Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 3 November 2013

The real problem with German macroeconomic policy

Paul Krugman has been laying into Germany in the past few days (1, 2, 3, 4, 5, 6). I think it might be interesting to look at two possible defences for the German position. The first is that they are doing what any government would do, which is act in their national interest. The second is that, for from being at the centre of the Eurozone’s (EZ) problems, they have been holding it together.

Take the national interest argument first. If the EZ really had an EZ government that took decisions in the overall EZ interest, then given the problems with ECB monetary policy (whether self-inflicted or otherwise), EZ fiscal policy should be expansionary - or at least not contractionary. Given the needs of periphery countries, this implies fiscal expansion in Germany. The problem is that this appears not to be in the German national interest, because growth has been relatively healthy in German, unemployment is low and inflation not that low.

Here are the latest OECD forecasts (and outturns) from the September OECD Economic Outlook.

Consumer prices
GDP growth
Output gap

While this performance is nothing to write home about, it is also not enough to overcome the longstanding distrust in Germany of countercyclical fiscal policy. Why risk inflation going above 2%, when unemployment is less than half the EZ average?

Pointing out that the macroeconomic interests of Germany and the EZ as a whole conflict is important, because (for some at least) it strengthens the arguments for fiscal union. It is almost the fiscal equivalent to the arguments for monetary union in the 1990s. Pre-Euro we had a quasi-fixed exchange rate system where French and Italian monetary policy was effectively tied to what the Bundesbank wanted, and the Bundesbank’s job was to focus on Germany. This all came to a head after German unification, when German monetary policy was tightened as the rest of Europe was suffering a period of low growth. The parallel is not exact because today Germany does not dictate fiscal policy outside Germany: well, at least not in theory.

From this perspective, arguments about the German current account surplus are beside the point. Macroeconomic policy should not be geared to current account surpluses or deficits, but to economic fundamentals like unemployment and inflation. In the absence of fiscal union, German macroeconomic policy looks OK from a German point of view.

The second defence of the German position is that, far from acting selfishly, it is providing the financial glue which is holding the EZ together. As Gideon Rachman writes in the FT

“The Germans are also often given far too little credit for what they have already done to keep the eurozone together. German contributions and loan-guarantees to the various EU bail-out funds already total the equivalent of an entire year’s federal budget in Germany.”

As it becomes increasingly clear that some part of the funds provided by the Troika to Greece will have to be written off, this point of view can only strengthen in Germany.

I think both lines of defence are quite powerful, yet I think they are in danger of missing the point. The problem with German macroeconomic policy is not that it is acting in the national interest, or otherwise, but that it is based on a discredited and harmful set of ideas. In particular there are three key myths that are leading German policy making astray.

Myth 1: The EZ crisis stemmed from fiscal irresponsibility in the periphery EZ countries, and that the crisis can only be solved by reversing this through harsh austerity

Reality: The crisis was at least as much to do with private as public sector excess.

Myth 2: An anti-Keynesian view that fiscal policy has no place in managing aggregate demand, which can be safely left in the hands of the ECB as long as the ECB sticks to its job of keeping inflation below 2%.

Reality: The Keynesian argument against austerity at the Zero Lower Bound is correct. Keynesians also argue, correctly, that restoring competitiveness in a monetary union is much more difficult when inflation in your key competitor country is low.

Myth 3: To be independent, central banks must never buy government debt, as this indicates fiscal dominance.

Reality: EZ governments need the ECB to (potentially) act as a sovereign lender of last resort, to prevent self-fulfilling market panics. The introduction of OMT demonstrated this.

To see how these myths have distorted German policy, let’s start with the assistance Germany has provided to the periphery. Myth 1 has led to a focus on austerity, and a reluctance to see the pressure for austerity eased. (See my post here, or Krugman 4.) Myth 2 means that the damage caused by this austerity is discounted, and Myth 3 leads to reluctance to let the ECB help reduce market pressure. In short, the money that Germany has or will provide could have been much better spent. Ironically it could have been better spent in Germany, boosting domestic demand, which would have helped raise demand and inflation in Germany (the latter being the sacrifice Germany would make to help keep the EZ together), which would have done much more to help the periphery adjust their competitiveness at lower cost. Myth 2 prevents Germany from seeing this, although it is quite clear in the Commission’s QUEST simulations that I commented on here. (See also the subsequent comments from Jan I’nt Veld, particularly concerning the Commission’s view on this.) The financing needs of the periphery would have been much reduced if more Greek debt had been written off, and had German resistance (Myth 3) not delayed OMT until September 2012.

These myths have also damaged Germany’s own narrow domestic interests. Myths 1 and 2, besides leading to harsh austerity in the EZ periphery, has also led to fiscal contraction in the core (both outside - e.g. Netherlands - and inside Germany), which has reduced German GDP and led to inflation below 2% this year. The Fiscal Compact, despite slight softening around the edges, is a deeply flawed and damaging policy which comes directly from Myths 1 and 2.

So the problem is not with Germany, but with the macroeconomic myths that seem to be so deeply embedded in current policy. I do not think Germany has been simply acting in its own national interest, but the myths prevent it seeing that its current account surpluses are a key part of the problem and why some overheating in Germany is the best solution for the EZ as a whole. Although these three myths have a particular Ordoliberal flavour, they are not so very different from similar myths expounded by politicians and the occasional economist in the US, the UK and elsewhere in Europe. The myths are the problem.  


  1. I cannot find these numbers in the OECD Economic Outlook of September.

  2. Simon,

    I don't disagree, but I think you are missing one myth - namely, that creditors must always be made whole. German belief that debt is wrong is deeply rooted - "debt", "guilt" and "sin" are all the same word (Schuld) in German. So if debtors cannot pay their debts it is because debtors are sinful, not because creditors have lent irresponsibly. Consequently, for example, German banks that lent to Irish property companies were not at fault and should not have to suffer the consequences of the property collapse. That should be borne by the "irresponsible" Irish.

    The timing of the Greek PSI was all about giving German banks time to reduce their exposure. It would have made far more economic sense to restructure the debt earlier, but it would have meant Germany (and probably France) having to bail out their banks. Hence Merkel was not going to agree to debt restructuring until she was sure that German banks were safe. Similarly, the disembowelling of Cyprus was delayed for a year while German banks got their money out.

    As you say, Germany is fundamentally acting in its national interest and using moral arguments to defend the indefensible. This is not much of a union, really.

    1. Unfortunately that myth is a bit country specific, which is perhaps going a little against my final paragraph. Maybe you are right, but surely German history should warn against the consequences of saddling a country with debt it cannot repay. On this too Keynes was right.

    2. If the Germans cannot bring themselves to remember how they themselves broke the growth and stability pact (and forced the Commission to back down) in just 2005 then It is surely unlikely that distant memories of all the debt forgiveness Germany received in the early 1950's will now reverse the selfish and self righteous German programme of assisted suicide for the rest of the eurozone.

    3. German history should also warn against destructive austerity, too - after all, it was Chancellor Bruning's destructive austerity in the Depression that led directly to the rise of Hitler. But German folk memory is obsessed with the Weimar hyperinflation, to the point where Hitler's rise is attributed to this instead of the austerity of the early 1930s. I agree my comment is country-specific, but I do think that the German moral stance and partial view of history has a lot to do with this.

  3. I don't see how the first claim that EZ and Germany's interests conflict. The most that can be said at present is that Germany doesn't have a huge amount to gain from fiscal policy. But they'd still gain.

    Somewhat higher inflation wouldn't hurt Germany at all. In fact, it would help nearly every citizen of Germany. It would hurt a few rich assholes, but that's about it.

  4. Surely the argument that Germany has too much money could also be applied to US Corporates sitting on billions and those super-rich individuals who, by hoarding their own money, do not allow it to be recycled through the economy so that it cannot contribute to growth?

  5. German exports seem to go a lot outside the Euro zone, is this bad for the Euro zone?

    And then, if Germany is specialized in capital goods and these goods are in higher demand because of negative real reates and large investments in Asia, what is the problem with this? Germany's current account surplus might be a result of actions taken by others

  6. “restoring competitiveness in a monetary union is much more difficult when inflation in your key competitor country is low.”

    How about Germany says to the periphery, “We’ll put up with excess inflation for a few years on condition you reimburse us for the inconvenience. That way Germany doesn’t lose. And hopefully periphery GDP rises by more than the latter reimbursement.”

    I know that’s diplomatically and politically difficult, but anything is better than the current shambles.

  7. I think some of the comments on Krugman's own blog highlight the problems with his analysis and its conclusions. Japanese and German current account surpluses are structural - they relate fundamentally to the industrial, trade, and internal flow of funds structures in their countries. They are continually pressured by the US to expand their economies or appreciate their countries and drive world growth and restore balance of payments balance. When they do they get massive distortions like the Japanese asset price bubble, and the current account imbalance if it changes at all, quickly goes back to its previous position. Current account surpluses in these countries only happen when there are exceptional external shocks - unification, 70s style supply shocks, or massive tsunamis. As a blogger said, you need to follow post war movements in the balance of payments starting from at least the 60s to understand how it works.

    American economists don't like historical or any other context. They like models.

    1. typo, "current account DEFICITS in these countries only happen when there are exceptional external shocks"

  8. "So the problem is not with Germany, but with the macroeconomic myths that seem to be so deeply embedded in current policy."

    But Germany was at the forefront of creating these myths. It's central in the ordo-liberal economic view taken by the major German parties, Merkel's CDU in particular. So this really is a difference without a distinction.

  9. I have come to the cultural and political view of Germany that it has, unlike Austria, dealt with its role in WW2, but it has not dealt with its role in WW1. This is where the hyperinflation of 1923 comes in an explanation of causing WW2 in Germany, rather than it being a carry over from WW1.

    I think this is the foundation myth of modern Europe led by Germany (see Telegraph, 'Germany intervenes in WW1 commemoration debate', Jasper Copping, 18 Aug 2013).

    Remember that Enoch Powell saw the German targeting on inflation not unemployment in their 1957 central bank freed from US control as wonderful, and that Germany like Japan got through the 1970s stagflation in pretty good shape.

    1. A brief historical synopsis on what happened after that.

      Late 1970s, 1980s. Japan and Germany were prompted to expand their economies or appreciate their currencies (Plaza Accord) to act as locomotives. Reconciling of internal and external macro-economic objectives proved predictably elusive; result: Japanese bubble etc. Econometric models at the time (basically expanded IS-LM models with a supply side included) showed that such policies would be ineffective - but they really couldn't explain why. Nevermind, the real problem, it was concluded, was that expectations were not correctly specified. The holy grail was rational expectations. And then we got real monsters - General Equilibrium models.

      And have we learned any real lessons?

      Is it any wonder that these countries get annoyed when foreigners tell them what to do?

  10. I understand why you have stated Myth 2 in the way you have, and of course stated that way it is a myth, but it is certainly not robust to very slightly different specifications!

    If you pointed out that the Eurozone was not in fact at the lower bound—which it clearly wasn't, it even raised rates in 2011—and if you re-stated "inflation below 2%" as "inflation at 2%, or above if needed for AD reasons" then it would no longer be a myth. Your specification, though perhaps exactly what the Germans are in fact thinking, makes it look like monetary policy is impotent. Of course it may be that the Eurozone needed fiscal *and* monetary stimulus, but I think it comes across as misleading to suggest that monetary firepower is spent.

  11. It is understandable why those myths exist in the German mind:
    - As you say, things are not going too bad in Germany. No one is keen on changing a winning team (even with top players on the bench).
    - Germans (like the Japanese or the Swiss) are good at engineering, but they don't know much about trade or economics. I don't think any US or British economist will ever realize how economically illiterate European elites can be.
    - Germans may be intellectually brilliant, but they are not very creative of flexible. This might be even more of cliché than the previous point, but sometimes clichés hold true.

    Now, what's not understandable at all is why those myths exist in the minds of other Europeans too. The Irish, the Spanyard, the Portuguese... Why don't they challenge those myths?

  12. Reality: The Keynesian argument against austerity at the Zero Lower Bound is correct. Keynesians also argue, correctly, that restoring competitiveness in a monetary union is much more difficult when inflation in your key competitor country is low.

    Yes, but will this help the EU Periphery countries, or countries with which Germany's exports actually compete with (Japan and China)? You are also making assumptions about Germany's import structure and whether any increase in aggregate demand translates to increased imports from the periphery.

  13. Only a few remarks:
    To Myth 1:
    The public discussion in Germany including the parties was "haircut" versus "austerity". Argument against the "haircut" were mainly the moral hazrd problem that i.e. Greece will not tackle its problems without financial pressure. This is still the official position of the government.
    Myth 2: I almost totally subscribe to your views.
    Myth 3:
    In 1975 the Bundebank bought German government bonds (7.6 Mrd. D-Mark which was approx. 1% of the GDP of 1974) to stop the falling bond prices and to fight the emerging recession.
    Recently, Weidmann has argued that he would object against OMT if the ECB will buy a representative basket of EuroZone government bonds. However, if the ECB will buy only bonds of some single countries, he will fight against such a programme, although being aware that he will be overruled.

  14. Dear Professor,

    you are exactly right that that some overheating in Germany is the best solution for the eurozone as a whole. But Germans will never go for such a proposal if it is not part of a wider framework but simply a discretionary measure. Due to a strong ordoliberal tradition and other historical reasons, Germans resent discretionary macroeconomic management by the government. The good thing is this: you could achieve the same thing through rules-based fiscal policy.

    Every country of the EMU should be subject to a fiscal rule requiring the budget balance to be set in such a way as to ensure that, over time, the national price level increases by the same proportion as the price level in the eurozone as a whole. That is, on the national level there should be a price level targeting mandate for fiscal policy.

    The thing is simply this: the basic requirement for the workability of a currency union with heavily constrained labour mobility between its member states (such as the EMU) is that the price levels in all member countries rise by the same proportion over time. Put differently: while a member state of the EMU may no longer have its own monetary policy, it still has an “inflation target” to meet year by year. But how can each member state of a single currency area ensure to meet the common “inflation target” without having its own monetary policy? The answer is: through using fiscal policy.

    Long story short: a framework requiring all member countries of the EMU to close the gaps between their price levels by, say, 2016 and thereafter to keep their national price levels in line with the price level of the eurozone as a whole may find the support of German decision makers because it is rules-based and all but eliminates any fiscal discretion.

  15. I tend to be much more skeptical about what is in the German interests nowadays.
    Unemployment is low, but most is a consequences of the emergence of part-time jobs, low-paid jobs and the increase of the number of people which stopped looking for a job. The government is cutting essential services, infrastructure, health, education. Poverty is increasing. Market concentration is transforming German town and cities in huge shopping malls.

    Then, as Krugman is saying, the German national bank is selling German bonds to sterilize capital inflows, so inflation is low for a reason, there is nothing normal, it is repressed inflation.

  16. "Why risk inflation going above 2%". One of the problems I see is that if euro area inflation is going to stick around 2%, German inflation will have to go above 2% if Germany has a stronger economy than the rest of Europe. It seems the Germans did not read up on how averages work when they signed up to join the euro.


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