Before getting to the point of the lack of German leadership, the main subject of this post, it is useful to note the following: the shortcomings of others do not excuse the incapacity of Italian politicians in the last 40 years. They have failed to check public spending and did not put in place necessary reforms to enhance growth. The graph below is from a study of the Bank of Italy, an obviously non-partisan organization (Francese, M, Pace, A. ‘Il debito pubblico italiano dall’Unità a oggi. Una ricostruzione della serie storica’, Ottobre 2008. The full article can be downloaded for free here: http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qef_31/QEF_31.pdf).
It can be clearly noted that debt rises above 40% of GDP around 1971. At that time Italy was ruled by the so-called ‘governments of national solidarity’, headed by Democratic Christians with the external backing of the Communist Party. Since the Communists could not have ministers, presumably because of the nervousness this would have created in Washington, they obtained spending concession which made their constituents happy at the expense of their own children and grandchildren, who now have to foot the bill (see previous post). Thus, centre-left search for consensus of the 1968 kind, started with Andreotti and continued by Craxi, started the spiral of spending, debt and lack of reforms that would have cost in electoral terms but of which now the payment is required. Let us hope that the ‘spending generation’ going to retirement will stop this negative feedback loop.
Therefore, it is clear that anything that is decided in Berlin or Brussels will not delay the time of unpopular reforms. Failure to do so would result in punitive yields with the potential of sending public finances out of control. And now to Germany.
When Goethe wrote his famous ballad Der Zauberlehrling (the Apprentice Sorcerer) he did not imagine that the moral contained in it would be ignored by the same Germany which reveres him so much as a poet.
Germany seems trapped in the curse of the apprentice sorcerer: his desires becomes reality but he has to live with the consequences of his power and face the wrath of the Master Sorcerer on the latter’s return.
Germans have in fact created a system of high added value exports with which emerging economies cannot easily compete. This system, however, has turned in a huge success with the critical help of monetary policy.
With introduction of the Euro, the main trading partners of Germany started absorbing German exports without the automatic stabiliser of a stronger Mark. In the past, when a Frenchman bought a German car, he had to sell Francs and buy Marks at the same time, thus making the next car more expensive in Francs.
After introduction of the Euro this does not happen anymore: the Frenchman buys the car but the next car is not more expensive as France and Germany share the same currency.
E second positive effect for Germany comes from ECB monetary policy which has, at least so far, yielded to Berlin’s influence on everything. The ECB in fact is mandated to control inflation but in the first decade of the new millennium peripheral countries were booming (particularly Ireland and Spain). At that time monetary policy remained accommodating, just as Germany was not growing much.
Now that peripheral countries have put in place a restrictive fiscal policy ( the State spends less and taxes more) they would need an expansive monetary policy (the combination used in Britain), but Germans live with the nightmare of the 1 million Marks stamp because of the inflationary spiral which caused the end of the Weimar republic and the rise of Nazism. Therefore the ECB cannot create inflation.
So far goes the first part of the story of the Apprentice Sorcerer. The second is starting just now.
About 2/3 of German exports go to the Eurozone. The amount is around 650 billion Euros per year. Having forced a fiscal retrenchment in their export markets, Germans face a decrease in demand for its goods, which is already resulting in lower exports.
What can the Berlin do?
Essentially it has to make up its mind as, simplifying as usual, it has 2 possibilities:
1- More fiscal integration. If Germany is to continue enjoying the benefits to its exports (which we try to estimate below) it has to accept this, which in the end is what the Euro was created for. This would cost Germany, in the worst case, 1.5-2% of GDP, or about 48 billion per year, in increased interest costs. This estimate by German institute IFO is pessimistic, in that it is just a weighted average of borrowing costs of all Eurozone countries. This does not take into account the benefits that could result from increased liquidity and, in the best hypothesis, the rise of the Euro as world reserve currency.
In the second case it is probable that yields would be in line with those paid by Germany if not lower.
2- Germany leaves the Euro, probably with Austria, the Netherlands, Finland and perhaps France, but Paris would probably say ‘no thanks’, as it has certainly run the numbers.
In this case Germany would have to immediately recapitalise its banks: the estimated cost is of 21 billion. However, this would be just a one-off payment, while the worst would be the impact on exports.
In fact, German trade surplus is around 150 billion Euro per year (Eurostat data for 2010). Many economists think a new Mark would appreciate 30-40% against the Euro. If this is true, there would be enough to send the German trade balance to negative territory, counting the appreciation of the new Mark against the dollar too with a clear disadvantage on all world markets. So Germany would have to do what it should have done already: consume a higher percentage of what it produces, thus further reducing its trade surplus. The damage would be, according to our estimates, in the region of 190 billion for the first year. A reduced competitiveness, however, would still linger. Correcting it would take time, which would probably increase unemployment in Germany: it would not be unreasonable to assume an unemployment rate double than that enjoyed in Germany now.
At that point there would be little choice to contain the damage: Berlin would have to step up government spending (supporting both German production and exports) or expand the monetary base with probable inflation creation. For the 1 million mark nightmare, Berlin can rely upon a pan-German export of great success: psychoanalysis (in fact Freud was Austrian and Jung Swiss but both were German speakers).
Of course, there is the option that has been followed until now: do nothing and wait for better times.
This option, however, is disappearing as the market understood the structural imbalances at play and demands to ‘see the bluff’.
Chancellor Merkel, with a PhD in Physics, should understand the effects of compounding interests, as they are strictly related to the exponential function that she cannot ignore.
Let her take the decision she thinks best but show a bit of leadership before the Master Sorcerer comes back and punishes the Apprentice.
No comments:
Post a Comment