Belfast Telegraph

Monday 1 September 2014

EU’s bad boys make prudent Germans pay

In the mid-Nineties, I was one of many economists who thought the euro would only get off the ground if its membership was restricted to those countries which, year-in-year-out, had demonstrated their commitment to the rigours of Bundesbank-style price stability.

I believed membership would only be for the select few.

Germany, France, Austria, the Netherlands, Luxembourg, Ireland and Belgium would be in, but the southern European countries would mostly be out. After all, these Mediterranean nations had lurched from one devaluation to the next within the exchange rate mechanism of the European Monetary System. Moreover, some of them had been fiscally incontinent to a degree that suggested they had no real chance of meeting the so-called Maastricht convergence criteria, a set of rules designed to keep monetary and fiscal profligacy at bay.

Of course, I was wrong. I was thinking too much like an economist. I'd forgotten that the creation of the euro was a political, rather than an economic act. And so it was that the euro included all sorts of financially challenged reprobates — countries which had not been able to demonstrate the monastic commitment to economic orthodoxy which had proved to be part of Germany's DNA.

Soon after its creation, other countries were allowed to sign up, further emphasising the euro's political backbone. These ‘second-wave’ nations included Greece, Slovenia, Cyprus, Malta and Slovakia. In passing the entrance examination for convergence, it turns out that one of these countries was, to use the polite version, economical with the truth.

Initially, the reprobates found euro membership extremely cosy. Interest rates collapsed to German levels because the euro seemed to promise a Teutonic monetary nirvana for all.

Unfortunately, the reprobates forgot that interest rates were low for a reason. Germany had successfully kept its prices and wages under control for decades, and its cautious citizens had chosen to save, rather than spend, their money.

Low interest rates were a consequence of good behaviour, not an incentive for bad behaviour.

For the reprobates, however, the opposite applied. Faced with exquisitely low interest rates, their discipline went out of the window. They had housing booms, big wage gains (relative to their limited productivity successes), and large increases in both private-sector and government borrowing.

They lived the good life. All the while, they slowly lost competitiveness against the austere Germans.

Now the party's over. Countries can borrow a lot only if creditors lend to them.

Most commentators agree that the reprobates have to improve their competitiveness within the eurozone.

That either means their wages and prices have to fall compared with the “best in class” or, alternatively, that wages and prices for the best in class have to rise.

If, however, Germany — the best in class — prevents its wages and prices from rising too far, wages and prices elsewhere will have to fall.

And, as they do so, eurozone inflation on average will likely undershoot the European Central Bank's target band of 1.5 to 2% . That, in turn, makes a nonsense of the idea that all countries have surrendered their national economic sovereignty for the greater good.

The German piper is still calling the tune.

In doing so, the risk is that the eurozone is condemned to years of grinding deflation which, in turn, will see Greek-style problems cropping up all over the place. Germany would also be damaged. Its companies trade a lot with the rest of Europe, so the fabled German export machine would splutter a lot more frequently.

Even worse, because Germans save a lot more than they invest domestically, they need to find foreign bolt-holes for their wealth. Over the last 10 years, the foreign assets of choice have included |US mortgage-backed securities and Greek government bonds, neither of which has proved to be safe.

Germans may think they're being prudent, but their prudence merely encourages bad behaviour elsewhere in the world, including within the eurozone.

To subvert a phrase, it's prudence without a purpose.

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