This is the third in a series of posts on the origins of the Euro crisis. "The roots of the European sovereign debt crisis go back thirty years" and "How Belgian debt, Italian anarchy and Greek profligacy lead to economic chaos in Europe" are the first and second posts.
On Wednesday I wrote a post about the breakdown in the euro-zone from the more caricaturised view that seems to dominate the German press today. I want to take the flip side of this and write a bit about what the German press is not telling you about Germany’s role in the Euro crisis. It’s about the soft depression in Germany that has persisted since reunification and the pressure it has put on wage costs in that country.
Coincidentally, Michael Pettis is out with a stellar piece today which makes many of the same points I had intended to make, so rather than re-hash what he has discussed, I will quote from his piece where appropriate.
So let’s start with re-unification.
East Meets West
When the Berlin Wall fell, it ushered in monumental changes across central and eastern Europe and no country would feel its impact more than Germany. The German political elite at the time were all born in the 1920s and 1930s. Their personal histories were deeply marked by the split of Germany into east and west. So when the opportunity came for reunification, there was no question in the minds of Helmut Kohl, Hans-Dietrich Genscher and Theo Waigel and the CDU/CSU/FDP governing coalition. The only question was the currency and economic harmonisation.
Kohl was adamant about bringing the two countries back together in a way that quickly brought the east up to the living standards in the west. Germany instituted a solidarity tax to pay for an upgrading of the infrastructure in the east, which soon became in many respects better than in the west. Furthermore, the economies were unified economically using the Deutsche Mark and a quick integration of eastern German workers into the unions and wage structures in the west. Initially, wages were lower in the east, which caused bitterness for workers there. But wages were quickly brought up to western levels.
Nevertheless, the economic side of re-unification was a complete disaster. For purely political reasons, Helmut Kohl, then the German Chancellor, rebuffed the advice of his economic advisors and decided to unite East and West Germany at an exchange rate of one for one. This represented a significant over-valuation of the East German currency. Moreover, the privatization of eastern German state enterprises by the Treuhand was a boondoggle for the few to enrich themselves at the expense of the many as it was in Russia. And it led to massive speculation in eastern German real estate by companies with zero experience in property. The result was a property bubble and crash and lingering indebtedness in the German corporate sector.
To make matters worse, Kohl also pushed through the now infamous east-west Lohnangleichung (wage parity) whereby eastern German worker wages quickly rose to the level in the west. The east was a heavily manufacturing-based economy. So wage parity meant a pricing out of eastern German labour, high unemployment there, and an eventual move of German manufacturing to central and Eastern Europe instead of to the former East Germany.
Depression sets in
In short, eastern Germany was uncompetitive. Forget about blühende Landschaften (a flourishing economy ) in the former East Germany. Try depression. I’m talking unemployment to the high teens, a rise in neo-Nazis amongst unemployed young males, huge municipality and state indebtedness to deal with the social costs, and a mass migration from east to west.
Many people don’t realize this, but Germany has all of the hallmarks of a country in a balance sheet recession that Japan does. It had a property bubble and bust. It has suffered from high business sector indebtedness. The public sector states and municipalities are now highly indebted as well. The result has been low consumption growth and high household sector savings. And the German economy has been in and out of recession 4 times since reunification as a result. While an aging population plays a large roll here, clearly there is more to it than that.
German politicians are well aware of these problems. The question is what to do about it.
‘Beggar Thy Neighbour’ labour reforms?
During the end of the days under Helmut Kohl, Germany was completely unable to undertake any kind of structural labour reform. But the neo-liberal German Chancellor Gerhard Schroeder followed the Clinton model very effectively and moved his party to the centre. Schroeder instituted widespread reforms in four stages called the Hartz Concept after Peter Hartz, a German manager and member of the board of directors of Volkswagen. The result has been stagnating wage growth in Germany which has facilitated an export boom.
However, this stagnating wage growth cannot be seen in a vacuum. This is where comments by Michael Pettis piece about the effect on southern Europe come into the picture. Pettis says about the German posture toward southern Europe:
Critics of Germany will argue that this moralistic posturing is thoroughly misplaced. European monetary policy, which was driven largely by Germany, was incompatible with German trade and labor policies that effectively suppressed German consumption, forced a large trade surplus onto its neighbors, and together made a southern European debt crisis almost inevitable.
The strong euro and burgeoning liquidity it brought on meant that much of Germany’s trade surplus had to be absorbed within the eurozone, forcing especially southern Europe into high trade deficits. These deficits were dismissed, very foolishly it turns out, and against all historical precedents, as being easily managed as long as the sanctity of the euro was maintained. A very false analogy was made with the US, in which it was argued that because European countries all use the same currency, trade imbalance within Europe are sustainable in the same way they are sustainable between states in the US.
But states in the US are not like states in Europe. Labor and capital mobility in Europe is very low compared to the US, and the Civil War in the US ensured that sovereignty, including most importantly fiscal sovereignty, resided in Washington DC, and not in the various state capitals. The US is clearly as much an optimal currency zone as any large economy can be.
This isn’t the case in Europe. In fact I would argue that the existence of a common currency in Europe, the euro, is only a little more meaningful than the existence of various currencies under the gold standard, and it was pretty obvious under the gold standard that balance of payments crises could indeed exist.
So why not also in Europe under the euro? As I see it, domestic German policies, perhaps aimed at absorbing East German unemployment, forced a structural trade surplus. The strong euro, along with the automatic recycling of Germany’s large trade surplus within Europe, ensured the corresponding trade deficits in the rest of Europe – unless Europeans were willing to enact policies that raised unemployment in order to counter the deficits. As long as the ECB refused to raise interest rates, southern Europe had to accept asset bubbles and rapidly rising debt-fueled consumption.
This couldn’t go on forever, or even for very long. Now southern Europe is paying the inevitable price, and of course the moralists are accusing the south of being shiftless and lazy, confusing the automatic balancing mechanisms in the balance of payments with moral weakness.
Translation: The Hartz reforms in Germany, the direct result of a botched currency union at re-unification, are specifically designed to keep down wage pressure in Germany. Because of the fixed exchange rate in Euroland, this has made southern Europe uncompetitive. Therefore, despite – or should I say because of – the high Euro this past decade, Germany has run a currency account surplus within the Eurozone, countered by current account deficits in the South. The strength of the Euro – something the Germans have always wanted – has made it impossible for the south to balance the current account without taking on similar structural reforms that suppress wage growth.
Is this a deliberate beggar thy neighbour policy? Did the Germans enter into the currency union with this in mind? In some circles, analysts are saying yes. And it is this that has angered some in southern Europe.
They say that Eurozone monetary policy was made for Germany, inflating bubbles in Ireland and Spain as their economies overheated. To make matters worse, the inappropriate monetary policy made it that much harder to suppress wage growth, making the economies uncompetitive and creating an unsustainable current account balance. Now that things have gone decidedly pear-shaped, the euro has tied the government’s hands on fiscal and monetary policy and the only way forward is a deflationary depression.
There is a lot of truth to all of that. But, should we blame the Germans? Pettis has it right when he says:
This is not to say that it is all Germany’s fault (although I’m sure I will be accused of making this claim anyway), but rather that the existence of the euro seriously exacerbated the problem by making it very difficult for certain countries to adjust to Germany’s domestic policies, which generated employment growth at home at the expense of Germany’s trading partners. There is no question that a long history of fiscal irresponsibility in southern Europe made things much worse, but the imbalance could have never gotten so large without Germany’s role, and since in a crisis it is always easier to blame foreigners, bashing Germans will become a very popular sport in much of Europe.
I anticipate that economic nationalism will be a significant factor in the politics of the euro-zone for some time to come. And when the chips are down, the ugly populism of ‘blame the foreigner’ is very seductive. Unless the euro-zone policy makers develop a pro-growth approach, this populism and depression are going to rip the Euro apart.
Are you ready for the United States of Germany? – Michael Pettis