Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 28 August 2014

Lessons of the Great Depression for the Eurozone

It is easier to consider the problems of the Eurozone by first thinking about the Eurozone as a whole, and then thinking about distribution between countries. In both cases, the Eurozone is making exactly the same mistakes that were made in the Great Depression of the 1920s/30s.

The Eurozone is currently suffering from a chronic lack of aggregate demand. The OECD estimates an output gap of nearly -3.5% in 2013. Monetary policy is either unable or unwilling to do much about this, so fiscal stimulus is required. This is the first lesson from the Great Depression that is being ignored. Instead of stimulus we have austerity imposed by the Stability and Growth Pact (SGP).

Within the Eurozone, we have a problem created by Germany undercutting pretty well every other economy in the 2000-2007 period. I am not suggesting this was a deliberate policy, but the consequences were not appreciated by any Eurozone government at the time. Some correction has occurred since 2007, but it is incomplete. The second lesson of the Great Depression and the Gold Standard is that achieving correction through deflation and trying to cut wages is both hard and unnecessarily painful.

The solution eventually arrived at in the 1920s/30s was a series of devaluations (leaving the Gold Standard). That is not possible within the Eurozone. However adjustment is much less costly if it is achieved by raising prices in the country that is too competitive, rather than reducing prices in those that are uncompetitive. In practical terms we are not talking about very much here: a period with inflation in Germany at 3%, and at a little above 1% elsewhere, should be sufficient. Instead we now have inflation in Germany of 1% and in the rest of the Eurozone only a little above zero.

Relative unit labour costs (2000=100): source, OECD Economic Outlook May 2014

At this point a sort of moral indignation overcomes economic logic in the debate. Many Germans say why should we suffer 3% inflation to help put right irresponsible policy elsewhere? This is illogical, because it sees inflation below the Eurozone average as a virtue rather than a sin. A country within a monetary union obtaining inflation below the average (as Germany did in the early 2000s) is not a sign of virtue but a sign of a problem, just as it is for other union members to exceed the average.

A country cannot undercut its competitors forever. Any country experiencing below average Eurozone inflation should expect that this will be followed at some point by above average inflation. If the Eurozone could achieve average 2% inflation over the next few years that would mean 3% inflation in Germany - that is part of the Euro contract. To the extent that German policymakers attempt to renege on this contract by either preventing the ECB using unconventional means to achieve its target, or insisting on maintaining the deflationary SGP, then they become directly responsible for the misery that the Eurozone is currently going through.

I have not mentioned at any point levels of debt or structural reforms. Both are distractions for the current problem of inadequate demand and below target inflation. They are relevant only in that they allow policymakers to distract attention from the basic issues. Two of the major lessons of the Great Depression are to use fiscal stimulus to get out of a liquidity trap, and that it is far too painful to insist that uncompetitive countries should bear all the costs of readjustment. The Eurozone has failed to learn either lesson.



  1. I don't think it is dislike of having higher relative inflation which lies behind German dislike of inflation going to 3%. It is a dislike of higher absolute inflation. Contrary to the common view in economic discourse, the natural bias in societies is to be inclined to prefer low inflation high unemployment to the opposite. Since most economic policies are founded on the belief that the opposite is true we have a problem.

    1. I agree about the dislike - my focus on relative inflation was simply to emphasise the macroeconomic mechanisms.

  2. Is it possible for Germany to achieve the end you desire by raising the cost of exported goods and services above 3% limit to well below 3% inflation in domestic goods and services?
    My uneducated guess is that the answer is no but I would like to understand why.

  3. It is a measure of how inadequate the union is that Germany, which has low unemployment, sees inflation as the main risk. Ten years ago Germany saw unemployment and low growth as the main risks. That is actually the problem facing the whole Eurozone now - but not Germany itself. Catastrophic unemployment and economic depression elsewhere is simply not their concern.

    1. Both Krugman and Friedman warned the Europeans about the problems with assymetric shocks. The present problem was predicted.

  4. " If the Eurozone could achieve average 2% inflation over the next few years that would mean..."

    Do wave the magic wand. Japan devalued its currency 40%, and inflation is up to 1%.

    Major fiscal stimulus can only come after the eurozone moves to a more federal system. This is simplest if the UK were to exit the EU.

    1. I do not understand your last assertion. What political difference would a more federal system make?

    2. If you read N. Gregory Mankiw's text on Macro, it is clearly New Keynesian. Even though he was W.'s chairman of the council of economic advisers, our Republican party is thoroughly anti-Keynesian while the Democrats are not. It is interesting that the left in Europe does not have the same orientation.

    3. What do you think the reason for the SGP was for anyway? It wasn't for the fun of it, right? You may not believe it, but the theory was that under a currency union all nations suffer if even one country has problems with its debt, so the purpose of the SGP was to create the conditions where this couldn't happen. That still holds. It's not fair - and fairness matters - to ask nations which have no say in the governance of country A to bail out country A.E.g. Germany should not have to bail out Portugal because it never had any (or much) say in how Portugal ran its economy. The only way out of this problem is federalism. You can scrap SGP once you have a federal system because the moral problem disappears; the European people decide how to run the entire economy as a whole, so are in it together, for better or worse.

      Now I'm pretty sure you don't believe much of what I wrote. For instance, you write below fiscal stimulus by Germany would not be helping other countries - yet it most certainly would. So for whatever reason there is a gap in comprehension.

    4. a above is very true: German citizens of the Eurozone should not have to bail out Portuguese citizens of the Eurozone if they have no say in the policy followed by the Portuguese govt. The way to solve this currently is by having treaties constraining policy at the state level; the correct way out would be to have a policy decided at the EZ level, ie federal institutions. The UK govt is one element blocking this evolution, others are internal political situations, mainly in France.

    5. "What political difference would a more federal system make?"

      People have been making this point in the comments on your blogs for some time. A Federal Union would give Germans some say over Fiscal Policy in Greece, and Greeks over Fiscal Policy in Germany. Under current arrangements you are asking Germans to initiate an AD expansion to act as a locomotive, hoping that the effects will spill out to Greek exports, etc and lift the economy. Or you are asking for increases in transfers (loans, grants) to Greece from Germany over which Germans have no say over reforms which they have a right to say are needed.

      Devaluations in Greece or Italy (even if they could) are not wanted. It would only take them back to the Drachma or Lira days. Not popular, even with everything Greeks and Italians have gone through.

      (So drop optimal currency arguments - they are irrelevant.)

      The answer is through fiscal transfers from Germany, something Germans should rightly have a say over what is transferred exactly and how it will be used to restructure the fundamental problem in these countries (the lack of an industrial base such that exports (eg olive oil) does not pay for needed inputs (eg machinery to even produce that).

      (Please also note invoke naive comparative advantage theory, it does not apply here.)

      People think that an AD expansion in Greece will simply aggravate existing distortions.

      (Economic theory eg ISLM analysis might say differently, but even a casual, but historically informed analysis of business cycles in Greece since 1918 almost certainly suggests they are right.)

    6. This is NOT about transfers!!! It is about a AD shortfall in the EZ as a whole, which normally monetary policy would deal with, but now fiscal policy has to. If monetary policy was not broken because interest rates were zero, this would be happening anyway.

    7. It should be about transfers. Relying on monetary policy is unwise. Lax MP creates real estate and other booms in the periphery. It increases German exports for sure (not exactly what is needed) and the periphery's imports.

      The problems in the periphery are terms of trade issues, ie low value added exports vv imports. Running up high levels of government (or private) debt is a problem when you have such a trade imbalance in a relatively small open economy that causes external payments issues. (One good thing is that they can pay for imports in Euro - paying in Lira and Drachma would ("own currencies") actually make these problems in many ways much worse).

      Let's put Dear Model away and start doing a bit of history. Why are Greece and Spain a certain type of economy, and Germany another? Ie why are some countries rich and some countries poor? Why is it that a certain country goes from boom to bust and tries to solve its problems with things like devaluations (which they did before they were in a currency union?).

      Greece's problem has never been fixed since it was a member of the Turkish Empire - under which it became a backward agrarian state. Spain and Italy never really sorted out their political issues which are a must before you get anywhere economically that have been around since at least the collapse of their fascist systems. Fiscal union is the way out. Political reforms will happen which will restructure their institutional systems. Once that is done, you will see genuine multiplier effects from German centred macro-economic policy expansion. It will increase their investment in productive activity, their exports, and their aggregate demand. It will be sustainable. It will not create a speculative boom that does not filter down to flows of credit to the people that really need it but actually dispossess them.

      (Next time you take a holiday in Crete, leave the British holiday resorts and go and talk to some Greeks about what happened during the boom time.)

    8. The effects of a EU-wide AD expansion will be uneven. They need to be redistributed and targeted through a system of fiscal transfers.

    9. 44% of Italians would love a return to the lira. Why shouldn't they? Last time they had a properly floating currency and control over fiscal and monetary policy, they became richer than the French and British and almost as rich as the Germans. Italian per-capita GDP achieved full parity with the European core in the late '80s. It is now at 75%.

      Oh and olive oil? And Southern Europeans should somehow listen to your advice?

    10. Anon 01:57. This post was about 'a bit of history'! The point of what you call 'Dear Model', and what I call economic science, is to sort out relevant and irrelevant history.

    11. 44% of Italians would love a return to the lira.

      With everything Italians have been through, why isn't that 98%?

    12. Anon 01:57. This post was about 'a bit of history'! The point of what you call 'Dear Model', and what I call economic science, is to sort out relevant and irrelevant history.

      Simon, in history everything is relevant. OK sure you will need an analytical model at the stage before you try to estimate the effect of fiscal expansion on AD (and not before that). But then you let history decide what is in the model, not the model decide what history to put into it.

    13. Anon 02:59. You seem to have the wrong conception of a model here. I'm talking about models as in understanding how the world works. It is a model in this sense that tells you that trying to stay on the Gold Standard in the 20s/30s was a huge mistake. It is also a model in this sense that says austerity in a recession is a crazy idea.

    14. I'm talking about models as in understanding how the world works. By "model" you mean a coherent explanation? Fine, but it must be comprehensive. You have to ask why did the Gold standard work for so long before 1914? Your model will need to consider things like power (ie the ability of the UK to underwrite a sterling area. Neo-realist International relations theory (well informed by history) tells us that multi-polar regimes are unstable, uncooperative and plagued by suspicion. You cannot have an international monetary arrangement based on that. Ultimately we needed a new hegemon (the US and its dollar after 1945.)

      What I am saying is that there is a lot involved here. I am not saying you do it, but a few macro-economists throw around gadgetry instead of comprehensively considering context. When we look at these things we need holistic analysis, preferably showing the arguments from different schools of thought. We need to consider views for example, widely shared by many central banks, that the gold standard imposed discipline that enabled structural financial and other reform; ok it went to far, but when this was achieved and Keynesian policy implemented to fight the depression, it was highly effective.

  5. If I understand it correctly, your recipe of fiscal stimulus in deficit countries only works with higher inflation in Germany.
    How do you stoke above average inflation in Germany?
    You could try to create a housing bubble (which was the cause of higher inflation in Spain), with the usual devastating effects afterwards, therefore not recommended.
    You could try to devaluate the euro, but with a eurozone export surplus, and other countries in the world wanting to devaluate too, that seems difficult to achieve. It would also create above average inflation deficit countries.
    You could try to increase wages in Germany, which is already happening, but that will only bring you so far, and Germany doesn't just need to consider it's competitiveness against eurozone countries, also non eurozone countries.
    And than there is the cultural element, how do Germans react to increasing prices? Maybe by becoming more frugal. In particular in an aging and shrinking society it seems difficult to increase spending or to create inflation, just look at Japan. Even in China it has been proven difficult to increase consumption because they rather save.
    Than you say that lack of structural reforms is a distraction from the current problem. But what if your fiscal policy does solve the current problem, but the deficit countries do not improve their competitiveness, in and outside the eurozone? What is fiscal stimulus going to achieve in the long term?
    What works in anglo saxon countries (who love to consume) doesn't necessarily work in other countries.
    How terrible the results of being on the eurozone gold standard may be for some countries, it doesn't make much sense to me to try to adapt policies to less competitive countries, They need to adapt to more competitive countries or leave the eurozone for a sustainable long term solution.

    1. Where did I say that you should only have to have fiscal stimulus in deficit countries? We need to scrap the SGP, and have a coordinated stimulus in all countries.

  6. ''If the Eurozone could achieve average 2% inflation over the next few years that would mean 3% inflation in Germany -''

    could you please explain how to achieve this?

    1. I did. Replace the SGP with fiscal stimulus.

    2. Germany is not going to do fiscal stimulus to help other countries.
      That leaves fiscal stimulus for troubled eurozone countries. Could you please explain in layman's terms how this is going to increase inflation in Germany? And how is fiscal stimulus going to improve competitiveness of deficit countries compared to outside eurozone?
      And how do deficit countries prevent falling into the same trap of increased trade deficits again?
      If what you propose would be a win win for all eurozone countries involved, I think it would already have been implemented.

    3. As I said, stimulus in Germany is not 'helping other countries', it is part of its original Euro commitment. What Germany has to be convinced of is that fiscal stimulus is just replacing what the ECB would do (a monetary stimulus in Germany) if they were capable of doing so, so its quite unfair for Germany to refuse to enact fiscal stimulus.

      But your question is a reasonable one - suppose France and other countries enacted a fiscal stimulus (or at least stopped doing the opposite under the SGP), but Germany did nothing.

      That would reduce the output gap in France, but not by enough to prevent France continuing to have inflation below Germany. German inflation would probably increase a bit because of spillovers from the rest of the EZ, but not to 3%. So we might see something like 2% inflation in Germany and 1% elsewhere, rather than the 1% and zero we have at the moment. A clear win for the rest of the EZ, but Germany gets higher inflation.

    4. "As I said, stimulus in Germany is not 'helping other countries', it is part of its original Euro commitment."
      The original Euro commitment is not this, but only the Maastricht treaty, ie the 3% deficit and 60% debt upper limits. I agree with you that your position is logical, and that a commitment for stimulus is implicit but it's not the legal commitment, and Anonymous explains well below how rule of law is important in German society.

    5. But surely it is more important to do the fair and right thing, than hide behind a law that was not designed for this situation.

    6. While I (the guy who has written the descriptions about keynesian macro in Germany) certainly agree this is not so clear for German ordoliberals and law people.

      The ordoliberals disagree because the market rules were determined beforehand and if we change them now the "market order" will break down. You basically would have to argue that the stimulus was agreed upon beforehand which has been denied by them. They basically say: They rules were clear but southern europe has chosen the wrong business model so it is their fault. It is imho a very primitive economic thinking.
      The German law people tend to disagree due to strong "legal positivism" in the German law scene. The law is in some sense "absolute" (parts of the German consitution mirror this idea). Which is a good idea for things like human rights but not for economic policy. The "debt break" written into the German constitution also comes from this thinking.
      You could even argue that the difference "common law vs civil law" amplifies the problem because for German law people "reference cases" are a lot less relevant than "the law".

  7. Thanks for the article, which is in line with lots of other things I read. I have written a post myself on the differences between ordo and neo liberalism:

    There are still a number of things I do not understand. Two are

    (1) The article suggests that the vast majority of economists follow this anti-interventionist line on macro. Yet as far as I can tell Keynesian economics is still taught to students in Germany as elsewhere. So I wonder whether the economists who are so against Keynesian economics are actually macroeconomists? Otherwise this is a bit of a contradiction.

    (2) Inflation reached a peak of almost 8% in the 1970s, a peak of above 7% in the 1970s, a peak of above 6% in the 1990s - all in the 'golden era' of the Bundesbank. So why is 3% inflation suddenly deemed unacceptable?

  8. The problem is the thing is a complete mess. Inflationtarget is just one point another one is eg the South bringing the whole thing in danger by not having debtlevels under control.
    The latter being one of the main arguments with which this was sold to the German public.

    This will end in a hopeless discussion therefor. And no German politician will want to burn his/her fingers to defend inflation that is higher than say 2-3%.

    The legal situation resp the perception thereof by (here the German) electorate is simply a mess. It ius far more than only inflation. And the EZ is simply unable to clear it up (make new rules that make it a proper monetary union).

  9. Thanks for the link I just discovered your blog a few weeks ago.
    1.) This is a very good question. I would like to distinguish between policy institutions, the general public and universities:
    a.) Important policy instutions (German treasury, important ministries even the antitrust division) are dominated by people with a background in a law not economics. If there are economists they are mainly ordoliberal, sometimes new classical but not (new/old)-keynesian. Schäuble just proudly announced that all important positions in the treasury have now NO background in economics but in law. Since the ordoliberal policy advise did not work the government now seems to take no advice at all from economists which correlates with a strong distrusts in economists in the public.
    The dominance of law people also leads to the absurd situation that if the spending under the current circumstances would have been agreed upon before the crisis we would be doing it but as it has not been we should not do it (i.e. rules should not be changed halfway).

    b.) General public: The economists who engage in the public sphere are totally disjoint from the people who do research according to international standards (and not publish in some obscure German journal). The only important exceptions are Prof. Sinn and since his nomination as head of DIW Prof. Fratzscher. While the former is clearly antikeynesian the latter has the problem that he has been at the ecb before his appointment which hurts his credibility for the German public.
    Nearly all other economists in the public debate are 80s-supplysiders or oldfashioned 70s-keynesians which are directly or indirectly connected to unions and therefore lack all credibility for a neutral perspective.
    The important positions in the economic parts of the newspapers are also dominated by supplysiders or ordoliberals since they have been educated by professors of the corresponding type.

    The German public also has never really felt the crisis which means that the antikeynesian economic policy advisers and newspaper columnist have not lost the credibility to such an extent as in the UK or the US. This is why it is very easy to portray the current German policy as the right way and to portray the other countries as wanting "to take an easy way instead of hard reforms" (which also fits particular well to long existing stereotypes) and as having chosen the wrong business model.

    The declining real wages have also smashed the belief that under (higher) inflation wages would go up correspondingly. In combination with a high proportion of fixed income investments and few equity investments this leads to a refusal of inflation.

    c.) Universities: Yes keynesian economics is taught but it is mainly oldstyle is/lm in intro and advanced courses. "New Keynesianism" never got track in
    German universities (or at least not until recently) which also fits to the absence of "new keynesian economist" in the media and bureaucracy. I don't know why.

    As I am only in my mid 20s I am probably not in the best position to answer (2). But in my opinion inflation was accepted due to increasing wages (especially in the 70s) and because the causes of the inflation were seen in external shocks (oil price hikes and reunification) and not as "manipulating" the economy or the money supply by fiscal or monetary interventions.

  10. What puzzles me in contributions on Germany - both by German an by Non-German economists - is that everybody seems to take the allged strong inflation aversion of the German public for granted. It is true, in the 1970s and 1980s the German public was still constituted to a large extend by people who had lived through at least one hyperinflation period and had thus developed a strong inflation aversion. That probably helped the Bundesbank to stear its anti-inflationary course against social-democratic policymakers such as Helmut Schmidt and Helmut Kohl. Nowadays, however, there is practically nobody alive who can actively recall the inflations of 1923 and 1945-48.

    Indeed, we did not have demonstrations in front of the Bundesbank headquarter in Frankfurt or other forms of public unrest when inflation rose to above 6 percent in early 1992! Why not? Because we had an economic boom, wages soared and everybody was in "party mood" at that time. Yes, the Bundesbank hiked interest rates in autumn 1992. But that was not because of demands of the German public or German politicians!

    The same applies today. It is indeed economic party time in Germany. As a result of the labor market reforms ten years ago as well as of ultra-low interest rates, we are in the middle of a boom. Employment has been rising steadily since 2006 now - with a brief pause in 2009. Wage growth is picking up. It will exceed 3 percent this year. Next year, it will probably be close to 4 percent as the result of introduction of a mandatory general minimum wage. The low unemployment rate and the minimum wage - at € 8.50 one of the highest in the world - will mean that we will see accelerated wage growth in Germany for a prolonged period.

    While inflation is rather low in the euro area and in Germany at the moment, this is most likely a temporary phenomenon caused by the fall in oil prices and the re-appreciation of the euro. The wage adjustment process is well under way, both in the periphery countries and in Germany. The German public and German politicians are not obstructing it. Quite to the contrary, with the minimum wage legislation that become effective from January 2015 onwards they are strongly promoting it!

  11. I note that the perspective in this debate is mainly that of the German viewpoint. My viewpoint is from the periphery.

    I find that the citizens of bailed out countries do not want their governments to take on more debt as the perception exists that it just ends up in the hands of corrupt officialdom. Personal debt levels are very high and looming home foreclosures are focussing minds very intently on deleveraging. There is little demand for credit.

    In the wake of corporate closures and redundancies, there has been a profusion of small business start-ups. Entrepreneurs have no need of bank loans when suppliers will extend 90 to 180 days credit.

    With the steep drop in prices that has accompanied the contraction of money supply, tourists from the north are flocking to the south. Greece and Cyprus are particularly seeing huge increases in tourist revenue from countries outside the Eurozone, who are taking advantage of wage and price deflation in the south and gaining added advantage from their own strong currencies.

    When I went to fetch my wife from Larnaca airport last week, her plane arrived from Dubai at 08:05. Arrivals between 08:05 and 08:30 included Aeroflot from Moscow at 08:10 and four arrivals of Monarch Air from Denmark, Norway, Finland, Sweden. Thomas Cook Air also touched down from Stanstead. The airport concourse was packed with Scandinavians, Russians and British tourists.

    Tourist arrivals are at their strongest levels since 2008 and are helping to reflate the economy. The local banks have shed non-core businesses and are recapitalising adequately from existing revenue streams.

    If these micro economic trends are replicated throughout the strong tourist economies of the periphery, it can be extrapolated that small businesses are growing from foreign cash inflows and are avoiding taking on extra debt. Monetary or fiscal stimulus may be falling on vacant ground.

    The worries about inflation targeting and QE seem to be confined to falling bond market yields rather than to the real economy. From what I see, the economies of the south are finding ways to get by without taking on more debt, hence the fall in M3.

    I would estimate that it is impossible for governments, companies and individuals to deleverage without producing a deflationary cycle. What is the need for stimulus at this point? I believe the graph needs to go substantially below the x-axis, into negative territory, before the turning point is reached. I believe that would be the correct time to apply more monetary and fiscal stimulus. I hope that the Germans will agree.

  12. This comment has been removed by the author.

  13. I think one point which is often overlooked by anglo saxon commentators and pundits is the fact that (i presume based on the low inflation history since WW II and maybe other socio-economic factors) Germans invest relatively little in RE (more than 50% of population rents) and equities, but predominantly in FI, especially in the lower and middle class. (compared to say Italy, traditionally a higher inflation country, where much more people own the estate in which they live)

    Hence higher inflation in Germany might hit the lower and middle class much harder than some imagine, when they casually ask for (much) more inflationary politics in Germany.

    1. If Eurozone monetary was working, Germany would be getting something like 3% inflation whether it liked it or not. So what you are saying is that it is better for German savers to take advantage of the fact that it is not, at the expense of higher unemployment in the Eurozone.

  14. Neither monetary nor fiscal policy can trump the forces of demographics. Just look at Japan. An aging population is a drag on AD.

    Sure, EU inflation could be stoked for a year or two, but after that the same problems would resurface. The debt would be much higher in the end. What kind of 'fix' is that?

    Debt/GDP in Japan is now 225%. Who is it that thinks that this is an acceptable outcome? And who is it that thinks this would be a good outcome for the EU? (Certainly not the German population.) Throwing more debt at the problem will only create a different crisis.

  15. "I have not mentioned at any point levels of debt or structural reforms. Both are distractions for the current problem of inadequate demand and below target inflation. They are relevant only in that they allow policymakers to distract attention from the basic issues."

    So the latest breakthrough in economics is to maintain that plenty of PRODUCTIVE jobs would be created in Greece, Italy, Spain, France ... if only them f'g Germans would tolerate just a tincy little bit of higher Inflation?

    Convinces me that the intellectual progress in this field is simply overhwelming.

    More credits for Greece, so that every Greek can get a government job - and buy German cars.

    Obviously, the perpetual motion machine IS possible.
    If not in physics, then for sure in the economy!

  16. anon3 says:

    Euroland has 2 primary problems:

    a) too much debt, and
    b) endless criminal attempts

    Keynes sounds all nice and furry, but in each crisis round the deficit spending has gone up, and the debt has seen only one way since at least 40 years, for the most countries.

    And now the end of the pole is reached

    b) endless criminal attacks, especially by crime propagating Krugtrons and other, anglo academics

    the law is just, clear, and simple :

    1. no inflation (meaning longer term inflation expectations < = 2.0 %)
    2. no bail out (Germans will not pay one single cent of Italian or Greek debt)

    The only priority of countries with too much dept because of dozens of years of indulgences in Keynesanism is to reduce that, and they have signed the legally binding SGP to that.

    Speaking of common AD just encourages further criminal attempts (like Smaghi / Berlusconi) to push one nations debt onto others.

    An alleged output gap of 3.5% scales with typical utility functions to just 1% "happiness loss".

    The happiness loss because of mass scale financial crime and the resulting hate would be probably about 10 times higher.

    As several before me have already said, we will have 3% inflation in Germany, because of minimum wage AND 10% wage rises in the export industry over the last 2 years, and nobody will complain.

    This funny old 1923 hyperinflation scare is just a myth, the continious 10% inflation as in Italy and other southern countries since the end of Bretton Woods, that is the real thing Germans are rightly afraid of, and therefore we will not give a millimeter on the Euroland < = 2 % limit

    1. 1) The problem of deficit bias, on which I have written a great deal, is about spending too much in booms, not recessions.

      2) The 'law' does not say no inflation, it says 2% or just under 2%. That is not 0.3%. So the law is being broken. I am telling you how to fix that.

      3) If you want to talk about the unhappiness caused by a -3.5% output gap and the resulting unemployment do your homework!

    2. The Problem with your (and others') argument, professor Wren-Lewis, is that in your opinion our economic system is basically fine. Except that, from time to time, some temporary problems arise. Which, however, can be overcome by applying the right kind of potion:
      Not enough money "out there"? No Problem: you need it, you print it! And off it goes ...

      But, for starters, problems in Greece (and eventually also in the other problem states) arise from the fact the Greeks want to consume more than they "produce" (i. e. give in exchange - tourism etc.).

      Of course one can boost the economy and create jobs with OPM (other peoples' money - and yes, the Apostrophe is at the right place).

      But then again. even with us Krauts, nobody can fool ALL of us ALL of the time. It may take us a little longer, but even the Germans in their woods DO understand, sooner or later, that some states don't mean credit when they say so: They want a free lunch.
      Now I do understand that in the olden days superior civilizations like Greeks and Romans could harness German slaves. But, quite frankly, I don't think we should bear this yoke in the 21st century.
      Free the Greeks et al. from the Euro-yoke, and us too, and everybody will be responsible once more for their own wellbeing.
      But obviously, it's lots more fun to sponge off other peoples.

      (Mostly) independent from this particular case there is, however, another problem looming in the back of the whole financial crisis. And that cannot be solved simply by the injection of money as such.

      The main characteristic of an economy with private owners is the fact that the owners collect fees from the ones that are using their products, savings etc. I'm not saying this is wrong (and we should introduce communism).
      But obviously (as Keynes predicted, but as his disciples prefer to bury under a heap of pure technical erudition) problems are bound to arise when those 'money collectors' don't want to spend (all of) their income. I. e. when they have too much to consume, and do not see any lucrative investment chances.
      Obviously, this is a vicious cycle: The masses are out of money, which the happy few accumulate, so they cannot buy goods, so it doesn't pay for the money accumulators to invest in new factories etc.

      I'm not an economist and I haven't read (so far) beyond chapters 23 and 24 of the GT. But clearly, "underconsumption" (or, to include "underinvestment": overaccumulation) was (or at any rate was to become) a problem in the eyes of Keynes.
      Which he suggested to solve by taxation, especially on heritage. Which somehow doesn't seem to work: Tax Evasion through globalisation? Influence of special interest of the affluent?

      So (more or less) forcing banks to issue more credit (Crouch's "privatised Keynesianism") in the end won't do the Job. Since people don't get the chance to earn their OWN money. their creditworthiness must of needs deteriorate.
      And back we are to 2008.

      Maybe, in the end, we can indeed only solve this problem with higher Inflation (much as I loathe it), i. e. negative interest rates on deposits (which, in my opinion, should work the same as Silvio Gesells stamp script money).
      However, this fundamental problem (or implicit antagonism) of a capitalist economy has nothing or at the most very little to do with Greece - or the other problem countries in the ECU.

      This dissolute monster is ripe for dissolution!

    3. 1) deficit bias

      a) but governments did not act according to your writings, for many dozen years

      b) they did not target for the 60% debt/ 3% deficit limits

      c) therefore we have now the stability pact (SGP), legally binding, with clear reduction goals (5% of any above 60 % debt)

      d) if they do not adhere, investors will get skiddish, just like with the GIPSI's after 2009, not overnight, but accumulating

      e) if their risk premiums go up, they have take action much more drastically, or have to apply for a ESM programme, which will provide money only for a legally enforcable turn around programme

      f) if they violate those again, the ECB must cut them off the target 2 system, and the results of this, especially for their “Elites” will be much worse

    4. The SGP was also ignored many times 2000-2007. This is because it is a flawed system, which bites at the wrong time (a recession), but not in booms. I suspect what worries investors most today is lack of growth.

    5. anon3 says:

      It was ignored even during the once in a lifetime boom , because that is human nature. And the endless extensions for countries 7 years after the recession 2008 are legendary.

      Speaking of growth, output gaps, government deficits

      based on the latest OECD forecasts, I downloaded mine on 3/22/2014, brandnew at this time. Following numbers forecast for 2015

      Annex Table 10 output gaps
      Germany plus 0.2%
      UK minus 1.2%

      Annex Table 27 Government financial balances
      Germany plus 0.6%
      UK minus 4.7%

      Even if the UK government gets half the output gap as tax,
      this o so austere England still has a 4.1% deficit problem

      How are you going to solve this?

      Do you think you can live beyond your means forever, fuelled by larger and larger real estate bubbles?

    6. Mainly Macro29 August 2014 06:53:

      There is no 'law' that says 2% or just under 2%. So there is no law being broken.

      The ECB thinks that 2% or slightly less is a good idea. That does not make it a law. And there are people who do not think it a good idea. That makes it worth discussing, but it also shows you are ill-informed,

    7. Why do you think I wrote 'law' rather than law? In the Eurozone the ECB has authority to set the inflation target for the union. It is implicit that countries should follow that target: a currency union cannot work if they do not. Because Germany undershot that target in the early 2000s, they should overshoot it now. Those are the rules of the game which are clear to anyone who understands the economics. Why? Because to do otherwise causes large costs on other union members, which is exactly what is happening now.

  17. anon3 says:

    2. inflation /violation

    Just as Draghi said 3 months ago, so far this is well within its mandate <= 2%

    Those who cry “violation” now, should take a look at inflation data prior 2008, how much deviation was accepted then by everyone to be “within noise”.

    And with that noise definition we could run 2 more years of 0% inflation without “violation” declared. Please ask your engineering colleagues, how this would look like in an SPC chart

    1. ECB mandate: at, or below but close to, 2%. Average 2000 to 2012: 2.16% Current 0.3%.

    2. for deriving the "noise figure", the degree of process control, taking the simple 12 year average is by far not enough.

      Again, please contact your favourite engineer to explain it to you

    3. Peak: 3.3% 2008, followed by 0.3% 2009. Otherwise highest annual 2.4%, lowest 1.6%. 2013 1.3%, current 0.3%. Are you expecting 3% in 2015? (OECD forecast 1.1%)

    4. I try to say this as polite as possible.

      You don't have an engineering department in your university, and what you would need is actually more some real person with some real world process / SPC (statistical process control) experience. I dont have a good book as reference, and this is not something which can be explained in a few lines in a blog, especially not for elderly / retired people.

      But the real world economy runs on that !!

    5. Can I perhaps suggest you try and understand some macroeconomics before trying to make comments on monetary policy.

    6. Mainly Macro29 August 2014 08:
      "ECB mandate: at, or below but close to, 2%. "

      There is no such mandate - you are inventing it. Draghi said that 2 % is within ihe ECB's mandate, which is not the same thing.

    7. You are right, mandate is the wrong word - it is the target it has set.

      But that target sets the average inflation rate for each country in the union.

  18. I happened to discover your blog and I have been reading the comments. The most shared assumption seems to be that no one wants a break up of the EMU. So this is considered as an "irrelevant" issue. The point is that the level of animosity between nationalities in this blog indicates that there is not a "common future" and there will not be a common European currency in the future. The EMU is dead in the heart of Europeans. There is no common destiny or solidarity but just distrust and recrimination between nationalities. That means EMU will disappear in a matter of a few years. As in a marriage you cannot go back to engagement and it will be a divorce. We will see what sort of divorce it will be..... EMU is one of the most horrible mistakes in the history of political economy. It will take decades to fix economies and European hearts. This is an interesting reading from IMF about the situation:

  19. Let me just add that the comment by "Anonymous 29 August 2014 01:57" about the Turkish Empire and fascism in Spain and Italy was especially disturbing. I cannot understand why people educated in economics should use that sort of arguments. If academics are so down to discussing of old days fascism (and may be comparing it to the superior efficiency of nazism ...) and national antrophology, then EU is in a desparate situations and not just from an economic point of view. A cold and simple going back to optimal currency areas would help to understand what is going on, here.

  20. anon3 says, since your id handling is , lets say weird,

    I could offer 3 tests of my "macroeconomic knowledge"

    1. discussing what is wrong with nobel prize winner Solow 1957 paper

    2. SWL proposes one Krugman paper of his own choosing, and says in a few OWN words, why that is a remarkable contribution to macroeconomic understanding, then I go over it, and SWL defends it : - )

    3. We discuss the implementation of the Cobb-Douglas function in the macroeconomic model of the Fed , a.k.a as FRB/US

    other suggestions?

    We might not agree on everything, but we would most probably gain additional insight in each other’s thinking, and why people coming from the scientific/ engineering world do not respect macro economic statements that much, most of the times 

  21. "Until the European political elite can show that they can design appropriate and successful macroeconomic institutions (i.e. better than ECB, SGP), any move to fiscal union would seem extremely unwise."

    First, if the UK wants to take this attitude, fair enough. OTOH, if the other Europeans want to move forward - and they do - the proper response of the UK shouldn't be to stand in the way and gum things up, but move aside and let the other Europeans try.

    Secondly, it was always intended for the euro to be the currency of a more federal Europe. The present arrangements were always supposed to be transitional.

    Thirdly, before the US moved to a fiscal union, it had the period with the Articles of Confederation Even less satisfactory than the European experience with the euro. And the US, with its endless round of panics in the 19th century and early 20th, still had serious problems with its money.

    But leave all that aside. If the Anglo-Saxons want so much to help, then why are they not offering constructive advice how to move Europe ahead to a fiscal union? It can only be because they don't want it no matter what - even if it worked.Seriously Simon, even if fiscal union worked, would you support it? want the UK to be part of it? Or is that attitude the kiss of death for someone who wants to work in a Labour government?

    1. There are two things I object to about this comment. First, I am not a representative of the UK. I am an economist. Second, you seem to think that I want to work for a Labour government, and so you assume that influences what I say. That is insulting.

      But it reveals an attitude that I come across frequently. It involves starting from assuming a political position, and working backwards to the economics. I suspect it was exactly this attitude that made those that designed the Euro framework just wish away the problem of asymmetric shocks, a problem whose consequences now dominate what is happening in the Eurozone.

      I have been told a number of times in comments that I am ignoring the politics. I think a more accurate description of what is going on is that the politics is ignoring the economics.

    2. Economics is politics

    3. No, economics are political, which is quite a different thing. Economics and politics are not co-terminous. If the political forces desire what the economic ones cannot deliver, they will not get it.

  22. You are absolutely right that politics is ignoring (and has ignored) the economics. Based on the literature and knowledge we have EMU was a very wrong idea from the very beginning and we are losing a generation at the European periphery discussing how to keep it alive. We should go back to basics and start building a European identity (if we want to) in school, language, culture, legal systems, politics, welfare .... and then, at the very end, may be, introduce again a common currency if it makes economic sense and not just political sense. Forcing European people into a union by means of monetary policy, debt restructuring and crisis is a reckless project and it will end in pain. It was a mistake and it is time to admit it. That's the main point.

  23. Dear Sir,

    as a German, you have lost me at "too competitive". The consequence of what you are saying is that the Eurozone as a whole should settle on a less competitive state than Germany is at right now. You will NOT be able to sell this to the German public.

    Instead, internal devaluation, becoming more competitive vis-a-vis the rest of the world, is the strategy. It's true that this makes the debt burden heavier, but I am not opposed to a debt write-off. In fact, I consider it preferable. Capitalism can be tough and the European in economies in trouble should face the music and grow from it (no pun intended). Will this have consequences? Yes. I accept that.

    1. OK, I understand. I am using competitive as a relative concept. As the rest of the Eurozone get more competitive (relative to Germany), Germany will get less competitive relative to the rest of the Eurozone. Now you might say, that if this happens by internal devaluations in the rest of the Eurozone, that is better because the Eurozone will be more competitive against the rest of the world. But that is wrong - all that will happen is that the Euro appreciates.

      The lesson of the Great Depression and the Gold Standard that economists are pretty much agreed upon is that trying to get competitive by internal devaluation is too painful and deflationary.

      So its much better if Germany gets less competitive relative with the rest of the Eurozone by higher inflation in Germany. Germany will still be as competitive with respect to the rest of the world, because the Euro will not appreciate.

    2. This is from a different ano:

      "The lesson of the Great Depression and the Gold Standard that economists are pretty much agreed upon is that trying to get competitive by internal devaluation is too painful and deflationary."

      This experience is not shared by the German public (although it is shared by modern macroeonomists in Germany). The experience of the Great Depression is forgotten in the German public knowledge.
      I think it was forgotten intentionally after the war because otherwise the German public would have had to ask himself what came after the depression. The confrontation of German public with his own nazi past came only in the late 60s.

      "But that is wrong - all that will happen is that the Euro appreciates."
      This is not viewed as a problem in the traditiona, German public eye. It is even something good. The German model was "export as much as possible" (shared by unions and employers) then the Bundesbank recycles the export gains. Then the mark appreciates and German consumers can get cheaper products by cheaper imports. Then there will be more productive gains in Germany which makes net exports again possible ...
      For details I recommend literature by proponents of the model like Nölling, Hankel or Schachtschneider.
      Being a net exporter and having a high exchange rate is very positive in this kind of thinking.
      This kind of thinking is also the reason why "competitiveness (against the world) is everything" for many Germans.

      I do not recommend this model but this the model which was hammered into the minds of the German public for a long time. And of course this model is not really possible under a currency union unless everybody becomes a net exporter to the world.
      The thinking is slowly changing as more and more people are understanding the problem with the model but demographics in Germany are not in favor for a change of the public opinion.

    3. "Now you might say, that if this happens by internal devaluations in the rest of the Eurozone, that is better because the Eurozone will be more competitive against the rest of the world. But that is wrong - all that will happen is that the Euro appreciates."

      As did the DM before. Compare to my comments to "Eurozone delusions". The Euro was designed as Euro-DM, not Euro-Lira. Some of the other EZ nations were so eager to have a strong currency like the DM that they hired Goldman-Sachs to do creative work with their debt levels. They wanted a DM-like currency.

      We Germans are not afraid of currency appeciation. It has worked for us before and we do not understand why it should not work for the other EZ countries. Whether right or wrong, you be the judge, we expect other countries to adapt to us.

      What you are having here is, in my mind, an unresolved conflict between France and Germany. France wanted the common currency, there was a tacit agreement that it would be based on BuBa principles and now it looks from a German perspective as if France might be have second thoughts about it. A potentially dangerous situation for the Euro.

      If I may again briefly go back in time to highlight the root cause of the problem:
      Back in the early 2000s, the early years of the Euro, the German public was intimidated by the ascent of China and India. Germany felt threatened and from this public mood the low wage increases came forth. In the so-called PIIGS, however, the mood was different. People were elated to have become part of the common currency. They did not stop to think about competitors outside of Europe. Or if they did, it did not have the same consequences. What then followed was a breakdown of common EZ economic strategy: Germany's wages stagnated more or less, while today's crisis countries were rather inclined to raise wages more. This opened up the scissors in inflation rates. What would have been required (from my layman's perspective) was the German chancellor back then addressing the need to become more competitive vis-a-vis the rest of the world to other EZ governments. A common EZ strategy, if you will. EZ governments obviously need to walk hand-in-hand regarding inflation rates.

      A final thought: wage raise compression has decreased German unemployment from 5 millions to 3 millions. Germany is today the powerhouse in Europe. How do you think you can convince the German public of even giving up 25% of what is gained? If Germany inflates 3% and other EZ nations 1%, the other nations become more competitive. If that causes unemployment to climb back to, say, 3.5 million, the German government that allows that to happen is toast. The Euro is mainly a project by the elites. Germans like the Euro but 500,000 additionally unemployed would strain those sympathies heavily.

  24. Isn't the real problem that no one knows how to create inflation or really goose aggregate demand in a modern advanced economy? I live in America... I have a job and plenty of disposable income, but you couldn't get me to spend more money no matter how much inflation we created. I have everything I need. I believe the real problem in the West is that most people are content with what they have. There is no need for more materialism... that time has passed.

    I'm sure that poor people could use more food, better shelter, and transportation, and that might improve growth to give them the stuff they need but it is hardly going to make a huge difference. What economists like Krugman and Wren-Lewis seem to be proposing are policies to get people like me to spend more money.... and that's just not going to happen. The upper middle class has all the junk they need already.

    1. @Anonymous30 August 2014 12:26

      "Isn't the real problem that no one knows how to create inflation or really goose aggregate demand in a modern advanced economy?"

      Quite right. Pail Krugman says there will be no inflation at the zero lower bound, which is, as Simon Wren-Lewis points out, where we are.

  25. .
    Is it possible that an entity as unique as the European Monetary Union needs a unique solution?

    For example, if we assume that National Psychology will trump logic in perpetuity, that leaves only the ECB as an actor free of National Psychology and the only one that can have an effect.

    Focusing on the ECB: Would vastly more QE be adequate? If not, then perhaps it could do something unique?

    A unique approach would be for the ECB to adopt Central Bank Dividends. A Central Bank Dividend, whose precise implementation can vary, is essentially the Central Bank giving a dividend to its owners - which in all cases is really the citizens.

    There are many ways to implement a CBD. In this case a good example might be for the ECB to declare a CBD of €1000. This would mean the ECB would open an account for each euro area country and each account would have €1000 * number of citizens in that country.

    The money could be constrained in many ways, the most palatable would be to require the money be used for debt retirement.

    The net effect is that each country would be able to retire, on average, enough debt to equal 3.5% of GDP.

    This case is not completely unlike QE, except that the debt is vaporized instead of merely redirecting the payments to the ECB for the purchased debt.

    CBD is a clean, fast, effective and most importantly fair way to deal with this type of situation.

    Avraam J. Dectis

  26. This comment has been removed by the author.

  27. For the European Union to survive we have to acknowledge that while integration and free trade is a good thing, it’s not the solution for everything.

    Weaker countries and regions need some sort of protection from bigger more competitive countries, integration promotes economies of scale and agglomeration, so we need mechanisms to prevent this from happening.

    Curving imports by limiting internal demand is criminal, we could accomplish the same by incorporating some defense mechanism in our tax laws. VAT is a problem in Europe, it taxes value added at the same rate has imported value which makes no sense at all in economies that need protection or incentive to grow, so differential VAT rates for imported products should be a transitory measure in Europe’s toolbox for crisis situations.

    Other mechanism that should be put place is that when the ECB buys debt, the debt should be valued at the purchasing price and not the issued cuppon, or that ECB would buy sovereign debt only by financing sovereign states, allowing them to take advantage of the discounts of the debt that is trading in the markets. The way the ECB is acting mimics the acts of a loan shark, it guarantees a country will not default on its debt by buying it on the secondary market but will demand the principal and coupons to be paid until maturity.

  28. "Within the Eurozone, we have a problem created by Germany undercutting pretty well every other economy in the 2000-2007 period. I am not suggesting this was a deliberate policy......"

    I've lived in D for 25 years and I think it was deliberate. In the 90's German labor would trike at the drop of a hat.. almost like the French. In the 2000's suddenly the red banners, the whistles, the banging of pots and pans.... it simply vanished from the streets. I believe the Germans knew the Euro would work their way, that there was a quiet coordination between politics, management, and labor on the internal devaluation (admirable I guess), and also that the Germans completely underestimated just how well it would work.


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.