believe the sovereign is salvageable or the OMT commitment will be sustained. What happens? The pressure will come primarily through the fact that an ECCL is basically an IMF program under a different name, and (largely) without the option of default. So it will be down to the sovereign in question to convince markets they can work through a program. Moreover, the ECCL will give the rest of the region control over how much debt the sovereign issues (including the short term stuff OMT can buy), and the rest of the region will impose a hard budget constraint.

    Now let’s suppose that the sovereign will not or can’t comply. Then they will not be fulfilling the conditions of the ECCL, and OMT will stop and never restart around a program review.

    If the sovereign is compliant with the program, their need to issue new debt will be limited, and the ECB can buy until markets realise that the support will continue to be forthcoming.

    Let’s imagine Germany doesn’t like what the ECB is doing even though a country is deemed compliant with the ECCL. What can they do about it? After the ECJ ruling, nothing that directly effects the ECB. And they agreed to the ECCL at the outset. In all likelihood angst about OMT support would be directed toward the question of program compliance, not at the ECB.

    Malcolm

    • Tony Yates says:

      Thanks for these [as always] excellent points.
      One thing that arises from them is the argument that there is, in effect, no promise for unlimited purchases. Since these would never be needed.
      Perhaps so, in which case ‘whatever it takes’ means ‘whatever it takes, since it won’t take very much’.
      Another point to make is that since the framework governing intervention has changed more than once, it may well change again. So what’s there now is not a cast-iron description of what might be there in the event that this was really tested.
      A related point can be made about the nature of IMF programs. They have shown themselves quite capable of bending their own rules to make something happen that their major stakeholders want to happen.
      A final thing; I agre with your final paragraph, but I personally doubt that the ECB would proceed anyway, since they would be taking large risks with their balance sheet, and likely risk multiple resignations, and a subsequent Treaty revision that would clip their wings.

  2. Nick Rowe says:

    Acting as lender of last resort always creates a moral hazard/Samaritan’s dilemma problem. But it seems to be worse in the Eurozone, with one central bank and many countries. And you can always nationalise a commercial bank, but “nationalising” Greece is a bit tricky.

    I would say it’s a structural problem in the Eurozone.

  3. TokyoJones says:

    Much of the thrust of your argument seems to come down to

    …………………………………………………………………………………….
    “Rewinding history a little further, the Germans’ own institutional design, which they insisted be reflected in the Eurozone, is plausibly seen as a response to its own experience of how political dysfunction [which, if we want to get into a blame game, we can lay at the doors of the victorious allied powers at the end of WW1] leads to bad monetary and fiscal policy.”
    …………………………………………………………………………………….

    German hyperinflation resulted from what der Spiegel* calls “French intransigence” in forcing Germany to repay her debts, ultimately leading France occupy the Ruhr valley. This deprived Germany of its industrial core and paradoxically prevented it from paying its debts. The emphasis we so often hear on hyperinflation then is well off the mark, if you’ll excuse the pun. The economic crisis in interwar Germany was the result of German wartime profligacy, harsh post-war settlements, and the refusal of Germany’s creditors to restructure its debts into a more manageable solution. In other words, the lessons of Germany’s past do not support the present German approach to the Eurozone, which in fact has more in common with interwar France than Weimar Germany.

    In any case, the German people have inadvertently aligned themselves with Germany’s interwar creditors with their well known frustration with Greece. Schäuble defends this by positioning Germany as the defender of the social basis of capitalism, as if his concerns about moral hazard weren’t in fact actualized in the taxpayer funded bailout of Greece’s creditors.

    If we locate the fear held by German policy makers about exposing Germany to bad monetary and fiscal policy, then we must conclude their present actions are self-defeating, as their own history shows such crises themselves yield bad policy.

    Better I think to look to material consequences, and from this perspective it is clear that German policy makers have been immensely successful in improving Germany’s short and long term positions. Its GDP growth trend has, since 2006 or so, resumed its historical rate and Germany has, alone among the major Eurozone states, clearly benefitted from the euro. Even Germany’s contributions to the Greek bailouts has been more than offset by reductions in its cost of borrowing, and the turn around in its current account balance has been staggering.

    But all this comes at a cost, and Germany has simply exported that cost along with BMWs and financial bubbles and unemployment. It is wrong for German policy makers to place the sole or even primary blame on what amounts to its customers; wrong both because it isn’t true and also because it won’t work.

    * “Millions, Billions, Trillions: Germany in the Era of Hyperinflation”, by Alexander Jung

  4. FearTheTree says:

    Why not admit that two countries as different as Germany and Greece have no business sharing monetary policy? Why not admit that Milton Friedman and Margaret Thatcher were right regarding the viability of the Eurozone?

    Or perhaps the Eurocrats should admit that the end goal is a United States of Europe, and that that dystopian vision will be realized with or without the consent of the nation-states that comprise the EZ.

    • grkstav says:

      There is *nothing* wrong with a proper United States of Europe, with a bicameral directly elected Legislative, a directly elected Executive (head) and the existing Judiciary; the Euro as the currency of an actual federal sovereign, actual federal income (and as appears to be the custom, sales or value-added) tax, federal expenditures, federal stabilizers, the works.

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