Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday 13 November 2013

Eurozone Morality Plays

In my last post I wrote: “Mapping macroeconomics into a morality play is almost always a mistake.” I can think of lots of examples. For example: The private sector has to tighten its belt, so the public sector should too. Or: Recessions are a punishment for previous excess.

Within a currency union, when the central bank is willing and able to do its job, these morality stories are often about what happens when one part of the union deviates from the inflation target. (Any deviation of inflation from target is accompanied by unwarranted movements in output: I’ll take these as read in what follows.) Let’s imagine dividing the Eurozone in half, and call each half G and R. So the standard story is that ‘excess’ in R raises inflation in R: to 3% say. The ECB does its job, keeping average inflation at 2%, which means inflation is forced down to 1% in G. This makes G too competitive, so if the ECB was willing or able to keep average inflation at 2% we would have to have a period of 3% inflation in G and 1% in R to put things right.

The morality often drawn here is straightforward: irresponsible excess in R has led to uncomfortable deviations from the ideal of 2% inflation in G. The morality play normally skates over the fact that this excess in at least parts of R was financed by lending from G: morality always seems to reside with the borrower. But we could tell the story a different way. The problem started because G tried to undercut prices in R, by allowing inflation in G to be 1%. As the ECB had to keep average inflation at 2%, this 'forced' inflation in R to 3%. G is now enjoying the benefits of undercutting R, and is very reluctant to undo the process.

So which story is right? We all know there was excess in some parts of R, either by governments (Greece) or banks (Ireland), but both countries are small. One way of discriminating between the two stories would be to look at real interest rates. If the ECB was having to react to excess demand in R, we would expect to see high real interest rates. If instead the ECB was having to offset deflation in G, we would see low real interest rates. Here is what actually happened.


From 2000 to 2007 the ECB kept inflation pretty close to 2%. But it did not achieve this by raising real interest rates. Instead interest rates fell in 2003, so that real short rates were close to zero from 2003 to 2005. This seems much more consistent with the story where G tries to undercut R, and the ECB has to cut rates to keep average inflation at 2%, forcing inflation in R to 3%. Sure enough, 2003-5 were years when the output gap in Germany was significantly negative (OECD estimates -1.4% 2003, -1.7% 2004, -1.9% 2005).

Both the ‘undercutting by G’ story and the more traditional ‘excess in R’ story still contain much too much pseudo morality for my taste. The German government did not deliberately engineer zero growth in domestic demand from 2003-5, any more than governments outside Germany (Greece excepted) tried to stoke up excess demand. In an ideal world both could have used fiscal policy more effectively, but the system hardly encouraged that. But this evidence does suggest that seeing the competitiveness imbalances in the Eurozone as simply the result of excess outside Germany is at best only half the story, and at worst not a very realistic story at all. 


  1. The problem is that the ECB, for some reasons, was not willing to raise rates when peripheral countries were experiencing inflation nor the Commission could force some countries (as, for example, Spain) to achieve a budget surplus.

    However, at the first hint of inflation in Germany above 2%, the ECB raised rates in 2010.
    And Germany has also decided that it is the right time to consolidate debt by achieving budget surplus.

    It's not a morality play, but the fact that Germany has more structural power and has been able so far to maintain almost perfect fiscal and monetary policy independence, while other countries have no control whatsoever on their policies: they cannot count on an independent central bank which restraint their policy mix when Germany has troubles and they cannot count on stabilization policies when they need them.

    This is not a morality play, but a description of how the system works.

    Simply put, peripheral countries do not have an independent central bank who can run counter-cyclical policies.

  2. This is a simple academic model, reality is more complicated.
    In the UK and maybe Southern Europe too, the market may push up wages with inflation, but Northern Europe has a tradition of wage bargaining, based upon the idea of jobs over wage increases. So let's say G thinks wage increases are a bad idea that will hurt global competitiveness, than wages will not automatically follow inflation and any inflation targeting of the ECB is futile and will only hurt consumption.
    The second criticism that can be given is that the example chosen always seems to be Germany with Spain, and that this would represent the situation of the eurozone.
    However, reality is much more complicated. Italy for example did not have a housing bubble, pushing up inflation. So no excess. Inflation in Italy during the euroboom years was similar to Germany. Italy has other problems. What would inflation targeting solve for Italy?
    All eurozone countries have uniquely different problems, I would like to see first what inflation targeting is exactly supposed to achieve for each country.
    The model also doesn't look at the effects of the eurozone compared to the rest of the world. 60% of exports of Germany go outside the eurozone, only a limited part of their exports within the eurozone go to Spain.
    Southern Europe has in particular lost competitiveness compared with countries outside the eurozone, how is inflation targeting by the ECB supposed to solve this problem? Southern Europe needs deflation compared to the rest of the world.

    1. But then why the ECB is not willing to cut rates or why did the German government choose restrictive fiscal policy as long as the eye can see?

      If Germany is so good at wage bargaining, why they fear inflation above 2%?

      More in general, your point is quite silly. If inflation rises, then it means that prices rise all over the board apart from contingent variables.

      When a country loose competitiveness, there are automatic adjustment mechanisms, but you need your own currency.

      The more I read people with no good knowledge of economics trying to defend Germany, the more Germany looks bad.

  3. "The German government did not deliberately engineer zero growth in domestic demand from 2003-5, any more than governments outside Germany (Greece excepted) tried to stoke up excess demand."

    If you mean literal Government policy, then you are right, and they didn't. However, Germany entered the euro with low inflation expectations, due to the low inflation in the DMark, so demands on nominal wage settlements were also low. Meanwhile, countries that had had weak national currencies, higher inflation expectations and periodic devaluations, had Unions that demanded high nominal wage settlements, and they kept demanding them in a low inflation euro era. Newly cheaper credit in the periphery probably helped things along.

    So no, G did not have a secret plan to undercut R, but due to conflicting inflation expectations within a single currency, it was bound to happen.

  4. Since everything that is produced gets consumed, demand is a number, just as production is. It is roughly the same number.

    So if G runs a trade surplus, it is exporting goods, but importing demand from R. In the same way, R running a trade deficit is importing goods, but exporting demand to G.

    So G gets to produce more than its domestic demand, while R gets to consume more than its domestic production. In fact, G gets to create production facilities and jobs - at low wages, to create a surplus for export - in excess of what its domestic market requires, while R gets to increase consumption without increasing production facilities and jobs, as long as its domestic demand remains high, which means partly financed by credit, some of which comes from G.

    Of course, this is not sustainable. In R credit must eventually run out, because domestic production and jobs did not increase because goods were being imported, not produced domestically, and because G becomes less willing to lend to R. So R's living standards will drop and its trade deficit will shrink, so it will import less from G.

    But G already used the imported demand from R to build production facilities and to hire low paid workers, so it will keep running a trade surplus, but with someone other than R.

    Then G will say "Hey, R, your problems are nothing to do with me. I don't even export that much to you any more."

    1. But then, if G behaves like you say at the end, R could eventually decide to stop repaying its debt to G.

      As long as R accept that its debt to G are legitimate and tries to do whatever G requires R to do, R is behaving morally good and responsibly, while G simply does not care anymore.

      IF G is behaving unilaterally, a coalition of Rs should also start to act unilaterally (together) against G. The problem is that the rules in the Eurozone legitimize (make possible) Germany's unilateralism because, due to veto power (for amendments and for ECB monetary policies), one country can block every policy even if the other 20 would like a different policy.

      So basically, the rest of Europe has three unrealistic possibilities: convince Germany to stop acting unilaterally (5% probability); force Germany out of the Euro (1%); stop repaying its debt to Germany alone (0,1%, hard to implement, it requires also capital controls).

      By the way, Germany's debt (war debt plus post-WWII financial, post-reconstruction aids) was cancelled in 1953 by the U.S.-England-France and Italy and Greece too!

      Should we have started a morality play back in 1953?

    2. Yes, good comments. But of course G actually *is* behaving as I suggest at the end. They are disclaiming responsibility for imbalances by pointing out that these days they export less to the rest of the EU than they used to.

      Their interpretation of that is that imbalances are finally being resolved. My response is that if you suck demand out of a R to the point where R can no longer generate the domestic demand it used to, then sure, the imbalance has been resolved because it had to be.

      Your question about outcomes is very interesting. My guess is that what happens in the end is that G recycles its export earnings by buying up assets in R at fire-sale prices and gradually makes R's economy a low-cost part of G's. Gosh, is that what the eruo was all about? How cynical.

      And 1953? Well, the sad truth is that in 1953 the highest priority was integrating Germany into NATO and making darned sure that it re-armed and readied a plausible defence against a possible Soviet invasion of Western Europe. The story about fifty million "good Germans" somehow being hypnotized by about a dozen "bad Germans" dates from about then, as well.

    3. With 2% GDP growth on average, G can hardly afford to buy assets somewhere else. You mean Russian oligarchs, Arab and Chinese billionaires.

      And given the kind of goods G is exporting, G needs a lot of public and private investments to upgrade their capital infrastructure.

      Don't forget that G is sacrificing a lot on the altar of a competitive real exchange rate. The artificial contraction of internal demand has its price in terms of economic growth. Apart from granting an unjustified sense of national pride, be able to export more and (not) be able to consume more is a quite masochistic enterprise. Let us think for a second how an imaginary country would look like if export/GDP ratio is close 100%.

  5. In the very long-run, the only solution is that all European countries start to talk English in all public intercourses (business, government), so that Southern-European can move to richer regions and fill the demographic gap. Then, national elections should be based not on citizenship, but on residence. I mean, the United States of Europe.


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.