Working Paper No.

721
The Euro Debt Crisis and Germanys Euro Trilemma by Jrg Bibow

Levy Economics Institute of Bard College May 2012

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B!T" CT This paper investigates the causes behind the euro debt crisis particularly ;ermany<s role in it. It is argued that the crisis is not primarily a =sovereign debt crisis> but rather a ?t6in@ banking and balance of payments crisis. Intra.area competitiveness and current account imbalances and the corresponding debt flo6s that such imbalances give rise to are at the heart of the matter and they ultimately go back to competitive 6age deflation on ;ermany<s part since the late !"",s. ;ermany broke the golden rule of a monetary union4 commitment to a common inflation rate. -s a result the country faces a trilemma of its o6n making and must make a critical choice since it cannot have it all Aperpetual e*port surpluses a no transfer 5 no bailout monetary union and a =clean > independent central bank. Bisdiagnosis and the 6rongly prescribed medication of austerity have made the situation 6orse by adding a gro6th crisis to the potpourri of internal stresses that threaten the euro<s survival. The crisis in Euroland poses a global =too big to fail> threat and presents a moral ha%ard of perhaps unprecedented scale to the global community. #eywords$ EuroC Bonetary 'nionC Banking CrisisC Balance.of.Payments CrisisC (overeign Debt CrisisC Competitiveness ImbalancesC Eiscal TransfersC BailoutsC -usterity JE% Classi&i'ations$ E32 E+2 E+# E$+ E9$ ;,!

1( )*T"+D,CT)+* This paper investigates the causes behind the euro debt crisis particularly ;ermany<s role in it. It is argued that the crisis is not primarily a =sovereign debt crisis> and that policy prescriptions derived from this popular misdiagnosis 6ill make the situation only 6orseAa ?t6in@ banking and balance of payments crisis. Intra.area competitiveness and current account imbalances and the corresponding debt flo6s such imbalances give rise to are at the heart of the matter and they ultimately go back to competitive 6age deflation on ;ermany<s part since the late !"",s. ;ermany reneged on the golden rule of a monetary union4 commitment to a common inflation rate. -s a result the country faces a trilemma of its o6n making and must make a critical choice since it cannot have it allAperpetual e*port surpluses a no transfer 5 no bailout monetary union and a =clean > independent central bank. (tarting 6ith a comparative analysis of the budgetary and e*ternal position of Euroland in global perspective in section 2 section 9 highlights that intra.area imbalances rather than Euroland<s aggregate position are at issue. -s this finding implies that key institutions and policies have failed in securing the convergence and cohesion re&uired for Economic and Bonetary 'nion ?EB'@ member countries the analysis in section 3 %ooms in on the part played in all this by ;ermany Euroland<s core country and traditional =stability anchor.> /aving identified 6age divergences as the critical factor section + investigates ho6 the =sick man of the euro> eventually re.emerged as Euroland<s apparent po6erhouse. (ection $ investigates ;ermany<s vulnerability and highlights a critical trilemma facing the country. (ection 8 6arns that unconditional austerity the supposed panacea favored by ;ermany is turning Euroland into today<s foremost threat to global stability and prosperityAa moral ha%ard challenging the global community to the utmost. (ection # concludes and offers policy recommendations. ;ermany<s ill.guided policies have burdened the EB' 6ith imbalances and debt legacies that 6ill be very difficult to overcome 6ithout reforming the EB' in the direction of a full.blo6n fiscal union. There is a non.negligible risk that the political process may not produce timely decisions before European Central Bank ?ECB@ li&uidity runs dry.

2( E,"+% *D )* G%+B % -E"!-ECT).E Erom looking at the area<s aggregate situation it is far from obvious 6hy Euroland is today<s global hotspot of instability. In particular seen from a global perspective Euroland<s public finances do not appear to be in especially poor shape.

-fter hovering around 9 percent in the first half of the 2,,,s Euroland<s deficit ?.to. ;DP@ ratio briefly declined 6hen the currency area belatedly Foined the global boom in 2,,$.8 then deteriorated to Fust over $ percent as the global crisis struck. It is forecast to decline further from its 3 percent level in 2,!! to 9 percent this year. ;overnment deficits deteriorated far more sharply in the '( 'G and Hapan 6ith only little improvement from near !, percent levels forecast for this year in all three cases.

Debt ?.to.;DP@ ratios sho6 a similar global constellation. While starting from a some6hat higher level of around 8+ percent the rise in Euroland<s debt ratio since the global crisis has been less steep than in the other three cases. Public debt of the '( 'G and Euroland 6as all in the neighborhood of !,, percent of ;DP by 2,!2 6hile Hapan is seen in a league of its o6n 6ith a debt ratio of over 2,, percent.

0or does a comparison of current account positions suggest any special vulnerability in the case of Euroland. While stagnant Hapan is notorious for running a large current account surplus position both the 'G and especially the '( had large deficit positions prior to the global crisis. These have shrunk since then ?'(@ or may even be on the verge of disappearing today ?'G@. By contrast Euroland<s current account position has been fairly balanced throughout the euro<s e*istence 6ith small surpluses in most years interrupted by small ?oil.price.driven@ deficits in 2,,, and 2,,#. This seemingly favorable comparison 6ith other maFor rich countries may have encouraged complacent self.perceptions prevalent among key Euroland authorities prior to the global crisis 6ho often felt compelled to lecture foreign peers on their supposed failings peddling the purportedly superior =stability.oriented> 6isdom that had come to guide the design of institutions and policies in Euroland habitually portrayed as an =island of stability> surrounded by precarious global currents. In particular the Euroland authorities never tired of 6arning of the heightened risks posed by irresponsibly large =global ?current account@ imbalances > a malign un6inding of 6hich they had feared Euroland might become a victim of despite Euroland<s lack of any contributing role in their buildup in their vie6. 0icely capturing the mood of European pride about being a =pole of stability for the global economy > European 'nion ?E'@ Commissioner for Economic and Bonetary -ffairs Hoa&uIn -lmunia ?2,,#@ blissfully declared in the fore6ord to the official =EB'J!,> success story volume4 - full decade after EuropeKs leaders took the decision to launch the euro 6e have good reason to be proud of our single currency. The Economic and Bonetary 'nion LEB'M and the euro are a maFor success. Eor its member countries EB' has anchored macroeconomic stability and increased cross border trade financial integration and investment. Eor the E' as a 6hole the euro is a keystone of further economic integration and a potent symbol of our gro6ing political unity. -nd for the 6orld the euro is a maFor ne6 pillar in the international monetary system and a pole of stability for the global economy. -s the euro area enlarges in the coming years its benefits 6ill increasingly spread to the ne6 E' members that Foined in 2,,3 and 2,,8. While the grand =island of stability> illusion 6as to unravel shortly even by the spring of 2,!2 the Euroland authorities are still playing catch.up 6ith events. When &uite uncharacteristically the International Bonetary Eund urged its members to set stimulus plans in early 2,,# the 8

Euroland authorities responded that they 6ould have none of that arguing that it 6ould harm the

credibility of the (tability and ;ro6th Pact.! The core of Europe had entered recession in the spring of 2,,# but the authorities remained in complete denial until the fall. Even the Lehman failure at first failed to a6ake them from their much.cherished dream that stability.oriented policies had kept the Euroland house in order so that any storm 6ould soon be past. Commenting on '( rescue measures initiated in response to the Lehman failure ;erman finance minister Peer (teinbrNck declared in late (eptember 2,,# that =this crisis originated in the '( and is mainly hitting the '( ... LIn Europe and ;ermany such a package 6ould beM neither sensible nor necessary.>2 (tarting in )ctober 2,,# Euroland agreed to participate in globally coordinated stimulus measures designed to counter the global crisis albeit never more than half.heartedly as this 6as against their conviction. (o 6hen the 6orld economy had barely turned the corner and 6hile the situation in Euroland in particular 6as still especially precarious the Euroland authoritiesA under ;erman leadershipAbegan to pester their ;.2, partners to start shifting policy focus a6ay from stimulus and to6ard austerity.9 -ll along the Euroland authorities maintained their self. righteous vie6 that Euroland had been hit as an innocent bystander by an e*ternal crisis that it had shared no responsibility in provoking and that the rest of the 6orld 6ould be 6ell.advised to follo6 Euroland<s model of stability.oriented policymaking ?see Bibo6 2,,3 2,,$a 2,,8b 2,,"a b@. The facts as they 6ere presenting themselves to the eyes of more neutral and vigilant observers in ever greater clarity revealed a very different picture though. Even earlier starting in the spring of 2,,8 more and more signs 6ere emerging indicating that European banks had built up large e*posures to '( mortgage risks that European banking supervisors seemed 6holly una6are of. In so doing European banks had provided an important helping hand in sponsoring the '( housing bubble of the 2,,,s that 6as bursting at that time. In fact the Lehman collapse 6hich 6as sending the global financial system and interbank markets in particular into cardiac
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(ee David Wessel =Trichet4 0o fiscal stimulus here please > Wall Street Journal Eebruary 8 2,,#. Bertrand Benoit =;ermany sees an end to '.(. hegemony > FT.com, (eptember 2$ 2,,#. 9 (i%eable fiscal stimulus packages had been agreed upon at the ;.2, summit meetings in Washington in 0ovember 2,,# and in London in -pril 2,,". Launched at the ;.2, summit meeting in Pittsburgh in (eptember 2,," the =Erame6ork for (trong (ustainable and Balanced ;ro6th> has become the centerpiece of economic policy coordination among members committing ;.2, members to =6ork together to assess ho6 Ltheir nationalM policies fit together to evaluate 6hether they are collectively consistent 6ith more sustainable and balanced gro6th and to act as necessary to meet LourM common obFectives> ?;.2, 2,,"@. Turning a6ay from their previous position that fiscal stimulus should be maintained until recovery 6as assured largely under ;erman pressure the ;2, Toronto summit in Hune 2,!, then established fiscal consolidation as the ne6 policy priority ?Parkin 2,!,@.

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arrest made it clear that European banks had behaved especially recklessly in their gambling in foreign lands namely by tolerating a huge short dollar position that even the ECB as their home lender of last resort 6ould be unable to look after ?at least 6ithout the cooperation of the '( Eederal Oeserve met through currency s6ap arrangements bet6een the central banks in due courseAsee Baba BcCauley and Oamas6amy 2,,"C BcCauley and von Peter 2,,"C Bc;uire and von Peter 2,,"C Borio and Disyatat 2,!!@. Oeckless global adventures of European banks and the buildup of corresponding global e*posures meant that Europe 6as about to have a maFor banking crisis on hand. In this 6ay the '( =subprime mortgage crisis > as it 6as initially called 6as not much of an =e*ternal> shock at all but an internal credit shock from the beginning. -las on top of stress due to foreign e*posures property market bubbles closer to home started bursting very much in tandem 6ith events across the -tlantic. In this regard the ECB<s tightening binge initiated in late 2,,+ had surely played its part in the anything.but.preemptive bubble =popping> that 6as going to re&uire a lot of =mopping up> at the home front too ?much to the disappointment of ECB propaganda on this countAsee ECB 2,,+ and Bibo6 2,,+ for instance@. Together these events Aand the unfolding banking crisis they heraldedA6ere going to undermine the continuation of lush intra.area capital flo6s that severely unbalanced demand gro6th in Euroland had come to depend upon. -s 6ill be developed in detail belo6 Europe<s banking crisis is inherently intert6ined 6ith an intra.EB' balance of payments crisis. /o6ever in the minds of the Euroland authorities the illusion of Euroland as an innocent bystander that got hit by a '(.made e*ternal crisis survived the Lehman failure for another year 6hen it finally gave 6ay to a fresh illusion e&ually cherished until this day namely that Euroland has fallen victim to a =sovereign debt crisis.> (tarting in late 2,," events in ;reece a mere fortieth part of the Euroland economy came to epitomi%e the evil po6ers of fiscal profligacy and 6ere &uickly identified as the alleged root cause of all euro troubles.3 Debunking this ne6 myth 6ill re&uire taking a closer look inside Euroland.

Earlier in 2,," 6ell before ;reece moved into the spotlight market stress follo6ing a series of rating do6ngrades of Ireland had prompted ;ermany<s finance minister Peer (teinbrNck to declare4 =the euro.region treaties don<t foresee any help for insolvent countries but in reality the other states 6ould have to rescue those running into

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difficulty> ?Benoit 2,,"@.

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,*)T1 T %% The Baastricht regime of EB' is designed for stabilityAto satisfy and e*port ;erman =stability culture.> (tability is believed to come about through the ECB<s ?price.@ stability?.only@.oriented monetary policy of keeping inflation =belo6 but close to 2 percent> paired 6ith =sound> public finances that is budget deficits belo6 9 percent ?and balanced or in surplus over the course of the cycle as prescribed by the so.called =(tability and ;ro6th Pact>A(;P@. When Euroland became home of acute debt market disruptions in 2,!, ECB representatives 6ere &uick to point out that independent central bankers had dutifully delivered on their part of the deal4 6ith an average inflation rate of !."" percent bet6een !""" and 2,!! the masters of Europe<s monetary union 6ere surely faultless ?Trichet 2,!!@. It 6as the economic union part of the =EB'> that had failed and a look at budget deficits made it seemingly obvious to identify finance ministers as the villains in the play.

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In particular for long fudging its budgetary numbers ;reece had run budget deficits that 6ere persistently above the 9 percent mark both before and since Foining Euroland. When a ne6 incoming government brought this matter to daylight in the fall of 2,," yields on ;reek government bonds surged effectively shutting off the ;reek government<s access to market funding in due course. With fiscal misdoings on the part of ;reek profligates easily identified as the cause of ;reek troubles old ;erman fears that had inspired the =no bailout> clause of the Baastricht Treaty and the later (;P 6ere seemingly verified in 2,!, as the =sovereign debt crisis> spread across Euroland and beyond. - number of observations are in order here about the rather diverse budgetary situation that has characteri%ed Euroland both prior to and since the global crisis of 2,,#.". Eirst ;reece clearly is an outlier. While other member<s fiscal balances primarily reflect distinct cyclical patterns control of public finances in ;reece does appear to have been a matter of some neglect. (econd running large budget surpluses since the euro<s launch Einland is the opposite outlier. It is note6orthy that only a decade earlier Einland had found itself in a similar fiscal situation as ;reece is in today. The turnaround in Einland<s fiscal fortunes involved a large depreciation of the Einnish markka against the deutschmark of +, percent bet6een !""! and !""9 ?only half of !9

6hich 6as recovered by !"""@ that restored the country<s competitiveness and together 6ith a refocusing of its trade a6ay from the collapsed (oviet 'nion paved the 6ay for large current account surpluses. Third in running both favorable budgetary and e*ternal positions Einland is aligned 6ith -ustria the 0etherlands and ;ermany today. Eourth ho6ever among the group of the fiscally virtuous ;ermany actually had budget deficits of around 9 percent of ;DP for most of the time since !""!. Prior to its current favorable position ;ermany<s budget turned into balance only briefly and on t6o occasions4 at the peak of the dot.com boom in 2,,, and again at the peak of the global boom of the 2,,,s. Eifth the opposite group of the fiscally challenged includes t6o countries that actually ran budget surpluses prior to the crisis4 Ireland and (pain. These t6o countries then sa6 the sharpest deterioration in their fiscal balances as crisis struck. (i*th 6hile Portugal<s budgetary deterioration 6as less drastic the country<s current predicament in terms of re&uired austerity is in the same order of magnitude as that of (painC although its economic 6eight in Euroland is much smaller. Einally Erance the number 2 member in terms of si%e is currently in deeper fiscal doldrums than Italy Euroland<s number 9C 6hich has a more tarnished fiscal reputation and is considered part of the e*tended =PII;(> group ?Portugal Ireland Italy ;reece and (pain@. Turning to debt ratios the steepest and largest ?percentage.point@ rises have occurred in

Ireland ;reece Portugal and (pain. While ;reece is again the outlier ?or frontrunnerP@ at the high end of the spectrum Ireland has suffered the greatest crisis impact by far moving from top performer to among the three 6orst. While starting out from a much higher level the rise in Italy<s debt ratio has been more moderate and comparable to the other countries. Perhaps the most note6orthy trend of all is the almost synchronous doubling in the debt ratios of both ;ermany and Erance from 3, percent to over #, percent since !""!A6hen fiscal consolidation 6as promoted to the highest ranking economic policy priority becoming the embodiment of the Baastricht 6isdom of economic policymaking.

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I observed above that the fiscally vituous EB' members also share another common feature4 current account surplus positions. While Euroland<s overall current account positon has been roughly in balance throughout the fiscally challenged EB' members are all to be found on the side of current account deficit positions. This finding is not a mere coincidence. -s Wolf ?2,!2@ recently observed that =the euro%one is at 6ar 6ith double.entry bookkeeping > a &uick refresher in national income accounting may be in order here. 0ational income accounting for a closed economy informs us 6ith irrefutable certainty that the public sector of any one country can only run a budget surplus that is spend less than its income if the private sector does the opposite that is spends more than its aggregate sectoral income. Private sector =overspending> may either be driven by the business sector ?the dot.com investment boom being an e*ample@ or by households ?typically housing booms@ or both. By contrast if the private sector should embark on a sharp retrenchment as 6as the case in the global crisis of 2,,#." the public sector balance 6ill inevitably be the mirror image 6ith revenues falling and e*penditures rising reflecting the 6orking of the =automatic ?fiscal@ stabili%ers.> In open !+

economies an e*ternal sector needs to be added to the set of accounts and sectoral balances as captured by the balance of payments on current account. By logical necessity any particular country can only succeed in running a public sector surplus if either its o6n private sector and5or the foreign sector =overspend.> In the Euroland conte*t (pain and Ireland provide e*amples of the former propelled by property market booms that not only allo6ed for national public sector budget surpluses but for current account deficits on top of thatC 6ith private sector bubble hangovers today being all the 6orse for that. ;ermany -ustria Einland and the 0etherlands provide e*amples of the latter4 countries that relied on current account surpluses to help consolidate their o6n public finances. Being at 6ar 6ith double.entry bookeeping these countries may even convince themselves of their o6n virtuousness but their success 6as actually only made possible by others< =sinfullness.> -s to the aim of the (;P e*cept by courtesy of the rest of the 6orld Euroland as a 6hole can actually only achieve a balanced public sector position if its private sector stops saving in the aggregate. These remarks should not only 6arn us of Euroland<s ill.guided obsession 6ith the ;reek outlier sponsoring the convenient illusion of a =sovereign debt crisis.> Bore generally an e*clusive focus on public sector deficits only also runs the risk of seriously misdiagnosing private sector debt fragilities. Eor at the heart of today<s euro debt crisis is an intra.area balance of payments crisis caused by seriously unbalanced intra.area competitiveness positions and theAlargely privateA accompanying cross.border debt flo6s. This issue is the subFect of the ne*t section. (uffice to mention that the future performance of Euroland 6ill not so much depend on small members such as -ustria Einland and the 0etherlands running current account surpluses nor on other small members such as ;reece Ireland and Portugal running current account deficits. The real issue is the huge ?almost !,.percentage.pointQ@ shift in ;ermany<s current account position after 2,,, and the opposite shifts that have occurred in the other larger member countries. While (pain number 3 in si%e has shrunk its current account deficit through austerity.driven income compression much in line 6ith the smaller PII;( the coming adFustment in Italy and Erance is bound to add enormous spin to Euroland<s ongoing debt deflation process.

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4( +")G)*! +0 D).E"GE*CE! *D B,)%D,- +0 )*T" 5 "E )MB % *CE! Current account imbalances can arise for a number of reasons. The follo6ing t6o 6ere the most relevant in the Euroland conte*t4 first competitiveness positions running out of kilterC and second divergent domestic demand gro6th rates. Closely intert6ined these t6o influences actually reinforced each other o6ing to the 6orking of the Baastricht regime. In general the evolution of competitiveness at the national level is mainly shaped by t6o factors4 first the rate of increase in 6ages ?and other costs@ relative to the rate of productivity gro6thC and second the e*change rate. -s Euroland has eliminated the e*change rate factor completing the long.term %eal of getting rid of the risk of beggar.thy.neighbor policies through competitive e*change rate devaluation only the former factor remains relevantAattaining paramount importance in maintaining internal balanceQ Geynes had identified aggregate 6age trends interacting 6ith national monetary policies as shaping countries< competitiveness and net e*port performance in The General Theory. The !8

vital importance ofArelativeAnational 6age and productivity trends inside a monetary union can be most easily understood in terms of Bundell<s ?!"$!@ seminal contribution to =optimum currency area> ?)C-@ theory focusing on =asymmetric shocks> and ho6 either market mechanisms and5or policy responses might help to rebalance economies. Consider a shift in demand favoring ;erman over Erench cars leading to out.of.sync cyclical positions and trade imbalances bet6een the t6o countries subFected to the asymmetric shock. -n easy 6ay to counter the shock involves e*change rate realignment. If this is not an option and in a currency union it isn<t the same outcome could be achieved through 6age.price fle*ibility 6ith an =internal devaluation> in Erance and5or the opposite in ;ermany. Doubting that 6age.price fle*ibility 6ould be sufficient as a substitute for e*change rate adFustment Bundell concluded that countries ?using Canada and the '( as e*amples@ 6ould have to rest their hopes on factor mobility as an alternative adFustment mechanism instead. Importantly any of the considered market or policy adFustments 6ould only become necessary in the presence of asymmetric shocks shocks that hit countries differently and hence unbalance the currency union. -rguably the most important implication of Bundell<s analysis is the need for common 6age bargainingAor some form of area.6ide coordinationAso as to prevent national 6age trends from becoming the source of asymmetric shocks. Europe had learned its lessons from the !"9,s competitive currency devaluations. Erom the beginnings of European integration it 6as emphasi%ed that e*change rates 6ere a =matter of common concern > and the euro provided the =coronation> in handling this very threat. 'nfortunately the issue then someho6 fell through the cracks probably o6ing to Europe<s blind obsession 6ith structural reform of labor markets that the euro 6ould make national 6age trends all the more important and most fundamentally very much a =matter of common concern> indeed. -s a rule if 6ages and productivity gro6 at the same rate =unit.labor costs> stay steadyC

and so 6ould e*ternal competitiveness of countries that have the same gro6th rate in unit.labor costs ?assuming that profit margins and indirect ta*es etc. remain unchanged too@. -s unit.labor costs are the foremost determinant of inflation ?beyond the very short run of any temporary influences@ the target for the rate of inflation chosen by the authorities for any particular country ?or group of countries@ thereby also provides the standard or norm for the gro6th rate of nominal unit labor costs. Essentially a monetary union is a commitment to a common inflation rate. !#

Europe<s EB' meant a commitment of member countries to a common inflation rate that is also very lo6 and guarded by anAuntouchableAindependent central bank. The guardianship of the euro by an independent central bank 6as a ;erman sine qua non for giving up the country<s beloved deutschmark. ;ermany thoroughly misunderstood its o6n historical record though and ho6 monetary union 6ould change its o6n position. Ironically it 6as ;ermany of all countries that came to depart from its o6n historical stability norm under the Baastricht regimeA6ith potentially fatal conse&uences for the euro. -ccording to )C- theory common 6age bargainingAor 6age coordinationAis critical in preventing asymmetric shocks and sustaining a monetary union.

The ECB defined price stability as an area.6ide harmoni%ed inde* of consumer prices ?/ICP@ inflation rate of =belo6 but close to> 2 percent. In the absence of any asymmetric shocks that re&uire adFustment in relative competitiveness positions this implies that national unit labor cost trends should converge to 2 percent. Convergence to a common 2 percent trend 6ould be in !"

line 6ith monetary union members< commitment to a uniform inflation rate as 6ell as 6ith the older commitment predating monetary union of non.recourse to competitive devaluation strategies. In the !"#,s large disparities in unit labor cost gro6th rates still prevailed. /istorically -ustria and the 0etherlands 6ere most closely aligned 6ith trends in ;ermany. In the !"#,s the 0etherlands actually systematically underbid ;ermany ?Bibo6 2,,!@Aproviding it 6ith some scope for slippage later on. While Erance converged to the ;erman standard by the mid.!"#,s Italy and (pain took until the early !"",s. -t the start of the euro Euroland had fully converged to the historical ;erman norm of 2 percent and by and large has stayed close to that norm ever sinceAe*cept for ;ermany itself that is. Eor starting by !""$ ;ermany shifted a gear do6n and henceforth established its o6n ne6 lo6er norm of %ero nominal unit labor cost inflation.

Importantly the decline in unit labor cost gro6th 6as not due to any acceleration in productivity gro6th but caused by a marked decline in 6age inflation. In other 6ords not ;erman engineering ingenuity but 6age restraint gave ;erman e*porters an e*tra boost. 2,

;erman productivity gro6th since !""# 6as no more than average similar to that of Erance and Portugal 6ell belo6 that of ;reece and Ireland as the outperformersC 6hile Italy and (pain stand out as the productivity gro6th laggards.

With 6age repression as the true cause of ;ermany<s competitieness gains inside Euroland the point is that Fust like inflation differentials unit labor costs gro6th differentials are cumulative. If sustained over a number of years divergent trends build up to ever larger distortions in relative competitiveness positions ?Bibo6 2,,$bC Elassbeck 2,,8@.

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0ot ;ermany but Erance most loyally stuck to the EB' commitment to a common 2 percent inflation rate throughout the euro era. )f the other partners Italy erred some6hat in the up6ard direction and even more so (pain and the smaller of the PII;( countries. )n the other hand of the smaller current account surplus countries -ustriaAand to a small e*tent Einland tooAstayed persistently belo6 the stability norm. But of all partner countries it is ;ermanyA the old stability anchor of the E*change Oate Bechanism of the European Bonetary (ystemA 6ho stands out as the true outlier of the 6hole pack. There can be no serious doubt that ;ermany<s departure from its o6n historical stability norm provided the main cause behind the build.up of intra.area current account imbalances. The ne*t section 6ill investigate ho6 the Baastricht regime further amplified divergences driven by unbalanced 6age trends. ;oing for6ard 6hat is most important is that 6hile the PII;( have mean6hile converged back to6ard the price level ?or unit labor cost@ path originally committed to a huge competitiveness gap remains bet6een ;ermany and the rest. This vital challenge to the euro<s survival 6ill be taken up again in section # belo6. 22

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In the spring of !""# ;ermany barely met the 9.percent deficit hurdle that by the rules of the Baastricht Treaty 6as so critical in getting the euro off the ground by !""". (tarting from a balanced budget in !"#" the initial budgetary impact of ;erman unificationA6hich essentially bankrupted much of the East ;erman economy over nightA6as a deficit of 2.# percent in !""!. )6ing to the authorities< thoroughly ill.guided macroeconomic policy response to the unification challenge the West ;erman economy too ?and much of the rest of Europe@ 6as then recklessly pushed into recession in !""2."9 ?Bibo6 2,,9@. The labor market and budgetary conse&uences of the latter policy mistake 6ere to shape the country<s economic policies until the global financial crisis in 2,,#.,"A6hile unconditional fiscal consolidation 6as made one never.to.be.&uestioned pillar of ;erman policymaking and 6age restraint the other. - severely unbalanced economy persistently high unemployment and continued budgetary stress 6ere the predictable fallout of a policy 6isdom that notoriously ignores domestic demand management. -part from t6o brief interruptions in 2,,, and 2,,8 6hen e*port.driven booms temporarily balanced ;ermany<s public budget the country<s finance ministers found themselves engaged in a Rui*otic fight 6ith the Baastricht 9.percent ceiling choking gro6th through austerity measures and 6age restraint and 6atching the deficit refusing to decline as a result. ;ermany 6as among the first countries to breech the (;P<s magic number in the early 2,,,s famously dodging Brussels< e*cessive deficit procedure by colluding 6ith Erance on the matter. -t that time ;ermany even became kno6n as =the sick man of the euro.>

29

This uncomplimentary title 6as besto6ed upon ;ermany for good reason. It 6as not only a reflection of the fact that the country<s overall ;DP gro6th 6as very meager indeed. In the period 2,,!.2,,+ ;ermany literally managed to gro6 ?rather cra6l@ on one cylinder only4 ?net@ e*ports. Even 6hen domestic demand finally got ignited at the peak of the global boom in 2,,$. ,8 this mainly o6ed to e*port.induced investment 6hile private consumption remained e*traordinarily 6eak throughout. With domestic demand persistently =sick > thanks to unconditional austerity and 6age restraint e*ports 6ere ;ermany<s lifeline and soleAalbeit cyclicalAengine of gro6th. Protracted stagnation in ;ermany meant a correspondingly easier =one.si%e.fits.all> ECB stance for Euroland far too easy for the periphery 6here bubbles 6ere nourished as a result. 0ote then ho6 the Baastricht regime actually amplified the asymmetric shock that arose as Euroland failed to ensure common 6age bargaining. In essence once ;ermany<s national 6age trend diverged from the Baastricht stability norm negative feedback loops o6ing to regime.inherent forces made the partners drift apart ever farther. In particular as ;ermany embarked on relative 6age disinflation this meant the ECB<s =one.si%e.fits.all> monetary stance 23

became relatively tighter for ;ermany than in countries 6ith higher 6age and price inflation

2+

dampening credit gro6th and asset prices in line 6ith 6age deflation. Eurther head6inds arose as the stagnant economy triggered a budgetary s&uee%e in compliance 6ith the (;P as the deficit ratio e*ceeded 9 percent bet6een 2,,2 and 2,,+. Countries 6ith higher national 6age trends 6ould e*perience the opposite kind of regime.inherent forces at 6ork even more so as stronger gro6th performances makes 6ages diverge from the norm in the up6ard direction.+ While balancing Euroland<s e*ternal competitiveness is largely dependent upon the euro e*change rate internally balancing EB' partners< competitiveness positions has to run through unit labor costs. While Euroland<s aggregate current account position may be roughly balanced or not in principle individual countries< intra.area and e*tra.area current account positions may reveal diverse patterns depending on their respective trade orientations. The focus in the follo6ing is on ;ermany. Traditionally three.&uarters of ;erman e*ports are headed for European destinations. In the !"",s European 'nion members received roughly t6o.thirds and Euroland members Fust under half of ;erman e*ports. (ince 2,,# the shares of ;ermany<s traditional e*port markets have sho6n declining trends 6hile the share of non.European e*port destinations has been on the rise reaching 9, percent by early 2,!2. The ongoing shift in shares of ;erman e*port destinations is foremost a reflection of Europe being the outstanding laggard in the unbalanced global recovery from the 2,,#." crisis ?'0CT-D 2,!,@.

In Bay 2,,+ )tmar Issing the ECB<s first chief economist ?and having previously served that same role at the Bundesbank mastermind behind the ECB<s approach to =stability.oriented> monetary policy@ declared in reflecting back on his credo that =one si%e must fit all> made at the start of EB'4 =Today in light of the evidence gathered so far in the euro area I am more confident in saying4 S)ne si%e does fit allQ<> ?Issing 2,,+@. In 2,,+.$ this author raised alarm about intra.area divergences and imbalances at numerous European conferences including one in

2$

Brussels at 6hich European Commission and ECB representatives 6ere present. (ee Bibo6 ?2,,$b 2,,8a@.

28

- look at the composition.by.destination of ;ermany<s trade surpluses is most revealing as these are even more regionally concentrated in Europe. Boreover trade surpluses 6ith the E' and Euroland as shares of ;ermany<s overall surplus position 6ere rising from the early 2,,,s until the crisis as euro appreciation initially made ;erman e*ports less competitive internationally 6hile ;ermany 6as gradually gaining ground vis.T.vis its European partners 6ith trends peaking at shares of over #, percent and t6o.thirds respectively. In the conte*t of the ongoing crisis in Europe these trends have reversed 6ith booming ;erman e*ports to China and other fast.gro6ing emerging market economies partly offsetting the spreading gloom in ;ermany<s traditional European e*port markets. Within Euroland e*ports to and e*port surpluses vis.T.vis Erance 6ere still gro6ing in early 2,!2 6hile the crunch in the southern periphery had started hitting back on ;erman e*ports earlier already.

2#

(uffice to mention that 6hile merchandise trade surpluses dominate ;ermany<s current account position vis.T.vis Euroland 6age restraint has also contributed to reversing the previous trend of rising deficits in commercial services. In addition the country<s income balance has improved significantly in the 2,,,s reflecting developments in the international investment position ?IIP@ to be discussed shortly and is no6 about one.&uarter the si%e of ;ermany<s merchandise trade surplus and much e*ceeds ;ermany<s net transfers.

2"

While the European crisis is hurting ;ermany through direct regionally.concentrated e*port e*posures the crisis is also benefiting the country in t6o important 6ays4 first by depressing the euro and hence stimulating non.euro net e*portsC and second by depressing ;erman interest ratesAo6ing to the market convention of ;ermany as a safe haven. While the latter channel has contributed to more balanced gro6th of the ;erman economy than ever seen in the last decade 6ith net e*ports contributing =only> a third of ;DP gro6th since 2,!, ignoring ;ermany<s vulnerability to its European partners through financial e*posures may not suit the markets forever.

:( GE"M *1! .,%*E" B)%)T1$ DE*) % +0 GE"M *1! E,"+ T")%EMM C **+T % !T Eor the past t6o years stellar ;erman ;DP gro6th and a fast.improving government budget have much impressed the markets. With repeated bouts of panic engulfing the markets about the prospects of peripheral Euroland members capital flight has a6arded ;ermany record lo6 9,

interest rates. ;ermany<s safe haven status in the markets< current perception arises from a historical record featuring Bundesbank discipline as guarantor of deutschmark stability and fiscal solidity in pre.euro times. But Europe<s common marketAand much more soAthe common currency have tied ;ermany<s fiscal fate to Europe in more intricate 6ays than currently appreciated by the markets. (pecifically the build.up of intra.area imbalances in competitiveness and current account positions has created corresponding financial e*posures that are ultimately fiscal e*posures of enormous proportion. In section 2 above 6e illustrated that Euroland<s overall current account position has been roughly balanced since the euro<s inception 6hile large and persistent intra.area imbalances have built up. Wolf<s ?2,!2@ remark about Euroland being at 6ar 6ith double.entry bookkeeping 6as made in the conte*t of discussing a recent European Commission report related to ne6 E' regulation on the prevention and correction of =macro.economic imbalances> ?see European Commission 2,!2@.$ In addition to stating the obvious point that intra.area rebalancing 6ill have to involve both surplus and deficit countries alike it may be 6orth6hile to spell out some further national ?and international@ income accounting truths here highlighting the vital issue of stock. flo6 consistency in economic analysis as championed by the late Wynne ;odley. To begin 6ith a country that runs persistent current account surpluses such as ;ermany is thereby improving its net international investment position4 either paying off ?net@ foreign debts or ac&uiring ?net@ foreign assets. (tarting from near %ero net foreign assets in the late !"",s ;ermany<s creditor position reached 3, percent of ;DP by the end of 2,!,. 0ot only has ;ermany<s net foreign asset position improved so markedly the introduction of the euro has also seen a sharp rise in gross cross.border positionsAreflecting surging gross capital flo6s of all kinds ?EDI portfolio e&uity portfolio debt and other investments the latter including bank loans@. In principle it is not necessary that ;ermany<s rising gross and net foreign asset positions

should include any significant direct e*posures to deficit members that are among today<s euro
$

The Commission initially favored a symmetric treatment of current account surpluses and deficits in implementing the ne6 =Bacroeconomic Imbalances Procedure > 6hich ho6ever met stark resistance from ;ermany and the ECB holding stern vie6s on deficits representing sinfulness 6hile surpluses are really a sign of virtue. (o the Commission<s scoreboard on persistent current account imbalances came to feature an =indicative threshold> of 3 percent for deficits and an indicative threshold for surpluses of $ percent. With ;ermany and the 0etherlands Fust falling belo6 the $ percent threshold I bite my tongue and forego any further comment on ho6 much usefulness one might reasonably e*pect from this 6hole e*ercise.

9!

crisis countries. These countries might have borro6ed from third.party ?either member or nonmember@ countries 6hile ;ermany might have invested in '( Treasuries for instance. /o6ever 6hile gross capital flo6s have gro6n sharply globally and national balance sheets thus become more intert6ined in the process across the globe the degree of global financial integration is actually regionally concentrated and especially advanced 6ithin Euroland.

Discussing the developments and structure of ;ermany<s international investment position since the beginning of EB' until the end of 2,,8 the ;erman Bundesbank observes that a =decreasing home bias seems to have been offset by an increased euro.area bias> ?Deutsche Bundesbank 2,,#4 2+@. -t the beginning of the EB' ;erman investors< portfolio choices 6ere still strongly biased to6ard domestic securities and securities of other Euroland members 6ere underrepresented compared to their share of the global market. In the follo6ing eight years the Euroland shares in ;ermany<s foreign assets and liabilities surged beyond the corresponding levels of trade integration. -t the end of 2,,8 =;ermany is therefore more financially integrated in the euro area than it is in a real economic sense > the Bundesbank ?2,,#4 92

29@ concluded. Oeferring to both loans as 6ell as foreign securities holdings the Bundesbank

99

?2,,#4 !#@ also observed4 =The banking sector plays a central role in ;ermany<s increasing financial integration 6ith other countries. -lmost half of all of ;ermany<s e*ternal assets and liabilities U 6ere attributable to credit institutions at the end of 2,,8.> Both international =consolidated banking statistics > as compiled by the Bank for International (ettlements ?and related analyses such as -vdFiev 'pper and Vause 2,!,@ and an IBE study of =European financial linkages> ?Waysand et al. 2,!,@ constructing and analy%ing a ne6 database comprising bilateral e*ternal financial assets and liabilities confirm that ;ermany<s global financial integration is especially concentrated 6ithin Euroland. -nd it is through these heightened financial e*posures that ;ermany<s overall vulnerabilities to euro crisis countries and the euro<s fate arises. It turns out that =;ermany e*hibited more similarity than most other countries bet6een trade and financial links> ?Waysand et al. 2,!,4 !8@. In particular at the end of 2,,# ;ermany<s bilateral net IIPs 6ithin Euroland sho6ed large creditor positions vis.T.vis (pain ?8.+ percent of ;erman ;DP@ and Italy ?9 percent of ;DP@ almost e*clusively in the form of portfolio debt and other investments. In addition there is a large creditor position concentrated in other investments vis.T.vis the 'nited Gingdom ?$ percent of ;DP@ reflecting London<s role as an international banking center 6ith the 'G itself sho6ing large bilateral IIP creditor positions in other investments vis.T.vis (pain Italy and Erance. ;ermany<s bilateral IIPs vis.T.vis Ireland and Erance 6ere atypical from a ;erman perspective. While actually running trade deficits 6ith Ireland ;ermany has nonetheless built up a large creditor position vis.T.vis the euro crisis country 6ith a bilateral net IIP of + percent of ;DP concentrated in portfolio debt and especially other investments. In Erance<s case 6hile running up rising bilateral trade surpluses 6ith Erance ;ermany<s overall bilateral IIP 6ith its key Euroland partner is actually negative ?3 percent of ;DP@. This ho6ever includes a creditor position in the other investment category ?! percent of ;DP@ 6hich most likely is a reflection of the very active foreign business e*pansion of Erench banks both 6ithin Europe and globally. It is note6orthy that Erance<s overall net IIP has seen a shift from around positive !, percent of ;DP in the late !"",s to negative !, percent by 2,!,. 1et Erance too has large bilateral net creditor IIPs vis.T.vis Italy and (pain concentrated in portfolio debt and other investments. While it is clear from the IBE study that ;ermany is highly vulnerable to debt problems in the financially deeply integrated E' and Euroland be it through direct e*posures to Euroland 93

crisis countries ?(pain Ireland and Italy@ or through indirect debt e*posures via Erance and the 'nited Gingdom ?and to a lesser e*tent Lu*embourg@ it is 6orth6hile to highlight that these risks get crystalli%ed in peculiar 6ays inside Europe<s EB' today namely on the balance sheet of the Eurosystem. Ruarterly data sho6s the surge in ;ermany<s net IIP to 3, percent of ;DP at its peak at the end of 2,!, declining to 99 percent by the end of the third &uarter of 2,!! o6ing to negative valuation effects. While ;ermany<s net debtor position in portfolio debt largely reflects the role of bonds as reserve assets the rise in ;ermany<s positive net foreign direct investment ?EDI@ position offset the decline in its positive net portfolio e&uity position. )f greatest interest is the category =other investments > decomposed here by sector ?banks nonbanks government and monetary authority i.e. Bundesbank@. The stark fact is that after increasing fivefold from + percent of ;DP in 2,,3 to 2+ percent by the end of 2,,# ;erman banks< overall net creditor position has declined again to belo6 !+ percent of ;DP of late. 1et 6hile ;erman banks are cutting back fast on their international e*posures concentrated in Europe the Bundesbank<s net foreign asset position has soared in their stead largely taking the form of a surge in the ;erman central bank<s creditor position 6ithin the Eurosystem as reflected in rising Trans.European -utomated Oeal time ;ross settlement E*press Transfer system ?T-O;ET2@ imbalances.

9+

By linking 6holesale payment systems and money markets across Euroland T-O;ET2 is a core part of the technical infrastructure underpinning the euro providing for final settlement on the Eurosystem<s balance sheet. T-O;ET2 is essential to the implementation of area.6ide monetary policy and interbank refinancing activities. T-O;ET2 balances arise endogenously 6hen EB' members< balance of payments are not other6ise balanced over a certain period. It may be odd to think of flo6s of ?foreign e*change@ =reserves> inside a currency union especially since T-O;ET2 balances are obviously denominated in euro. But the buildup of ;ermany<s T-O;ET2 creditor balance is essentially the e&uivalent of =gold reserves> fleeing from else6here in the system to6ard the supposed safe haven ;ermanyAonly that those =gold reserves> are not e*actly consisting of gold but are more in the nature of overdraft loans made by the creditor central bank to the ECB. The si%e of the Bundesbank<s T-O;ET2 balances reached roughly one half of ;ermany<s net international investment position by the end of the third &uarter of 2,!! ?and have continued their rapid gro6th since@Amuch to the alarm of /ans.Werner (inn one of ;ermany<s most vocal economists and the Bundesbank 6ith a corresponding rise in an*ieties 9$

among the ;erman media and general public. While (inn ?2,!!a b@ recommends placing tight national caps on T-O;ET2 balances and re&uiring annual settlements of balances among member central banks by transfer of gold or foreign e*change reserves the Bundesbank is directing its criti&ue at the ECB<s =Long.Term Oefinancing )perations> ?LTO)@ of December 2,!! and Eebruary 2,!2 since =LnMeither providing life support to ailing banks nor propping up the solvency of sovereigns falls under the remit of monetary policy> ?Weidmann 2,!2bC see also Wilson 2,!2@. Both kinds of criti&ues or proposals are much beside the point. It is obviously true that T-O;ET2 balances could not arise 6ithout Eurosystem lending ?see Bindseil and GWnig 2,!!@. It does not follo6 that restricting either T-O;ET2 balances or Eurosystem lending if 6orkable at all 6ould make resolving the euro debt crisis any more likely. -t issue is a t6in banking and balance of payments crisis the underlying causes of 6hich 6ere analy%ed above. It is one thing that going for6ard continued competitiveness and current account imbalances presuppose continued financing ?flo6s@ for as long as they persist. It is &uite another that the debt.overhang legacies ?stocks@ accumulated up until no6 need to be rolled over 6hile regional financial integration may go into reverse and capital flight adds further vengeance to the plight. While the so.called =bailouts> of ;reece Ireland and Portugal through the European Einancial (tability Eacility ?EE(E@ may have provided the respective sovereigns some breathing space developments on the Eurosystem<s balance sheet largely reflect the broader issue of financial disintegration and capital flight featuring the free%ing of bank refinancing through standard euro money market channels. But the fate of sovereigns and banks in EB' member countries in a balance of payments crisis is closely intert6ined4 fiscally challenged sovereigns are constrained in supporting their commercial banks 6hile banks facing solvency and li&uidity challenges are constrained in supporting their sovereigns. -ny deterioration in one party<s rating pulls do6n the other<s too. In Europe<s EB' both are missing the support of a national central bank in full control of national currency issuance.8 -s a result it is left for the Eurosystem to substitute for fro%en interbank refinancing channels either through nationally targeted =Emergency Li&uidity -ssistance> ?see Whittaker 2,!!@ or through system.6ide li&uidity measures ?such as LTO)s@. Proposals to limit the role of ECB li&uidity support and5or target balances 6ould need to e*plain
8

Contrasting the chartalist approach 6ith mainstream optimum currency area theory ;oodhart ?!""#@ had clearly

98

identified these issues prior to the euro<s launch.

9#

ho6 default of banks and sovereigns in crisis member countries could be avoided 6ithout it. (uch proposals seem to be especially popular in ;ermany reflecting denial of 6hat I else6here dubbed =;ermany<s euro trilemma.> ;ermany<s euro trilemma is that ;ermany =cannot have all three4 perpetual e*port surpluses a no transfer5no bailout monetary union and a =clean> independent central bank> ?Bibo6 2,!2a@. While trade imbalances may persist for &uite some time at some point the prospect of bankrupting the debtor countries 6ill no longer escape the markets< attentionAat 6hich time private financing 6ill suddenly stop ?or reverse@. Trade imbalances may then be sustained by official lending but such emergency loans ?li&uidity =bailouts>@ do not solve the underlying solvency problemAcalling for debt forgiveness ?proper fiscal bailouts@. Therefore as a rule perpetual e*port surpluses as apparently aspired by ;ermany can only be sustained if offset by fiscal transfers. In fact replacing lending by transfers fiscal union proper could save and make the euro overnight. ;ermany eagerly designed the Baastricht regime so as to e*clude both transfers and bailouts of partners but ignored that running perpetual trade surpluses 6ould bankrupt its trade partners and thus make application of the forbidden medicine inevitable. The true choice facing ;ermany is to either bail out its bankrupt EB' partners or its o6n banks ?after the latter got hit by EB' partners< defaulting on their debts@. Procrastinating on this simple choice has brought the Eurosystem into play. )f course ;ermany also eagerly designed the Baastricht regime so as to shield the central bank system from public debt in order to protect its glorified independence. /o6ever given the intert6ined fate of sovereigns and national banks in Europe<s EB' not helping debtor sovereigns means 6orsening the troubles of debtor country banks. -ccepting its de facto role as lender.of.last. resort to banking systems ?rather than individual banks@ through emergency li&uidity provision in money markets the ECB has 6atched euro interbank funding markets migrate onto the Eurosystem<s o6n balance sheet. Hust as in the case of EE(E =bailouts> or sovereigns ECB emergency lendingAat e*tended maturities and on the basis of lightened collateral re&uirements Adoes not make the underlying solvency problems go a6ay either. -s creditor country banks are given time to pull out and capital flight turns rampant ;ermany<s ultimate choice is merely being transformed into bailing out the Bundesbank instead of ;erman banks.

9"

In short ;ermany is on the hook and there is no 6ay around it.# Debt overhangs could be more easily 6orked off if intra.area competitiveness positions 6ere restored 6ithout undermining gro6th. -las in continued denial of the country<s euro trilemma ;ermany also has her o6n vie6s on ho6 best to sustain gro6th 6hile maintaining ;erman ?Nber.@ =competitiveness> ?i.e. e*port surpluses@.

;( ,*C+*D)T)+* % ,!TE")T1 *D E,"+% *D ! T3E 8!)C# M * +0 T3E 7+"%D EC+*+M19 )ffering his vie6s on =rebalancing Europe > Bundesbank president Weidmann ?2,!2c@ observes that normally e*change rate movements are an important channel through 6hich unsustainable current account positions are correctedAeventually deficit countries devalue 6hile surplus countries revalue their currencies. The reaction this triggers in imports and e*ports then helps to bring the current account closer to balance. 0ote that Weidmann describes adFustment for both deficit and surplus countries as being rather symmetric in this case. /o6ever given that e*change rate =realignment> is no longer an option in a monetary union adFustment 6ill have to 6ork through prices 6ages employment and output instead 6hich for Weidmann raises the &uestion4 6hich countries have to adFustP /e offers a curiously asymmetric ans6er to this &uestion4 The typical ;erman position could be described as follo6s4 the deficit countries must adFust. They must address their structural problems. They must reduce domestic demand. They must become more competitive and they must increase their e*ports. ?Weidmann 2,!2c@ /is =typical ;erman ans6er> has some rather critical implications. What may perhaps be the market consensus vie6 suggests that 6hile deficit countries 6ill have to go through an =internal devaluation> to restore their competitiveness ;ermany
#

The Bundesbank<s ?2,!2@ -nnual Oeport of 2,!! makes the point that any losses arising from T-O;ET2 balances 6ould be shared 6ithin the Eurosystem according to partner central banks< capital shares in the ECB 28 percent in ;ermany<s case. Confirming this vie6 Weidmann ?2,!2b@ also states =-s I see it the Bundesbank<s T-O;ET2 claims do not constitute a risk in themselves because I believe the idea that monetary union may fall apart is &uite absurd.> This hypothesis presumes that either e*it or default of any one member 6ould not trigger a domino effect

3,

that sees the Bundesbank as the last man standingAas playing out in sovereign debt markets 6ith bonds.

3!

6ould e*perience the opposite form of =internal revaluation> through elevated inflationC 6ith Euroland =meeting in the middle > as indicated in Eigure !# by symmetric convergence to6ards the t6o percent price stability norm that EB' members originally committed to. Eor instance a ;oldman (achs study on the =price adFustment re&uired for e*ternal sustainability> estimates that 6hile Ireland is already on target ?or even slightly belo6@ Portugal still needs to engineer a real depreciation of 9+ percent ;reece around 9, percent (pain and Erance around 2, percent and Italy around !,.!+ percent. The same study observes that4 =the flipside of a re&uired depreciation in the periphery is a re&uired appreciation in ;ermany LofM close to 2+ percent> ?0ielsen 2,!24 2@ 6hich is supposed to be brought about by above.trend output gro6th driving inflation 6ell above 2 percent for a sustained period of time ?more than 3 percent for five to ten years in their simulation@.

32

Oest assured that the =meeting in the middle> option is not on the table. Erom a ;erman perspective this adFustment path amounts to deliberately making ;ermany less competitive ?although this 6ould be the obvious result in case of e*change rate realignment too albeit 6ith disinflationary effects in ;ermany@. In case of internal price.6age adFustments symmetry is not tolerable to Weidmann ?2,!2c@ asking4 =ho6 can Europe succeed in this 6orld if 6e 6illingly give up our hard.6on competitivenessP>" It is clear then that ;ermany intends to stay the
"

Oecall here that 6age repression rather than engineering ingenuity 6ere behind ;ermany<s =hard.6on competitiveness> in the first place.

39

course and force everyone else to converge to its ne6 %ero percent stability norm instead. If this means forcing Euroland ?e*.;ermany@ on a debt deflation course as it does so be it. -ctually not at all fearsome of deflation Weidmann ?2,!2c@ even ackno6ledges that =unless productivity gro6th increases miraculously it is certainly true that prices and 6ages 6ill have to fall in many cases Lbut erroneously asserts thatM 6e must not confuse such a one.time adFustment 6ith full. fledged deflation.> It is of course Weidmann himself 6ho is confusing a one.time adFustment 6ith a debt deflation process. ;ermany<s prescribed adFustment path is forcing even Erance the country that stayed most loyal the 2.percent course that EB' partners had committed to on a debt deflation course Foining Italy the other large EB' member already imposing brutal austerity. -s EB' contraction is bound to catch up 6ith ;ermany at some point the country<s constitutional =debt brake> 6ill then seal EB'.6ide austerity.driven debt deflation. -ssuming that the ECB may have both the po6er and the 6ill to prevent a full.blo6n debt deflation is anything but a safe bet Aespecially as the Bundesbank 6ill also continue to do her utmost to prevent aggressive monetary action. Weidmann<s speech contains further eye.opening observations that are of great interest to the global community. Weidmann is not oblivious to the fact that =surplus countries 6ill eventually be affected as deficit countries adFust. U -s the deficit countries import less and become more competitive surplus countries 6ill run lo6er surpluses.> 0ote here ho6ever that he e*pects ;ermany to =eventually> run =lo6er> surpluses not a balanced trade account. Eor Weidmann earlier in his speech made the point that =a large proportion of the current account deficits and surpluses result from trade 6ith countries outside the euro area.> In fact as the analysis in section + above has revealed the s&uee%ing of ;ermany<s intra.area trade surpluses through austerity measures in EB' partner countries is receiving some 6elcome offset since the austerity.6reckage in EB' partners is conveniently depressing the euro so as to stimulate ;ermany<s e*tra.area e*ports. -s other EB' partners =restore their competitiveness> and realign theirs 6ith ;ermany<s competitiveness for intra.area rebalancing they 6ould see their e*tra.area competitiveness improve accordingly too. It is thus of great interest that Weidmann ?2,!2a@ describes the improvement in ;ermany<s current account balance since the start of EB' as the result of =restoring> ;ermany<s competitiveness. -rguably if turning a nearly balanced current account into an # percent of ;DP surplus &ualifies as =restoring> competitiveness 33

Weidmann reveals to the 6orld community 6hat the true implications of a ;erman.led EB' really are4 supercharged mercantilism. Containing the threat posed by the self.inflicted Euroland crisis to the global recovery therefore has to focus on stemming euro 6eakening. Bindless austerity imposed continent.6ide under ;erman leadershipAfollo6ing the e*ample of ;ermany<s constitutional =debt brake > 6hich inspired the latest =strengthening> of the (;P as 6ell as the ne6 =fiscal compact>Ais suffocating domestic demand. -s ever the E'<s =gro6th strategy> is Fust doing =more of the same > that is moreAallegedly confidence.boostingAausterity and structural reform amounting to nothing but an anti.gro6th strategy.!, -dding a gro6th crisis to Euroland<s t6in banking.and.balance.of.payments crisis is bound to make solvency problems 6orse not better and turn Europe into an even bigger drag on global gro6th and a bigger risk to global stability. euro breakup is a non.negligible risk at this point since timely political agreement may not be forthcoming and ECB li&uidity proves unconvincing at some point.

!,

Varoufakis and /olland ?2,!!@ provide a constructive =modest proposalX for overcoming the euro crisis

3+

including a proper gro6th strategy.

3$

Erom a global perspective not only is Euroland shamelessly freeloading on e*ternal gro6th to offset suffocation of domestic demand through mindless area.6ide austerity ?see Eigure !"@ but adding insult to inFury Euroland is also hiFacking the IBE as global sponsor in backstopping the EE(E5E(B ?European (tability Bechanism@ =fire6all> for its purely homemade internal crisis. ;erman mercantilism had given rise to regional imbalances and global tensions in the pre.EB' past. The euro has multiplied ;ermany<s 6eightAand the gravity of ;erman policy vie6sAin the global economy. Effectively ;ermany the 6orld champion of moral ha%ard talk is holding the 6orld community hostage to a =too big to fail> global risk =made in ;ermany> today4 arising as the potentially lethal mi* of a dysfunctional monetary union paired 6ith the economic conse&uences of ;ermany<s denial of her euro trilemma. It is one thing that by freeloading on e*ternal gro6th Euroland is reneging on its commitments to the ;.2, process of global rebalancing. It is &uite another for Euroland to create the 6orld<s foremost threat to stability by self.inflicted folly and to not even be ashamed of =marshalling support from countries that are either more fiscally challenged or a lot poorer than the euro%one itself> to bail it out ?Bibo6 2,!2b@.

<( C+*C%,D)*G "EM "#! Critical fla6s in the design of the Baastricht regime together 6ith regime.antagonistic policies pursued by the monetary union<s largest member ;ermany have brought the current homemade crisis upon Euroland. The crisis is best understood as a t6in banking and balance.of.payments crisis. The re&uired resolution calls for bank recapitali%ation and symmetric internal rebalancing both of 6hich can only be achieved if gro6th is sustained alongside. In a large economy such as Euroland that means sustaining domestic demand gro6th. By erroneously treating the situation as a =sovereign debt crisis > calling for nothing but austerity and 6age deflation in debtor countries Euroland is adding a self.inflicted gro6th crisis on top of its predicament 6hich 6ill backfire by further aggravating the underlying t6in.crisis. Turning Euroland into the =sick man of the 6orld economy> creates a global =too big too fail> threat and corresponding moral ha%ard that is challenging the global community to the utmost. ;ermany<s ill.guided vie6s and conduct have burdened EB' 6ith imbalances and debt legacies that 6ill be very difficult to overcome 6ithout reforming EB' in the direction of a full. 38

blo6n fiscal union ?Bibo6 2,!,@. - fiscal union can take many different forms. -part from covering the Common -gricultural Policy the current E' budget of roughly ! percent of E' ;DP allo6s for some redistribution among members to foster catching.up and cohesion. -s the budget has to be balanced it cannot serve stabili%ation policy purposes. ;oodhart ?2,,8@ recalls t6o reports by the European Commission e*amining the minimum re&uirements of federal fiscal support of a common currency. While the first the so.called BacDougall Oeport of !"88 argued that a federal budget of + to 8 percent of EB' ;DP 6ould be necessary the latter report of !""9 titled =(table Boney (ound Einance > found that even at a much smaller annual cost of Fust ,.2 percent of EB' ;DP a stabili%ation mechanism for asymmetric shocks comparable to 6hat e*ists in the '( could be established. This minimalist =mutual insurance> version of a fiscal union 6ould still leave it to national fiscal policies to coordinate an appropriate union.6ide fiscal stance to counter symmetric shocks. The =no bailout> clause of the Baastricht Treaty denies any role for mutual insurance 6hile the ill.named (;P has never even attempted to establish proper coordination of fiscal stance. Eurther crimping members< scope for fle*ibility in dealing 6ith asymmetric shocks the ne6ly strengthened (;P cum =fiscal compact> once again utterly fail in filling the vital EB' policy vacuum of a missing gro6th strategyA6hich must include domestic demand managementQ Perhaps the greatest irony of a =euro ?crisis@ made in ;ermany> is that failure to prevent asymmetric shocks potentially arising from 6age divergences amounting to nothing else but follo6ing through the original thrust of monetary cooperation in Europe directed at forestalling competitive devaluations has much increased the re&uired scope for fiscal union in ensuring the euro<s future survival. There is a non.negligible risk that the political process may not produce timely decisions before ECB li&uidity runs dry.

3#

"E0E"E*CE! -lmunia H. 2,,#. =Eore6ord.> In E !"#$%Successes and &hallenges after Ten 'ears of Economic and onetary !nion. Brussels4 European Commission.

-vdFiev (. C. 'pper and 0. Vause. 2,!,. =/ighlights of International Banking and Einancial Barket -ctivity. ()S *uarterly +e,ie- December4 !9.2+. Baba 0. O.0. BcCauley and (. Oamas6amy. 2,,". ='.(. Dollar Boney Barket Eunds and 0on.'.(. Banks.> ()S *uarterly +e,ie-, Barch4 $+Y#!. Benoit B. 2,,". =;ermany Oeady to /elp Euro%one Bembers.> FT.com Eebruary !#. Bibo6 H. 2,,!. =Baking EB' Work4 (ome Lessons from the !"",s.> )nternational +e,ie- of .pplied Economics !+?9@4 299Y2+". AAA. 2,,9. =)n the Sburden< of ;erman unification.> (anca /a0ionale del 1a,oro *uarterly +e,ie- $!?22+@4 !98Y!$". L)riginally publishes as Working Paper 0o. 92#. -nnandale. on./udson 014 Levy Economics Institute of Bard College.M AAA. 2,,3. =-ssessing the ECB<s Performance (ince the ;lobal (lo6do6nY- (tructural Policy Bias Coming /ome to OoostP> Working Paper 0o. 3,". -nnandale.on./udson 014 Levy Economics Institute of Bard College. AAA. 2,,+. =Issing Eails to Hustify Claims That ECB Policy Elagged 'p Likely Threats.> Letter to the Editor Financial Times December !". AAA. 2,,$a. =Inflation Persistence and Ta*.Push Inflation in ;ermany and the Euro -rea4 (ymptom of Bacroeconomic BismanagementP> (tudies !52,,$. DNsseldorf ;ermany4 Institut fuer Bakrooekonomie und GonFunkturforschung ?IBG@. AAA. 2,,$b. =The Euro -rea Drifting -partYDoes Oeform of Labor Barkets Deliver Competitive (tability or Competitive DivergenceP> In Structural +eforms and Economic 3olicy. ET'C 8$.#$. acro2

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AAA. 2,,8a. =/o6 the Baastricht Oegime Eosters Divergence as Well as Eragility.> In P. -restis E. /ein and E. Le /eron ?eds.@ onetary 3olicies% odern .pproaches. Basingstoke 'G4 Palgrave. L)riginally published as Working Paper 3$,. -nnandale.on. /udson 014 The Levy Economics Institute of Bard College.M AAA. 2,,8b. =;lobal Imbalances Bretton Woods II and Euroland<s Oole in -ll This.> In H. Bibo6 and -. Ter%i ?eds.@ Euroland and the World Economy%Global 3layer or Global 4rag5 Basingstoke 'G4 Palgrave. L)riginally published as Working Paper 3#$. -nnandale.on./udson 014 The Levy Economics Institute of Bard CollegeM. AAA. 2,,"a. =The Euro and Its ;uardian of (tability4 The Eiction and Oeality of the !,th -nniversary Blast.> Working Paper no. +#9. -nnandale.on./udson 014 The Levy Economics Institute of Bard College. Eorthcoming in L..P. Oochone ?ed.@ 3olicy and &risis Cheltenham 'G4 Ed6ard Elgar. AAA. 2,,"b. 6eynes on onetary 3olicy, Finance and !ncertainty7 1iquidity 3reference onetary

Theory and the Global Financial &risis. London 'G and 0e6 1ork 014 Ooutledge. AAA. 2,!,. =(uffocating Europe.> Eurointelligence Hune 2+. AAA. 2,!2a. =To Bake or Break the Euro4 ;ermany<s Euro Trilemma.> Eurointelligence Eebruary 23. AAA.2,!2b. =Deal Is Indeed 'nacceptable.> Financial Times Letter to the editors -pril 3. Bindseil '. and P.H. Goenig. 2,!!. =The Economics of T-O;ET2 Balances.> (EB Discussion Paper 2,!!.,9+. Borio C. and P. Disyatat. 2,!!. ;lobal Imbalances and the Einancial Crisis4 Link or 0o linkP> BI( Working Paper 0o. 93$ Bay. Deutsche Bundesbank. 2,,#. =Bonthly Bulletin ;ermany<s International Investment Position (ince the Beginning of Bonetary 'nion4 Developments and (tructure.> )ctober pp. !+. 92. +,

AAA. 2,!2. =-nnual Oeport 2,!! T-O;ET2 Balances in the Eurosystem.> pp. 3#.+,. European Central Bank ?ECB@. 2,,+. =-sset Price Bubbles and Bonetary Policy.> (ulletin -pril4 38.$, European Commission. 2,!2. Oeport from the Commission -lert Bechanism Oeport Oeport prepared in accordance 6ith -rticles 9 and 3 of the Oegulation on the Prevention and Correction of Bacro.Economic Imbalances Brussels !3 Eebruary http455ec.europa.eu5economyZfinance5economicZgovernance5documents5alertZmechanism ZreportZ2,!2Zen.pdf Elassbeck /. 2,,8. =Wage Divergences in Euroland4 E*plosive in the Baking.> In H. Bibo6 and -. Ter%i ?eds.@ Euroland and the World Economy7 Global 3layer or Global 4rag5 London 'G4 Palgrave.Bacmillan4 39.+2. ;oodhart C.-.E. !""#. =The T6o Concepts of Boney4 Implications for the -nalysis of )ptimal Currency -reas.> European Journal of 3olitical Economy !3 ?9@4 3,8Y392. AAA. 2,,8. =Oeplacing the (tability and ;ro6th PactP> In H. Bibo6 and -. Ter%i ?eds.@ Euroland and the World Economy7 Global 3layer or Global 4rag5 London 'G4 Palgrave.Bacmillan4 !9+.!+9. ;.2, Leaders. 2,,". =The Leaders (tatement4 The Pittsburgh (ummit.> 23.2+ (eptember. Issing ). 2,,+. =)ne (i%e Eits -llQ - single Bonetary Policy for the Euro -rea.> (peech given in Erankfurt ;ermany 2, Bay. http455666.ecb.int5press5key5date52,,+5html5sp,+,+2,.en.html BcCauley O.0. and ;. von Peter. 2,,". =The '.(. Dollar (hortage in ;lobal Banking.> *uarterly +e,ie- Barch. Basel (6it%erland4 Bank for International (ettlements. Bc;uire P. and ;. von Peter. 2,,". =The '( Dollar (hortage in ;lobal Banking and the International Policy Oesponse.> BI( Working Paper 0o. 2"! )ctober. Bundell O.-. !"$!. =- Theory of )ptimum Currency -reas.> .merican Economic +e,ie+!?3@4 $+8Y$8+. +! onthly

0ielsen L./.W. 2,!2. =-chieving Eiscal and E*ternal Balance ?Part !@4 The Price -dFustment Oe&uired for E*ternal (ustainability.> European Economics .nalyst 0o. !25,! Barch !+ ;oldman (achs. Parkin B. 2,!,. =Berkel (eeks SDecisive< ;erman Cuts as ;eithner 'rges (pending.> (loomberg Hune $. (inn /..W. 2,!!a. =The ECB<s (ecret Bailout (trategy.> 3ro8ect Syndicate -pril 2". http455666.proFect.syndicate.org5commentary5the.ecb.s.secret.bailout.strategy AAA. 2,!!b. =The ECB<s (tealth Bailout. > ---.,o9.org Hune !. http455666.vo*eu.org5inde*.phpP&[node5$+"" Trichet H..C. 2,!!. =Economic and Bonetary 'nionYWhat We /ave -chieved and What We Bust Do 0e*t.> (peech Hanuary 8. Varoufakis 1. and (. /olland. 2,!!. =- Bodest Proposal for )vercoming the Euro Crisis.> Policy 0ote 2,!!59 Bay. -nnandale.on./udson 014 Levy Economics Institute of Bard College. Waysand C. G. Ooss and H. de ;u%man. 2,!,. =European Einancial Linkages4 - 0e6 Look at Imbalances.> IBE Working Paper WP5!,52"+. Weidmann H. 2,!2a. =Containing the (overeign Debt CrisisY;ermany<s Oole and Contribution.> (peech Be*ico City Eebruary 23 BI( Central Bankers< (peeches. http455666.bis.org5revie65r!2,22#b.pdf AAA. 2,!2b. =What Is the )rigin and Beaning of T-O;ET2 BalancesP> Deutsche Bundesbank Barch !+. http455666.bundesbank.de5do6nload5presse5publikationen52,!2,9!+.target2Zbalances.p df AAA. 2,!2c. =Oebalancing Europe.> (peech London Barch 2# BI( Central Bankers< (peeches. http455666.bis.org5revie65r!2,92"a.pdf +2

Whittaker H. 2,!!. =Intra.Eurosystem Debts.> Lancaster 'niversity Banagement (chool Barch 9,. Wilson H. 2,!2. =Bundesbank (&uares 'p to Draghi<s ECB.> Financial Times Barch !. http455666.ft.com5intl5cms5s5,5eb99+2"#.$9be.!!e!.#8$2. ,,!33feabdc,.html\a*%%!oDOIDiR+ Wolf B. 2,!2. =The Pain in (pain Will Test the Euro.> Financial Times Barch $. http455666.ft.com5intl5cms5s5,5f+3992d2.$$dc.!!e!."e+9. ,,!33feabdc,.html\a*%%!&y6ylch) 'nited 0ations Conference on Trade and Development ?'0CT-D@. 2,!,. Trade and 4e,elopment +eport. Oeport by the secretariat 0e6 1ork ] ;eneva.

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