19 December 2014 - Is your love in vain?

Sergio De Nardis, Chief Economist 
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Once again we refer to Bob Dylan in talking about the euro: is it true love that Germany has for the single currency or only a limited  goodwill? This may seem an inappropriate question, but it isn’t. The spreads no longer signal the risks of a breakup, thanks to the ECB and the sizeable global liquidity. But if the fire has been put out, embers remain under the ashes. A euro without policies to stimulate demand produces stagnation. And true stimulus measures (that is, not the Junker Plan) cannot take place if one fails to overcome the attitude of denial of Germany, beginning with the correction of its imbalances. Structural reforms in the periphery do not resolve the impasse: reforms cannot play a role in these economies if inflation has to be zero. A difficult situation for three-quarters of the EU citizens, due to erroneous economic policies, is the recipe for undermining the euro, which instead can and should function better. Starting in the coming weeks Europe is going to face a period of elections, and the fire could break out again. Thus German self-centeredness must be overcome. Already at the beginning of 2015 there will be a test of the degree of involvement of Germany in the monetary union: the size and composition of the ECB’s QE. As the song says: are you willing to risk it all or is your love in vain?        

If you love the euro. To be concerned about the fate of the single currency today means not so much worrying about the pause in the fiscal adjustment of the peripheral countries nor about the shortcomings in their processes of structural reform, but rather about the attitude of denial towards any measures of support for the economic cycle from the core countries, particularly from Germany. An opposition that is closely linked to the refusal of these economies to adopt corrective actions on their own imbalances, which propagate depressive effects throughout the area.

In truth, this is a problem that did not emerge suddenly in 2014. It was obvious from the very beginning of the euro crisis in 2010. Not figuring it out in time was what led to the disastrous outcomes that can be observed today. Why the delay? Contributing to this is probably also a cultural - as well as political and economic - subordination to the dominant country not only by the Commission, but by the same peripheral countries. An approach that was the result of various elements--the underestimation of the impact of austerity on economies that were already beleaguered by the recession of 2008-2009 and not supported by monetary policy; a misguided fascination with the so-called German model, with its corollary of mercantilism and rejection of the basic rules of economic policy; the pursuit of political agendas (reduction of the burden of the state and modernisation of the economy) that had little to do with the priority of getting out of the recession and instead were potentially counterproductive. Today the problems are here to stay. The peripheral economies are confronted with severe structural damages caused by recessions (according to estimates from studies by the Bank of Italy, the Italian production capacity was reduced by 2.5%, with declines in manufacturing reaching 17-20%) with stagnating demand and no real prospects of recovery, with the risks of deflation impeding the efforts of fiscal consolidation.

In this situation, pointing the spotlight at the imbalances of the creditor countries in the monetary union does not mean hitting the ball into the court of others, it is not a matter of pointing out the faults of others in order to divert attention from the inability to resolve their own problems. Arguing that this is a diversion from domestic problems only confirms the misjudgement of the European crisis. In the context of a long stagnation, with lack of demand and zero inflation, the structural gaps in Italy and the other peripheral countries are difficult to remedy, and maybe cannot even be dealt with. Thus, if one wants to regain having the opportunity to pursue the objectives of modernisation and efficiency in our economic structures, it is absolutely necessary to get out of the trap of depression. If this doesn’t happen, it makes no sense to speak of measures that will improve the long-term capacity, a concept that risks becoming a purely theoretical abstraction: with an aggregate demand that is persistently inadequate, that long run , during which it is hoped to see the benefits of structural reforms , will never be reached.

Competitive devaluation. While the debtor countries have significantly reduced their external imbalances since beginning of the crisis, the creditors have not made progress on this front. Indeed they have further increased their current account surpluses, net of the influence of the economic cycle. According to the estimates of the European Commission, from 2007 all economies that were in deficit have seen decreases in their  current account deficits, even excluding the improving effects induced by the recession (Table 1). Besides Ireland, Italy, in particular, is the only country which, starting from a position of deficit, has in the last period experienced a positive structural current account balance. The economies that were in surplus in 2007 have instead increased their positive foreign trade balances: Germany’s cyclically adjusted positive trade balance that was 6% in 2007 was nearly 8% in 2013-2014.

Table 1 – Current account balance adjusted for the economic cycle, in % of GDP
1 Balance not adjusted for the economic cycle.
Source: EC, European Economic Forecast, Autumn 2014 and Nomisma calculations.

The very large and growing German surplus is largely the result of a competitive internal devaluation undertaken by Germany in the first decade of the euro. In absence of an exchange rate, internal devaluation was achieved by limiting the increase in real wages well below productivity growth, particularly in the industrial sector exposed to international competition. Between 1999 (the year of the launch of the single currency) and 2007 (before the crisis), the productivity of German industry has increased around 25% more than that in other sectors that are not exposed to foreign competition; in the peripheral countries this imbalance in efficiency was about 8 percentage points lower (Table 2, row A). A similar situation should have led to increasing real wages in Germany, higher than in the periphery. Instead the opposite occurred. Between 1999 and 2007, real per capita wages in German industry (deflated by the price of output) decreased 12.2% compared to productivity (Table 2, line B), i.e. on average by 1.2% per year. In the periphery they grew more than industrial productivity, albeit on a limited scale: 7.8%, or on average 0.7% per year. This was a competitive devaluation because the marked reduction in the real costs per unit compared to competitors (-20 percentage points) occurred in a monetary union, taking advantage of the lack of an exchange rate and resulting in an excessive advantage (German exports at 50% of GDP, industry at 26%), gained at the expense of trading partners whose products suffered a displacement in domestic and international markets.

Therefore, behind the boom in Germany’s net exports is not a higher increase in manufacturing productivity than in the periphery, but rather the strong compression of real wages compared to productivity, taking advantage of the protection provided by the monetary union. This is an essential pointin interpreting the German success during the years of the euro: if it were not for the curb on wages, the increase in productivity would have been transferred to labour compensations and would not have given rise to the explosion in the trade surplus; if it were not for the single currency, the compression of wages compared to productivity would have been compensated by an appreciation of the nominal exchange rate of Germany compared to the peripheral countries, eliminating the possibility for explosion of its trade surplus. Cutting costs in relation to competitors in the monetary union in order to gain advantages over them is like devaluing the nominal exchange rate when there is the  national currency. Productivity does not play a role in this story.       

A rough measure of the actual size of the German devaluation in relation to the periphery, accumulated between the launch of the single currency and the beginning of the crisis, is the distance between the differential in inflation that has historically occurred during that period (German price increases were 10.8% lower than in the deficit countries, row C of Table 2) and the differential that should have corrected the competitive intra-euro imbalance (prices in Germany would have had to grow 5% more than in the periphery, row D). This results in an estimate of the German real depreciation of around 16% during the period 1999-2007 (row E). In absence of rebalancing measures by Germany (as seen in the further increase in the structural surplus after 2007), the peripheral countries have to bear the burden of the correction by bringing their price and cost trends 16% below those in Germany.

Table 2 Increase in productivity and inflation rates in Germany and in the Periphery 1
(% variations and % differences between variations in the years of the euro preceding the crisis, 1999-2007)
1The peripherals include: Italy, France, Spain, Portugal, Greece.
2The estimate of the inflation differential required in the period 1999-2007 for rebalancing is obtained on the basis of a simplified model of two sectors (tradable/non-tradable and a unitary substitution elasticity between the two goods in the consumption basket) and two countries (Germany/Peripherals) that leads to the following equation: German inflation – peripheral inflation = variation in the nominal exchange rate Germany/Periphery (equal to zero) + 0.60 x [differential in productivity of industry /other sectors in Germany (+24.8%) - differential in productivity of industry /other sectors in Periphery (+16.4%)]; 0.60 = estimate of the weight of non-industrial goods in the consumer spending basket. Source: Nomisma calculations based on data from the European Commission (Ameco)

Historical precedents. Two further considerations are useful in order to qualify the discussion on current account imbalances in perspective. The first is that, historically, situations similar to that experienced in the monetary union - refusal of surplus countries to participate in rebalancing - have already occurred under other fixed exchange rate regimes and led to the fragmentation of the monetary agreements. This occurred in the 1930s with the breaking up of the Gold Standard, yet also at the beginning of 1970s with the crisis of the Bretton Woods regime. In the latter case, among the difficulties in adjusting the balance of payments that led to the end of the system set up after the Second World War, there was the resistance on the part of surplus countries (again Germany) to revalue their currencies in real terms through higher inflation, faced with productivity imbalances between sectors and compared to the United States very similar to the intra-euro imbalances shown in Table 2.[1] This situation of current account imbalances is, thus, a slippery slope that can lead to destructive results.

Exporting depression. The second consideration regards the trade balance of the entire euro area with the rest of the world. Persisting high German surpluses and the containment of deficits in the periphery have ended up being translated into positive current account balances of the Eurozone that are very large (2.5% of GDP in 2014, or more than US$300 billion; last row of Table 1), higher than those that characterise China (1.8% of GDP, US$190 billion). This reflects the excess in German savings compared to investment, which, no longer absorbed by the periphery in recession, since 2007 has been increasingly flowing to other economies. Face with this surplus, over the past year the euro exchange rate has started to depreciate, leading in perspective to a further expansion of the positive balance. It would seem, thus, that the beggar-thy-neighbour policy, intrinsic to the choices of Germany, is now shifting from trade relations with the periphery to outside the euro area. This too is something that reminds of the 1930s: the euro area with its large trade surplus and active pursuit of a weak exchange rate is not doing other than dumping its own unresolved internal contradictions (failure to adjust the intra-area imbalance and economic stagnation) onto foreign markets, exporting depressive tendencies to the rest of the world. Since, however, global growth is not high – it is lower than that experienced prior to the crisis - it seems unlikely that this attempt to grab international demand away from others in order to make up for its own weaknesses can be pursued without sooner or later causing reactions by the other large economies.

Do what we have done. Germany's position on the issue of intra-area rebalancing is to affirm that it is the exclusive task of the periphery to undertake adjustment, imitating what the German economy has done over the past decade. In other words, it is as if Germany were to say: it is up to you peripheral countries to try, if you can, to reduce our surplus of 7%, which we achieved with a competitive devaluation, and the virtuous way in which you can do this is through structural reforms that increase productivity, keeping wages in check. This is an incongruous position. Above all because Germany has been able to achieve an internal devaluation in a setting in which the ECB was able to maintain average Eurozone inflation at 2%, thanks to a price increase of 3% in other economies. Today the peripheral countries are called upon to undo the German competitive devaluation in a context in which euro inflation is 0.4% and that of the country in whose regards they must rebalance themselves is below 1%. The level of the inflation under which debtor countries must remain thus depends on the German economy. Given the level at which it has positioned, there is no wonder that one will observe stagnation, deflationary trends in the periphery, and the impossibility for the ECB to fulfil the mandate of price stability..

The reforms don’t help if inflation has to be zero. Yet there is a second problem with the reasoning that dumps the entire burden of adjustment on the periphery. Structural reforms, invoked as a virtuous tool for competitive recovery that would allow achieving rebalancing efforts with zero inflation, cannot actually play any role in improving the situation, indeed may worsen it. Figure 1 illustrates schematically the internal factors which determine the trends in prices. Inflation is much lower when the trend in unit labour costs (ULC) and profit margins is lower. The change in ULC, in turn, is much slower when the increases in wages are more contained and when productivity growth is stronger. If the inflation to which one must point is zero, then the economy must be very weak (negative output gap) in order to compress wage growth below that of productivity and allow, in the tradable sector, the transfer of resources from labour to profits which is part of competitive recovery. The need for a weak economy is not lessened if structural reforms that encourage productivity are implemented. Even with reforms, there will always be a need for a large negative output gap (i.e. recession and stagnation) in order to curb the growth of wages substantially below that of productivity and thus attain zero inflation. And under conditions of a weak economy the increase in productivity (output / employment) that would result from structural reforms risks leading to declines in employment, since output is not able to grow when demand is compressed. This is the trap of depression: the long term where supply reigns will never be reached; instead, the timeframes of the short term, dominated by the constraint on demand, will be indefinitely extended.  

Figure 1 – The internal factors that affect inflation 
Source: Nomisma

Higher inflation in Germany. If it is the level of German inflation that establishes the conditions for the economic cycle of the single currency area, how much would it need to rise in order to allow an exit from stagnation? Table 3 provides examples of some estimates, which use as a reference the competitive gap to be overcome shown in Table 1, that is 16 percentage points. Under the current situation, with inflation of 1% in Germany and zero in the peripheral countries, the elimination of the competitive gap occurs at 1% per year. This implies an incredibly long period (16 years) of depression in the periphery (zero inflation) and in the euro area (inflation around 0.5%), with the ECB failing to uphold the mandate of price stability throughout this long phase. This is clearly an unsustainable prospect, a declaration of failure of the single currency. Thus, we make two hypotheses to reduce by half (from 16 to 8 years) the period of time necessary to eliminate the competitive gap. To this end it is necessary that the annual rate of reduction of the gap between the German economy and the periphery doubles from 1% to 2%. In the first hypothesis, this is done with Germany bringing its inflation rate to 2%, or the objective of the ECB for the entire euro area, while the peripheral economies remain at a zero trend. Even this scenario appears untenable: the period of competitive recovery is halved, but still implies a depression that lasts too long, with the ECB failing to uphold its statutory mandate for many years. Hypothesis 2 outlines the only sustainable perspective. The responsibility for correcting the competitive imbalance is also assumed by Germany, which had helped create it in the past. German inflation is raised to 3% and that of the periphery to 1%. This allows closing the gap in half the period of time implied by current trends, with the ECB having the ability to reach the target of euro inflation close to 2% and overcoming the phase of economic stagnation. These are clearly illustrative exercises that depend on the assumption regarding the size of the competitive gap to be eliminated. However, even if one makes assumptions of gaps that are less pronounced (for example, 10 percentage points), the message does not change: the only sustainable prospect for the euro (ECB that achieves the target and end of stagnation) is that of German inflation rising to 3% during the period that is necessary for adjustment.

Table 3 – Internal devaluations and revaluations necessary in order to eliminate the 16 percentage point competitive gap between Germany and the Periphery 1
1The peripheral countries are the same ones as in Table 2.
Source: Nomisma calculations using Eurostat data

Euro priority. A situation in which the burden of intra-area adjustment rests exclusively on the shoulders of the debtor countries is unsustainable for the monetary union. This is not because of an inadequacy of the periphery countries, but due to the unsustainability of the German position that endangers the structure of the euro. There is full awareness of this in Frankfurt, though it would seem much less in Brussels. The above considerations highlight that when the ECB indicates its proposed quantitative easing actions in early 2015 to try to push the euro inflation to the target of 2%, it is practically stating that it seeks to bring German inflation above this level, towards 3%. Indeed, as seen, this is the appropriate inflation for Germany in the process of correcting the competitive imbalance built up over past years. Will this country accept such a prospect or will it oppose it, asking for limits on buying securities in order to neutralise that which is an appropriate policy for the euro area? Will it show awareness of being part of a monetary union or will short-sighted national interests prevail? Needless to say that from what one observes, premises are negative. This is a crucial point, an area of conflict that has developed within the very foundations of the European architecture., The role of the ECB, the functioning of the euro and, ultimately, its acceptability in the future, will all depend on the way it turns out.

Yet for the ECB to have  some chance of success, it is necessary that also the other arm of economic policy, fiscal policy, moves. The stagnation that threatens the sustainability of the euro is the result of policies that have collapsed--and in many cases suppressed --demand. In the situation of a liquidity trap in which Europe finds itself, rethinking the role of fiscal policies is indispensable. The timing of the consolidation of public finances needs to be redesigned, but above all Germany and the core countries need to be urged to undertake decisive stimulus actions. An increase in public investment in these systems would facilitate the acceleration of the German inflation, which is pursued by the ECB, and would have significant spillover effects on the economic activity of the periphery and the entire Union.[2] This should be the field of action of the European Commission, which, instead, appears to be moving in different directions. The intensity of the pressure on Germany to correct its imbalance - core priority for the future of Europe – cannot be compared with that exerted on the periphery to respect the rules of fiscal consolidation. For the rest, the Junker Plan, the "political" evaluation of budget overruns of some decimal points by France and Italy, and recommendations for structural reforms are all there is in terms of pro-growth initiatives: these are not elements of a scale sufficient to modify the weak outlook that looms ahead for the European economy. Monetary policy has lost traction, inflation is at zero, consumers and businesses prefer to employ their available financial resources in safe assets, consequently productive investments are extremely limited. It is time for a fiscal policy that works alongside a monetary policy that is not able by itself to overcome the depression. Unfortunately, the Commission does not see this yet.


[1]Under the Bretton Woods regime, the principal actors were Germany (surplus country) and the United States (deficit country), with the former registering since the 1950s a strong growth in manufacturing productivity compared to services, far more than occurred in the American economy. This should have led to a higher price dynamic in Germany than in the United States, something that did not happen because German authorities compressed the internal pressures on wages and prices by raising interest rates, sterilising the flows of liquidity connected to exports and accumulating huge foreign reserves; see M. Obstfeld, “The Adjustment Mechanism”, in A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, edited by M. Bordo and B. EIchengreen, University of Chicago Press, 1993. It should be noted that in the discussion on this paper, published in the volume, Vittorio Grilli, academic at the time and future Director General of the Treasury and Minister of Economy, underlined that the Bretton Woods experience should provide lessons for planning the governance of the nascent European Monetary Union, foretelling in this regard that “an error in design can prove fatal in this endeavor”.     

[2]An increase in public investment equal to 1% of the GDP of the core countries could stimulate 0.4% GDP growth in the periphery, according to the estimates presented in O. Blanchard, C. J. Erceg, J. Lindé, “Jump-Starting the Euro Area Recovery: Would a Rise in Core Fiscal Spending Help the Periphery?”, mimeo, June 2014.

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