Archive for July, 2010
I’ve had a number of posts on my blog about my piece on Merkelomics. I shall ignore the one which says ‘all debt is bad’: has the person in question has ever had a mortgage?
Let me take the more serious point made by one commentator (Commentator ‘A’) who clearly wants to Eurozone to succeed—a sentiment I share fully. ‘A’ says: ‘I believe the fault in your analysis is that you don’t see the Eurozone as a national economy in the making. If you were, you would’ve realised that it doesn’t matter whether Eurozone exports originate in Germany or some other Eurozone country.’
My reply? I do indeed wish that the Eurozone were a national economy in the making and that I could praise the Germans for their export-led growth model. That German industry is admirably efficient I have no doubt (far more so than the UK). But perhaps I can best explain the case for Eurozone reform in the following manner. Below is a short ‘thought experiment’.
Let us assume—you can tell I’m an economist—that the contemporary USA were like the Eurozone, that there was little labour mobility, no Federal Treasury, that Congress was weak and that power lay almost entirely with the individual states (as indeed it did in the late 18th century). Let us further assume that because there was no Treasury but only a Central Bank, there was no federal borrowing and that individual states had to finance themselves through taxation and state bond issues.
In such a world, the ‘rating agencies’ would look at the trade statistics of the various US states. Suppose that most US state-level trade was with other states (which it is) and that Michigan and Ohio (which produced mainly manufactures) had enormous trade surpluses while the relatively poor states of Louisiana and Mississippi (which produced mainly fish) ran persistent trade deficits. (Remember, this story is allegorical.)
Ohio and Louisiana might initially both have AAA+ ratings, but because Louisiana was dirt poor and suddenly was struck by a hurricane causing coastal devastation, its economy became a basket case and its tax receipts collapsed. In consequence, the rating agencies downgraded Louisiana’s dollar bonds, making it nearly impossible for the state to borrow. Nor could Louisiana export its way out of trouble because, as part of the dollar zone, it could not devalue. Drastic cuts (internal depreciation) would make it even poorer and more likely to default.
So Louisiana—-together with Alabama and Mississippi— needed help from richer states like Ohio and Michigan. But Ohio, Michigan and various other ‘northern states’ were not without internal problems, and their citizens were reluctant to help the ‘lazy and feckless southerners’. Nor would they let the Central Bank buy the bonds issued by these poorer states … until a major crisis occurred.
I leave the reader to finish the story. Needless to say, the crucial point is that the USA is not in the above situation because it has the economic institutions necessary for operating a federal economy.
At least the USA had Alexander Hamilton and James Madison to shape its structure—today, Europe has Angela Merkel and Nicolas Sarkozy. I’m not optimistic.
Last year, in defiance of all macroeconomic reasoning, Germany’s ‘grand coalition’ government (CDU/SDP) enshrined a budget balancing law in the Federal Constitution requiring the Federal budget to balance annually from 2016. Angela Merkel, currently in coalition with the centre-right FDP, trumpets the virtues of Schwabian thrift and apparently wants the whole Eurozone to follow Germany in adopting the same type of ‘debt brake’ economics. The rules of the SPG are to be tightened, probably involving new sanctions on members who violate the 60% public debt-to-GDP ratio such as imposing cash penalties and/or possibly withdrawing their voting rights. But Mrs Merkel apparently wants to go further, expelling deficit members altogether.
By contrast, most professional economists believe that deficit spending during and after recession is a good thing, and that government’s budget should only ‘balance’ over the 7-8 year business cycle at best. Why then does Germany reject this view? Can it be that by balancing the budget annually, Germany will have abolished the business cycle forever? Dream on!
Some put Germany’s debt-obsession down to the folk memory of the disastrous inflation of 1922-23. But that was nearly a century ago, when Germany was saddled with reparations from the Versailles Treaty which could only be met by printing money. Besides, debt finance is not inflationary; public borrowing financed by the non-bank public increases both public liabilities and private assets, so overall, the country’s books remain balanced.
Others point to the political fallout from the Greek sovereign debt crisis; unless Germany reduces its debt /GDP ratio from 75 to 60% as Maastricht requires, Germany’s credit rating risks being downgraded, they argue. This argument totally ignores that Germany is running an export surplus, that most of its debt is domestically held, that demand for German bunds has grown and that debt insurance rates for bunds have been rock steady.
Still others—in Germany, typically politicians and the Springer-dominated popular press—point to a rising national debt burden, an ageing population and the likelihood of higher interest rates (and thus high debt servicing costs). But the debt is rising because the deficit has grown faster than GDP—true by definition in a recession. And as Paul Krugman has noted, even allowing for higher future German debt servicing costs, the annual interest charge on debt would be less than 1% of GDP. Moreover, since the debt is mostly domestically contracted, servicing debt is simply a public-private transfer: a positive earnings stream for German bondholders.
In truth, there is overwhelming evidence for the twin propositions that (a) growth reduces the budget deficit; and (b) during and after a recession, deficit spending provides part of the necessary stimulus to reawaken growth. Just as these propositions were true in during the Great Depression, they held true in Europe’s 30 year post-war wirtschaftswunder, in the US under Clinton in the 1990s and again since the 2008 credit crunch and accompanying stimulus packages (not to be confused with bank bailouts).
The IMF, in its July revision of its own April 2010 growth projections, shows that countries which applied a stimulus are doing better in growth terms than those that did not. It has raised its growth projections for countries that applied a vigorous stimulus package (eg, US, Japan) and its lowered growth projections for those where the stimulus was small or negligible (eg, UK, Germany).
If there is any discernible logic to Germany’s position, it emerges using the simple ‘savings’ balance model taught in Economics 101. Assuming no change in the private sector’s savings surplus (eg, steady wage repression), reduced public spending by adopting a balanced budget must lead by definition to a larger current account surplus—if it does not, national income must fall. Suddenly, the ‘debt brake law’ seems to make sense. The object of the exercise in the long term is to boost Germany’s export-led growth model, not just outside the Eurozone but within it where 2/3rds of its exports go.
The German-based correspondent of the Financial Times, Wolfgang Muenchau, has summed up the situation admirably. Balancing the budget forever by entrenching it in the Constitution will either plunge Germany into the vicious circle of falling tax revenue, expenditure cutting and negative growth, resulting in the eventual collapse of the Eurozone. Or else it will bring a virtuous circle of export-led growth, reinforcing Germany’s trade dominance of the Eurozone. The latter option may seem preferable. But in reality, because not all Eurozone countries can run a surplus with each other (one country’s exports are another’s imports), the latter option is equally unpalatable and will result in failure of the euro by a different route.
So there’s an underlying logic for the Eurozone in Merkelomics after all: heads you lose—tails you lose again!