Last year, we saw a sea change in official German policy regarding the euro crisis and inflation. The German government came out in favour of accepting higher inflation domestically in Germany as a sacrifice for eurozone wage and price adjustments to help alleviate crisis. The question is whether this matters. I believe it does, but only in part.
I am writing this in part because of a back and forth between Ryan Avent on Free Exchange and Paul Krugman at the New York Times and Tyler Cowen and Alex Tabarrok at Marginal Revolution where I think some of the assumptions made about German policy views on inflation are incorrect.
The general consensus about the euro crisis is that it involves three separate adjustments beyond bank and private sector balance sheets. And these are on the wage/labour side, as well as regarding fiscal and monetary policy. Europe is using this three-legged policy stool as the basis for reform in the periphery. However, as I noted last week, although the ECB claims to have loose monetary policy, the Europeans are trying to effect change within a framework that involves contractionary fiscal policy without any currency offset. This is very different from what Japan is doing, which is short-term stimulative in both fiscal and monetary policy as well as via currency depreciation. I believe the policy mix is debt deflationary as it forces a herculean adjustment onto the private sector that weakens balance sheets and leads to defaults that exacerbate financial sector weakness.
In that context, the question is how can the euro zone rebalance economies given the constraints of the euro and the ECB’s limited mandate. A lot of people point to inflation. The theory is that if you get the Germans to inflate their domestic economy and add to aggregate demand, then the periphery would not have to go so heavy on so-called internal devaluation, wage and price cuts, to regain external competitiveness. The theory here is that the Germans are preventing this from happening because their hyperinflation 90 years ago is still such a huge trauma that they are completely irrational about crisis solutions. And so the pain continues.
There are two problems with this. First, as Tyler Cowen points out, wage competitiveness is not enough to restore the periphery to its glory days:
this mechanism solves (at best) only one of the core problems of the eurozone, namely incorrect relative prices between Portugal and Germany. It helps less with the “Portuguese nominal wages are too high” problem, the “Portuguese banks are not sound” problem, and the “Portugal badly needs structural reform” problem, among other difficulties. The inflation would be an easier sell to the German public if it really would set the rest of the eurozone right, but that is a difficult case to make.
The second problem here is that for at least a full year, the German government has openly supported a medium-term higher inflation target for the German domestic economy. The FT reported last May that German Finance minister Wolfgang Schäuble was willing to temporarily allow inflation to tick up in Germany in order to aid re-balancing:
Wolfgang Schäuble, German finance minister, has given vital political cover to the Bundesbank, speaking out in support of the idea that Germany could tolerate a rate of inflation above the eurozone average.
Making a rare exception to the rule that Berlin does not comment on central bank policy, Mr Schäuble declared that price rises “in a corridor between 2 and 3 per cent” would be “tolerable” in Germany – slightly above the European Central Bank’s target of keeping average inflation across the eurozone at close to but below 2 per cent.
His statement followed comments before a parliamentary committee on Wednesday by a Bundesbank official, who cautioned that the eurozone’s largest economy might face “an inflation rate somewhat above average” as the likes of Greece and Portugal squeezed prices and wages to regain competitiveness.
But here’s what we know that has happened since Wolfgang Schäuble formally announced the German government was willing to let inflation in Germany rise:
- Mario Draghi started the OMT program in order to avert crisis in Spain. Under the guidelines of the program, the euro bailout funds could buy euro government sovereign debt at auction with unlimited support in the secondary market from the ECB if the particular government agreed to enter a Troika program of fiscal and structural reforms. This was a dodge on monetary financing of national governments using the Troika program as cover to demonstrate that the ECB was not facilitating fiscal profligacy. Of particular note here is that German ECB member Jörg Asmussen was a vocal supporter of this policy and he was backed by German Chancellor Angela Merkel over Bundesbank head Jens Weidmann.
- Germany acquiesced to demands for above-inflation rates of wage increase for public sector workers in March. That means the German government is officially allowing wage inflation to resume in Germany after a decade in which wage suppression was seen as central to the revitalization of Germany’s export machine. Private sector workers are now agitating for the same.
- Angela Merkel made the unusual step of commenting on monetary policy last month, ahead of an ECB rate cut, specifically noting to German bankers that ECB policy is not just for Germans. While the press made it seem like she was interfering to keep interest rates high, it was clear to anyone who understands German politics that it was just the opposite.
To me, this looks increasingly like an orchestrated campaign on the part of the Merkel-led government in Germany to prepare the German people for higher inflation as a price they should willingly pay for the euro and European cohesion. Moreover, for a year now, official stated German policy is that inflation can move to 3% over the medium-term and that would sit well with the German government. So, it’s a complete myth that the Germans are still trapped in the hyperinflationary mindset of 90 years ago. And anyway, it was always the positive legacy of the strong D-Mark during Germany’s post-World War 2 economic miracle that counted most regarding German views on inflation and monetary policy.
Does all this matter though?
I would argue it doesn’t really. Euro zone inflation is at a 3-year low of 1.2% and falling. Right now deflation and debt deflation are the real concern for Europe, not inflation, irrespective of what Schäuble says about policy. That’s because the euro mandates this. The Maastricht Treaty 3/60 deficit/debt hurdles and the ECB’s no-monetisation clauses are etched in stone. Europe has been quite pragmatic in figuring out ways to flout both of these tenets because of the crisis but policy makers are not willing to completely disregard the rules. And those rules are both deflationary and pro-cyclical during an economic downturn – all the more so, given the severity of this downturn.
Moreover, as I have been arguing for months now, Germany is concerned about its own public finances. So when Angela Merkel says Germany is “too weak for more fiscal stimulus“, that’s what she’s talking about. People seem to forget that it was the capital markets that forced the periphery, as users of currency without an ECB backstop, into the sovereign debt crisis – not the Germans. The Germans too are afraid that they are one sovereign or bank bailout away from meeting the same fate and so they too are constrained fiscally.
Equally, the ECB, despite providing easy money to euro banks – even allowing insolvent Cypriot banks to tap the ELA for months despite their obvious insolvency, has limits imposed by the euro. No-bailout, no-monetisation has meant that the ECB cannot buy up sovereign debt the way the Japanese, British and American central banks are. And they had to jury-rig the OMT into place when it became clear the euro zone faced an existential crisis in Spain. And even there, the German courts might overrule. So, again the euro is a restriction that places downward pressure on inflation and growth in Europe.
I don’t expect any of this to change. Germany is completely willing to make sacrifices for the sake of the euro zone. But those sacrifices are limited by how the euro zone is set up. It’s almost irrelevant whether the Germans are willing to set a higher inflation target when fiscal policy is contractionary and the central bank’s only mandate is to keep inflation low.
The problem is not Germany. The problem is the euro.