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.

	2012	2013	2014
Consumer prices	2.1	1.6	2.0
Unemployment	5.1	5.0	4.7
GDP growth	0.4	1.3	2.1
Output gap	0.1	-0.8	-0.2

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.