The voice from the parallel universe announced that “The euro as a currency is a great success indeed … it is backed by remarkable fundamentals” and harsh fiscal austerity is “the best way to get sustainable growth and job creation”. The only problem is that the voice was none other than the retiring ECB boss Jean-Claude Trichet as he prepared to retire from his post in October 2011. During his term, Trichet was constantly preaching how the introduction of the Euro was a “success”. The only problem is that it is hard to reconcile that conclusion with an examination of the actual data. The Eurozone has failed and an orderly dismantling of the entire monetary system with a return to floating sovereign currencies is the only way that any semblance of prosperity will return.
The former ECB boss would undoubtedly argue that the ECB’s success lay in stabilising the inflation rate. But there was nothing particularly unique about the Eurozone in that respect.
Trichet and his ilk would argue that the ECB’s approach to inflation targeting has several advantages over previous monetary policy approaches. Many of the alleged gains are attributed to the fact that inflation targeting allegedly provides the central bank with the independence it needs to be credible, transparent and accountable – essential conditions for an effective policy regime.
The enhanced policy credibility allegedly allows a higher sustainable growth rate. The enhanced central bank independence overcomes the time inconsistency problem whereby an inflation bias is generated by the pressure the elected government places (implicitly or explicitly) on non elected officials in the central banks to achieve popular outcomes. Thus inflation targeting can allegedly lock in a low inflation environment.
It is also often argued that inflation targeting not only reduces inflation variability but also reduces the variance of output growth. If certainty in monetary policy generates more stable nominal values, it is argued that lower interest rates and reduced risk premiums follows. This allegedly stimulates higher real growth rates via an enhanced investment climate.
Further, inflation persistence is allegedly reduced because one time shocks to the inflation rate are quickly eliminated by the policy coherence. The reduced inflation variability allows more certainty in nominal contracting with less need for frequent wage and price adjustments. This in turn means less need for indexation and short-term contracts.
However, the implications of this are a flatter short-run Phillips curve. In other words, higher disinflation costs – more unemployment and real GDP losses.
How large are the output losses following discretionary disinflation? Can these output losses be attenuated by the design of the monetary policy? The conservatives argue that the losses are minimised if the disinflation is rapid. The credible research literature shows that the losses are inversely related to the speed of disinflation.
There is also no credible empirical research which shows that a more politically independent central bank can engineer disinflations with attenuated real output losses.
The evidence is that while inflation targeting does not generate significant improvements in the real performance of the economy, the ideology that accompanies inflation targeting does damage the real economy because it embraces a bias towards passive fiscal policy which in our view locks in persistently high levels of labour underutilisation.
Disinflationary monetary policy and tight fiscal policy can bring inflation down and stabilise it but it does so at the expense of creating and maintaining a buffer stock of unemployment. The policy approach is seemingly incapable of achieving both price stability and full employment.
An examination of the research literature suggests that inflation targeting has not been effective in achieving its aims. This is despite the constant claims by the proponents to the contrary. Only a minority of the research literature supports the contrary view.
The most comprehensive and rigorous work on the impact of inflation targeting shows that it does not deliver superior economic outcomes (mean inflation, inflation variability, real output variability, long-term interest rates).
Considered in isolation, inflation targeting does not appear to make much difference. It is certainly hard to distinguish it from non-inflation targeting countries, especially those which have adopted the broader fight inflation first monetary stance, such as the US.
But the real damage comes from the discretionary fiscal drag which is the ideological partner to inflation targeting.
Please read my blog – Inflation targeting spells bad fiscal policy – for more discussion on this point.
Which brings me to a very interesting Bloomberg Op Ed today (April 2, 2012) – Euro Was Flawed at Birth and Should Break Apart Now – written by one Charles Dumas, who works for a London-based macroeconomic research organisation.
He writes that:
Since the launch of the euro in January 1999, Germany and the Netherlands have experienced a growth slowdown and loss of wealth for their citizens that would not have happened had they never joined the euro.
We know this to be true, because we can compare the progress of these two Northern European economies with that of Sweden and Switzerland, which kept their freely floating currencies in 1999 and continued to grow as before. Indeed, over the period of the euro’s existence, the German and Dutch economies have grown significantly more slowly than those of the U.S. and the U.K., despite the debt crisis now engulfing the “Anglo-Saxons.”
While the counter-factual (whether Germany and the Netherlands, two of the Eurozone “powerhouses” would have grown faster without the Euro) is difficult to be conclusive about, the fact that two non-Euro, EU nations and the big two Anglo-nations (both of which have been hit hard by recession) have outperformed the EZ powerhouses is hard to argue against.
Consider the following graphs taken from National Accounts data available from the Eurostat database. The first graph shows in index number form (March 2000 = 100) the quarterly growth in real GDP for the Eurozone (EZ), Sweden, Switzerland, the UK, and the US from the inception of the common monetary union.
We see that the Eurozone nations as a whole (and the membership changed slightly during this period given that not all 17 current EMU nations entered at the outset) have performed below all but Switzerland in the period before the crisis but have had the worst recovery since the crisis (even though the crisis was not as harsh from peak to trough).
The second graph explicitly shows the comparison with Germany and the Netherlands, to overcome the fact that some stronger Eurozone nations (including some of the southern states during the credit-binge prior to the crisis) were blurring the picture.
The conclusion is even more emphatic.
The other point that Charles Dumas makes which is crucial when appraising the success or otherwise of the Eurozone is whether the growth performance of the powerhouse Northern nations, as modest as it was, reflected sound principles.
Charles Dumas writes:
Sweden and Switzerland grew as fast or faster in 2001-11 as they did in 1991-2001. The German and Dutch economies, by contrast, not only slowed down in 2001-2011 (to 1.25 percent from 3 percent in the case of the Netherlands), they also suppressed wage growth to adjust for the effects of the euro. As a result, real consumer-spending growth fell to a feeble one quarter of a percent a year in these countries. A recent report on the Netherlands’ experience in the euro calculated that if growth and consumer spending had followed the pattern of Sweden’s and Switzerland’s in the decade from 2001, Dutch consumers would have been 45 billion euros ($60 billion) a year better off.
In this blog – The German model is not workable for the Eurozone – I discussed this point in relation to the Hartz reforms that were imposed on the German workforce as a way to artificially tilt the EMU-playing field in favour of the Germans which had the effect of creating an unnatural economic environment for the Southern states to have to operate in.
The latter were doomed to fail no matter what independent of their fiscal positions (noting that Spain was running budget surpluses in the lead up to the crisis and Greece budget deficits).
We need to emphasise that the EU elites went one step further than the rest of the advanced world in adopting neo-liberalism. The decision to impose the monetary union meant they also abandoned floating exchange rates and deliberately, under pressure from the dominant Germans, chose to eschew the creation of a federal-level fiscal authority.
So we had the nonsensical situation of a common currency effectively rendering the member-states as foreign-currency users without an exchange rate and without the prospect of federal redistribution assistance in the face of asymmetrical and negative aggregate demand shocks. States such as California would have been bankrupt years ago if the US federal system had have adopted such a monetary system design. Same for states in Australia, for example.
The Germans had cultivated their own brand of extreme neo-liberalism which is known as ordoliberalism. The aim of the designers was to firmly limit the capacity of the “state”. I wrote about the influence of ordoliberalisms in this blog – Rescue packages and iron boots.
It was obvious that during the Maastricht process the neo-liberal leanings of the designers were never going to allow a fully-fledged federal fiscal capacity to be created, which would have allowed the EMU to actually effectively meet the challenges of the asymmetric aggregate demand shocks that the crisis generated.
Instead they wanted to limit the fiscal capacity of the state in the false belief that a self-regulating private market place would deliver the best outcomes and be resilient enough to withstand cyclical events. The Germans, of-course, knew that by signing up to the EMU they would have to change the way they pursued their mercantilist ambitions.
Previously, the Bundesbank had manipulated the Deutsch mark parity to ensure the German export sector remained very competitive. That is one of the reasons they became an export powerhouse. It is the same strategy that the Chinese are now following and being criticised for by the Europeans and others.
Once the Germans lost control of the exchange rate by signing up to the EMU they had to manipulate other “cost” variables to tilt the trade field in their favour. The Germans were aggressive in implementing their so-called “Hartz package of welfare reforms”. A few years ago we did a detailed study of the so-called Hartz reforms in the German labour market. One publicly available Working Paper is available describing some of that research.
The Hartz reforms were the exemplar of the neo-liberal approach to labour market deregulation. They were an integral part of the German government’s “Agenda 2010. They are a set of recommendations into the German labour market resulting from a 2002 commission, presided by and named after Peter Hartz, a key executive from German car manufacturer Volkswagen.
The recommendations were fully endorsed by the Schroeder government and introduced in four trenches: Hartz I to IV. The reforms of Hartz I to Hartz III, took place in January 2003-2004, while Hartz IV began in January 2005. The reforms represent extremely far reaching in terms of the labour market policy that had been stable for several decades.
The Hartz process was broadly inline with reforms that have been pursued in other industrialised countries, following the OECD’s job study in 1994; a focus on supply side measures and privatisation of public employment agencies to reduce unemployment. The underlying claim was that unemployment was a supply-side problem rather than a systemic failure of the economy to produce enough jobs.
The reforms accelerated the casualisation of the labour market (so-called mini/midi jobs) and there was a sharp fall in regular employment after the introduction of the Hartz reforms.
The German approach had overtones of the old canard of a federal system – “smokestack chasing”. One of the problems that federal systems can encounter is disparate regional development (in states or sub-state regions). A typical issue that arose as countries engaged in the strong growth period after World War 2 was the tax and other concession that states in various countries offered business firms in return for location.
There is a large literature which shows how this practice not only undermines the welfare of other regions in the federal system but also compromise the position of the state doing the “chasing”.
But in the context of the EMU, the way in which the Germans pursued the Hartz reforms not only meant that they were undermining the welfare of the other EMU nations but also droving the living standards of German workers down.
So it is clear that the German model that the “powerhouses” followed in the period leading up to the crisis attacked the welfare of their own populations and made it virtually impossible for the other member states to enjoy enduring success once they had surrendered their currency sovereignty and the capacity to adjust to trade imbalances via exchange rate variations.
It was obvious that with “fixed exchange rates” imposed on member nations, the there would be wide imbalances emerging in real exchange rates (measures of external competitiveness that take into account local productivity, price movements and nominal exchange rates) across the Eurozone.
It was obvious – and it was the German design – that nations such as Italy and Greece and the other nations that didn’t harshly repress the growth in living standards of their citizens – would become increasingly non-competitive. The “German Model” guaranteed that and the German growth was driven by that.
The fact that it was an unsustainable strategy appeared to escape the attention of the Euro elites, who to this day remain in denial.
Charles Dumas writes:
No wonder the Germans and Dutch are angry. But their anger should be directed at the governments that took them into the euro, not at the hapless citizens of Mediterranean Europe, who now are also suffering the effects of the common currency.
Sweden and Switzerland didn’t have to make any such sacrifice of ordinary people’s prosperity, while at the same time they enjoyed stronger employment as well as budget and current-account balances. That leads to only one conclusion: The euro was a mistake from the outset. It should be abandoned in unison and soon.
Whether we need to hold out Sweden and Switzerland as exemplars of sound fiscal practice is another matter. I would not. But the point is clear. The nations with flexible exchange rates and sovereign currencies have done better over the last 11 years (overall) and have come out of the crisis better, notwithstanding their own government’s attempts at undermining the growth process.
Charles Dumas also notes that the artificial sense of stability implied by the Stability and Growth Pact (SGP) was “irrelevant to these problems, and in any case was ignored even by the policy’s main proponent: Germany”. He was referring to the “blithe assumption that such imbalances would be evened out by the ready mobility of labor” and itemised why such a neo-liberal belief was flawed from the start (“absence of a common language, tax structure and social-security entitlements etc).
In terms of the current stock take – “13 years later, where are we?” – Charles Dumas notes that fiscal austerity is pushing the financial ratios (deficits, public debt ratios) so revered by the Euro elites in the opposite direction to that desired – “The austerity program the Greeks are following — their only option, given that without control of their own currency they cannot devalue — has made both the deficit and debt ratios greater”.
The automatic stabilisers are swamping the discretionary net cuts given that the latter are severely undermining growth. This phenomenon is spreading across the EMU – with Italy having “no prospect of improvement” and “Other euro-area economies are in worse shape”.
As the recessive forces further undermine the financial viability of these nations – there will be a sequence of forced exits – “meaning that Portugal will probably have to leave the euro shortly after Greece”.
I am often asked about the nub of the European problem. My answer is always the same. The problem is the Euro. In saying that I am not denying that the lack of financial oversight as the ECB’s “one-level-fits-all” monetary policy created unsustainable real estate booms in certain nations, etc were not serious issues.
Further, there may be a need for some changes in tax systems (say in Greece) and other entitlements given the real outlook. But these issues are not causes. They are just conduits to amplify the crisis.
The major issue is the Euro.
Charles Dumas notes that:
All these symptoms of the euro’s poor design are linked. Wage suppression in Germany and the Netherlands has created artificial cost competitiveness, boosting exports to, and exacerbating inflation in, Mediterranean Europe. Lower wages in Northern Europe, meanwhile, have ensured weak demand for imports from the South. The resulting trade surpluses enjoyed by Germany and the Netherlands were, and will be, wastefully invested in such assets as U.S. subprime-mortgage paper and Greek government bonds.
In the future, the euro can survive only if these surpluses are given away as unrequited transfers — more or less what is happening now, in the form of bailouts. With 2012-13 prospects for global growth much weaker than in 2010-11, dependence on the German “export machine” will blight the whole European economy, heightening the malignant effects of the euro.
In other words, a fiscal transfer has to take place. In Australia, for example, fiscal transfers between states are mediated through the Commonwealth Grants Commission which works to ensure that standards of living are broadly similar across all states irrespective of economic performance.
But the reliance on Germany to generate the largesse which is then distributed to the nations that it has impoverished via the impoverishment of its own workforce (real wage suppression) is unsustainable.
The crisis has demonstrated that Germany is not capable of maintaining sufficient growth to play this role and could only achieve the modest growth it did by harsh suppression of the living standards of its own workers.
Charles Dumas correctly notes that the ECB is the only thing that is keeping the EMU afloat at present. I disagree with his assessment that the “ECB has engaged in unprecedented and dubious practices to expand the euro system’s central-bank balance sheet, accepting junk collateral against the provision of banking liquidity”.
The quality of the ECB’s balance sheet is irrelevant given that it is the sole issuer of the Euro. It can always fund anything in Euros!
But he is correct in saying that:
… liquidity provision will not stop fiscal tightening from deepening recessions in Mediterranean Europe, widening deficits and debt ratios, and threatening banking crises.
The long-term lending that the ECB has been engaged in to the commercial banks was based on spurious grounds – that lending to the private sector was being constrained by a lack of reserves. The reality is that credit growth is low in the EMU because the state of the private economies is so parlous that there is a paucity of credit-worthy borrowers actually seeking loans.
That is why these credit operations of the ECB will not stop a deepening recession. The path to growth has to come from fiscal expansion and austerity is deliberately preventing that from happening.
I also agree with him that “(s)equential disorderly exits from the euro need to be avoided because of the huge and extended financial turbulence they would cause”.
I have been advocating for years a break-up of the EMU. The crisis brought the design flaws into stark relief. You didn’t need to understand Modern Monetary Theory (MMT) to see that the system is inoperable and cannot deliver long-term prosperity. At best, its growth rates have been inferior and it biases nations towards constant recession or stagnancy.
Further, and most importantly, it is incapable of meeting large variations in aggregate demand that arise from time to time.
In that case, I agree with Charles Dumas who says an orderly break-up is essential:
… the simultaneous return to freely floating national currencies offers both the best economic outlook for the member states, and the least damaging euro-decommissioning process.
This would be challenging, of course, but it could be done. All domestic deposits, transactions and obligations (including home mortgages) would be converted 1-to-1 into each new home currency. The ECB would become the guardian of a legacy “European Transition Currency” into which cross-border euro contracts would be converted at the 1:1 ratio, but without money-creating powers … And leaving the euro area is likely to be cheaper than staying in it. A recent report on the Netherlands and the euro estimated the net initial cost to that country of leaving would be 51 billion euros, an amount the economy would more than recoup within two years, by not having to continue contributing to euro-area bailouts.
All of which I have been advocating for a long while now.
The point – also made by Charles Dumas – is that the real situation in many parts of Europe is now dire – Spain is heading for Depression-level unemployment levels (and they already have more than 50 per cent of their youth out of work). This trend is being mirrored right across Europe at varying intensities.
The current policy tack will make the situation worse.
As Dumas says:
The politics of Mediterranean Europe could soon be seriously destabilized. It is less than 40 years since the dictatorships of Franco in Spain, Salazar and Caetano in Portugal, and Papadopoulos in Greece ended. Their equivalents may not be about to return yet, but the risk of turmoil is increasing rapidly.
By hook or by crook, the situation will have to change. Orderly change will be preferred although I think the Euro elites will hang onto their mantra for a while yet as the situation crumbles further.
But advanced nations cannot endure 50 per cent youth unemployment rates for long periods. They cannot endure 25 per cent unemployment rates overall for long periods.
Governments cannot stand for election with any credibility while their policies increase suicide rates and impoverish increasing numbers of their citizens.
That is enough for today!