Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 5 October 2014

Eurozone Asymmetries

Suppose a large Eurozone country – let’s call it France - decided that it needs to substantially increase its minimum wage in order to reduce poverty. The increase is sufficiently large that it leads to a sustained increase in average French wage inflation, which in turn decreases the competitiveness of France relative to the rest of the Eurozone. France cannot be permanently uncompetitive, so the obvious consequence would be that France has to endure a subsequent period in which its relative inflation was below the Eurozone average.

However this would require a period where French unemployment was above its natural rate. French politicians declare that this would be politically unacceptable to French voters. Instead they suggest French inflation should remain at 2%, and the remainder of the Eurozone should increase their inflation rate to 4% for a time (giving an average Eurozone inflation rate of over 3%) to ensure France regains competitiveness. Now this would not normally be possible, because the ECB’s inflation target is 2%. However the influence of France on the ECB is such that the ECB fails to raise interest rates in time to prevent 3% average inflation, and subsequently keeps interest rates low because they repeatedly forecast inflation falling back down to 2% in due course.

The rest of the Eurozone would understandably be upset at having to endure 4% inflation. Some countries might suggest that perhaps, in the absence of ECB action, they could tighten fiscal policy to get their inflation below 4%. However France refuses to countenance changes to agreed fiscal targets, and instead suggests that what is really required is for other countries to adopt a similar increase in the minimum wage to the one originally undertaken in France. The French head of the ECB gives a speech where he intimates that the ECB might be prepared to raise interest rates a little bit in exchange for other countries introducing this ‘structural reform’ to their minimum wage levels. The French government also hints that it might be prepared to allow very limited fiscal contraction outside of France, but only if this took the form of tax increases rather than public expenditure cuts.

Your reaction to this little imaginary story is that it couldn’t possibly happen because other Eurozone countries would not permit it to happen. My suggestion is that Germany rather than France is doing exactly this at the moment, except that in their case it started with a period where German wage inflation was below the Eurozone average (for reasons discussed by Dustmann et al here). [1] German control of the ECB might not be as complete and simple as I imagined French influence in the story above, but it has the advantage that interest rates have hit the zero lower bound, and the threat that anything unconventional could be declared illegal. And in this real world story I too wonder why other Eurozone countries allow Germany to get away with it.



[1] In fact what Germany is doing is worse, because inflation asymmetries and debt deflation mean that the output costs of achieving zero inflation outside Germany to regain non-German competitiveness are far greater than the costs associated with 4% inflation in my story. 

47 comments:

  1. I thought the 'natural rate' changed its name to the NAIRU acronym precisely to stop 0% inflation targets coming into being: one size fits none.

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  2. The other side of the asymmetry is permanent deflation in southern countries which means high structural unemployment and lower wages. This situation is not sustainable in the medium -long run, as social costs will be enormous.

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    1. The obvious hope is that the south will become more competitive compared to non-EZ countries.

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  3. One point where this scenario isn't valid is that EZ fiscal rules are asymetric - there are ceilings for deficits/expansions but not for surpluses/contractions. So nothing in existing rules (of course maybe in your scenario France could change the rules) would prevent the rest of the EZ undertaking unilateral fiscal contractions to bring domestic inflation down. Just another instance of the EZ's institutional deflationary bias, but then fundamentally the Germans seem not really to accept that there is any upside to inflation, e.g. Hans Werner Sinn, supposedly the country's most influential economist, was merrily calling for deflation in southern Europe this week.

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    1. "Hans Werner Sinn, supposedly the country's most influential economist, was merrily calling for deflation in southern Europe this week."

      Yes. The strategy is that the south should become more competitive compared to non-EZ countries. Germany doesn't want Italy to cut into its market shares, it wants Italy to cut into the market share of countries outside of Europe.

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  4. This is completely stupid behaviour on Germany's part. I know other countries are capable of mass derp (austerity denial in England) but Germany should know better - do they really want to be hated by large parts of Europe? Again?

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  5. Simon, have you responded to Ken Rogoff's skepticism towards the Germany-focused analysis of southern Europe's problems? It is notable that the EZ is a much more open economy than the US (about twice as open in terms of trade:GDP ratio) and the argument is that closing the PIIGS's bilateral deficits with Germany would still leave them with large deficits with the rest of the world. Rogoff: "larger German fiscal deficits would hardly have been a decisive factor in Europe. Research by the IMF and others suggests the demand spillovers from German fiscal policy to Europe are likely to be modest, particularly in the eurozone's troubled countries, such as Greece and Portugal. Germany trades with the entire world."

    http://www.theguardian.com/business/2014/apr/10/germany-current-account-surplus-wider-issue

    So in this view, Germany increasing its inflation may reduce Germany's (and perhaps the EZ's) CA surplus to more reasonable levels, but won't do much for Spain et al.

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    1. James, I think this is a different argument, and a good example of framing. This is not about fiscal expansion in Germany. It is about monetary and fiscal expansion in the Eurozone as a whole. What Germany is currently doing is stopping the rest of the Eurozone from reducing unemployment, both through their influence on the ECB and through the fiscal rules imposed on the Eurozone as a whole. (Actually its worse than this - the fiscal rules are creating the unemployment.)

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    2. Mainly Macro5 October 2014 03:48

      Prof. Wren-Lewis,

      Very sad to see you writing such stuff. You have turned into an economist that is against competition. Who would ever have thought that possible?

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    3. to SWL: You seem to think the crisis caused the problems, have you looked at the Spanish unemployment before it entered the eurozone (and they let in millions of immigrants)? Have you looked at the growth rate of the Italian economy before the crisis hit? And how large do you estimate the black economy to be? You need to dig deeper into the different country characteristics first.

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    4. Germany kept inflation near zero when PIIGS had 5-6%, thereby getting around 20% competitive advantage. Now Germany wants to continue keeping inflation near zero, and wants to force PIIGS to deflate, cumulatively, around 20%. And Germany ignores all the previous theories, as well as the data from the last six years, that spending contraction in near-zero-bound situation means contraction of economy, not expansion, as some like to dream.
      Zero inflation (and wage inflation) when others have 5-6% wage inflation is uncomfortable. 20% real (and nominal) wage deflation when inflation is kept near zero is near-riot condition.

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    5. ''Germany kept inflation near zero when PIIGS had 5-6%''

      You are talking Spain, and it was aprox 4%.

      If Germany ''kept'' inflation near zero as you claim, why didn't keep Spain inflation near zero too?
      The answer is Spanish inflation was caused by a housing boom, a boom Spain could have prevented but was very happy with. I didn't hear anyone complain at that time that inflation was too high, After it turned out that the boom was nothing but a bubble, suddenly the blame is put on Northern countries who don't want to co-operate with higher inflation or bending the fiscal rules even more.
      Why would they? They are sovereign countries. If you really want this, ask for full political and fiscal union first.

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    6. Northern countries provided the financing to fuel the boom, and they were very happy at that time, too...

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    7. @Marco: Do not tell them this fact, they might figure out who profitted from the boom ;-) and that in the end we are all saving banks and their private savings at these banks.

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    8. We are aware of the fact, believe me. We are aware that banks have been saved. But not just the banks. Debtors have been allowed to save face too.

      Personally, I would have rather seen a chain of defaults and bank nationalizations. I simply want to see the shareholders of said banks to be completely disowned of their shares. That should avoid moral hazard in the future. Also, the final tally is still outstanding. As far as I can see, most of the money given to Greece has been lost.

      German politicians are trying to hide the losses from the public to not completely erode support for the Euro. Are YOU aware of that?

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    9. "Debtors have been allowed to save face too."
      The current option is the worst outcome for debtors in the periphery because they are not allowed to default and cannot pay back their debt because the economy has restrained growth (due to wrong fiscal policy and a central bank which was for far too long more like a currency board and not like a real central bank) or outright deflation which increases the debt problem.
      In Germany it is never discussed that "over borrowing" goes together with "over lending" and that German (and French, Dutch, ...) banks directly (the big banks like Deutsche, Commerzbank and Landesbanken) or indirectly (Sparkassen, etc. which finance the larger banks) participated in this mess.
      The current policy is optimal for creditors as long as the current equilibrium is stable, which I do not believe it is but we might disagree on this point.

      From a moral point of view I prefer the defaults and bank nationalizations but it is impossible to bail the banking sector in the Eurozone (without additional ecb financing) since the banks are much too big relative to GDP (in contrast to the American banks) and I am strongly against a chain of defaults. We discovered in the Great Depression that "binge and purge" is not the best option to save a banking system (if the market participants are too big) because it drags down the entire economy (including healthy companies). Thankfully, the head of the Fed was someone who had studied the Great Depression in great detail. But I am quite sure that we will disagree on this point.

      The money given to Greece has not been lost, it was paid to creditors in the private sector (including some German banks).

      I do not think the public support for the Euro would erode if the real story would be told. Especially if there was clear communication along the lines:
      -We are in this mess together because we created it together
      -We cannot reintroduce the former currencies because we do not know how the existing debts would be distributed across the Eurozone countries, our own economy is far too dependent an exports to introduce a new Deutsche Mark and we do not know what will be left of the EU after the MOAB.
      -A collection of 18 countries with 80% US GDP is more like a large economy. and not like a collection of small open economies and therefore we need different economic policies

      This may not be true for the FAZ-Wirtschaft and AfD crowd but for a majority in the population. And most importantly this would breaks with the long tradition of German economic policy of a "late developing nation". Of course this would also lead to much stronger support for something like Brown-Kaufman to regulate banks in Europe which might not be desired by certain politicians and parts of the economic establishment.

      But I do not believe this will happen. In my view Merkel has understood the problem by now (as usual much too late) but she has cornered herself (due to bad economic advisers) into such a corner that she cannot leave. She is strangled by the conservative professors/media and especially by the Bundesverfassungsgericht which more or less is deciding the monetary policy currently although it has not understood financial markets or the rule of a central bank.

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    10. '' Do not tell them this fact, they might figure out who profitted from the boom ;-) and that in the end we are all saving banks and their private savings at these banks.''

      in the end nobody did profit from this boom, and banks in the Northern countries did need to be saved too.
      If the worst comes to the worst, the Northern countries will be able to save themselves, in or outside the eurozone, and that's what voters in these sovereign countries expect from their politicians.
      But can the Southern countries save themselves? This whole discussion gives me the impression that it's the job of Germany and other creditor nations to save the troubled countries. Well, it's not. This was not agreed in the Lisbon treaty and at the launch of the eurozone, In fact, the biggest worry of Northern taxpayers was, and still is, having to pay for other countries. Economists on this blog claim that monetary or fiscal stimulus is a free lunch, voters in those Northern countries simply do not believe this, they have no confidence that debt will ever go down or be repaid and some day in the future it will be payday.
      You can continue as long as you want putting the blame on Germany, or call them stupid, but if I tell you that over 90% of voters, and politicians from left to right, hold this opinion, than I think continuing the blame game won't bring you very far, you need to win over confidence of taxpayers in those countries first. Goodluck with that.

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    11. I do not see how QE is increasing the debt levels as such?
      It is an asset-swap on the banks' books which increases the money supply.
      Is no economic growth no worry to you? 25% unemployment?

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    12. Won't looser monetary policy at the ECB level (e.g helicopter money) reduce the euro's value and make German (and Eurozone) exports more competitive? Combine with structural reforms (my idea was a EU wide land value tax, legalise drugs and prostitution to tackle the Mafia and be tough on crime, flexible labour markets.)

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  6. Dear Sir,

    German control of the ECB is not only incomplete, it is non-existent. The only influence that Germany has on ECB policies is the looming threat of Germany saying at some point: 'You know what? Stuff it, this isn't working, we're walking away from the Euro.' This threat is a fairly long shot, however. Not as long anymore due to the rise of the AfD, I'll grant you that. But still quite long.

    Secondly, and this is *most crucial*, there is an asymmetry to the 2% inflation target. Suppose due to increasingly cheap and qualified labour outside of the EZ, the EZ would become uncompetitive as a whole. Then sticking to the 2% inflation target would be suicidal, the EZ would HAVE TO become cheaper because it could not hope for other world regions becoming less competitive for them.

    And this is what Germany's prescrption for the EZ is all about: becoming more competitive against the rest of the world. An EZ-wide inflation rate of between 0.5% and 1% is against the rules but, I believe, intended. The strategy for the EZ is that becomes for the world what some claim Germany has been for Europe. Yes, the USA or China could inflate price differences away. So what? They would become like Italy or France before then. This is a solution that Germany would be very comfortable with. So... Germany is working on making the EZ become a bigger version of itself. Will it succeed or fail miserably? I don't know.

    In short: the 2% inflation target isn't all that it's cracked up to be. Germany will see to it that it gets undercut if EZ competitiveness is at stake. As a German I would of course prefer to see this (undercutting the rate, not deviating to the upside) codified into rules instead of muddling through.

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    1. For the ECB the way I would put it is that a lot of central bank governors seem to think like the Bundesbank rather than as macroeconomists (or as monetary policymakers in the UK or US) - quite why is a little mysterious to me.

      However the main part of your analysis would only make sense if the Euro exchange rate was fixed, which it is not. So the Euro rate adjusts to make sure the EZ as a whole is competitive.

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    2. Dear Sir,

      you wrote:
      "For the ECB the way I would put it is that a lot of central bank governors seem to think like the Bundesbank rather than as macroeconomists (or as monetary policymakers in the UK or US) - quite why is a little mysterious to me."

      Jens Weidmann seems frequently isolated. And Asmussen had even been regarded as traitor by some here. So, I am not sure how much clout Germany holds. You might be aware that a fair number of Germans want to revise voting weights in the ECB... in Germany's favour.

      Regarding your other point, if anything the ECB has been founded under the premise that it would be like a BuBa for the EZ. So naturally central bank governors find it hard to toss all that out the window and adopt anglo-saxon-style Keynesianism.

      "However the main part of your analysis would only make sense if the Euro exchange rate was fixed, which it is not. So the Euro rate adjusts to make sure the EZ as a whole is competitive."

      There was a time before the Euro in which we had did not have fixed rates either. So my claim stands that Germany today wants the EZ to become for the world what Germany has been to Europe before. I am not judging whether that would be good or bad, it's just my analysis of the present situation.

      However, my main point in the above comment was that holding up the 2% inflation rate in an attempt to induce more inflation in Germany probably won't work. Undercutting the 2% rate for a few years will be quietly accepted instead - until crisis countries have regained competitiveness against external economies.

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    3. A constant theme in some posts seems to be that austerity and internal devalution is required in the EZ periphery until those countries "become competitive".

      I'd be interested to know what mechanism you think there is to link the two.

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    4. @ gastro george
      To be brief:
      a) reduction of wages
      b) reduction of social benefits (just decided in France) but also in most PIIGS countries.
      Result: government expenditures fall (austerity = declining aggregate demand), cost of production (wages plus ancillary labour costs) decline (enhances competitiveness).
      c) institutional reforms (e.g. labour market, etc.) enhance competiveness by reducing transaction costs and changing the scope of firms (Italy! firms are too small to realise economies of scale)

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    5. Well, not required. Obviously, Italy and France have been devaluing their currency in the past and therefore remained competitive against Germany.

      But this is what these countries have de facto vowed to leave behind when they signed up for the Euro-DM. The Euro is a currency that is supposed to rather appreciate (against the world) than not.

      So, are you saying that the crisis countries are backtracking or should be backtracking from what they subscribed to?

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    6. I think these countries signed up for 2% inflation. At the moment they have close to zero! Why care about what happens to the nominal exchange rate.

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    7. Mainly Macro5 October 2014 10:34

      "I think these countries signed up for 2% inflation."

      As far as I can remember nobody mentioned that inflation rate when the Euro was discussed in the early nineties.

      You, Prof. Wren-Lewis, have been trying to make out that it is an almost legal and certainly moral obligation to agree to that. That is a sheer invention. The Germans were promised by their politicians that there would be no more inflation than under the Bundesbank. The southern countries expected they would get solid finance without continually rising prices and the disadvantages of repeated devaluations.

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    8. The 2% limit is in the ECB charter. It may not have been heavily advertised, but was and is there. As it is the 6% trade surplus upper limit, which Germany keeps on violating, year after year.

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    9. Marco Cattaneo5 October 2014 13:32

      The 2% limit is in the ECB charter. It may not have been heavily advertised, but was and is there.

      If that is so, I consider myself beaten. But unfortunately, I must ask you for proof: Even Simon Wren-Lewis admitted a short timeago that the 2% were not a law. If they are in the ECB's charter, they are a law. So please give chapter and verse - if you can, which I doubt.

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    10. "The 2% limit is in the ECB charter. It may not have been heavily advertised, but was and is there. As it is the 6% trade surplus upper limit, which Germany keeps on violating, year after year."

      But then there is the no-bailout restriction which was blatantly and deliberately shattered, just ask Madame Lagarde. So rules can be broken at any time, anything goes. In truth, the 2% inflation rate is just means to an end here. At least in my humble opinion.

      I believe Prof. Wren-Lewis wants to engineer a balance between Eurozone member states (if so, I would dare to call that central planning). Some state more akin to 2004 than 2014. It's not about any rules, I doubt he cares too hard about following those strictly. It's about distribution - my impression is that he wants to redistribute labour (and therefore income) back to crisis states. It's all speculative but my guess is that the current distribution violates his sense of fairness.

      How about this for a test? German labour unions again practice wage restraint as before to make sure that German deflationary tendencies are in lock-step with crisis countries. Then any monetary policy by the ECB that brings the inflation rate back to 2% will not cause any redistribution (at least if evenly applied). I might be wrong but I doubt that Professor Wren-Lewis would be very satisfied with such a formal meeting of the 2% target.

      I also suspect another motive is to discourage further mutual undercutting. If Germany was now forced to accept higher inflation rates, no EZ country (nor their labour unions) would have incentive to undercut other EZ countries in the future. Which brings me back to the centrally planned approach, in contrast to letting actors out there decentrally decide on their own and everybody accepts the outcome. Which seems to me is actually is at the heart of capitalism.

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    11. Without any "planning", as you call it, there is no point in having a common currency, except that it allows Germany to exploit is superior ability to control wage inflation and obtain unduly competitive advantages at the expenses of peripheral countries. Without "planning", if countries are required to compete in a noncooperative way, much better that each keeps its own currency and its own central bank

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    12. Anonymous 5 October 2014 14:08 - source Wikipedia:

      The primary objective of the European Central Bank, as laid down in Article 127(1)[12] of the Treaty on the Functioning of the European Union, is to maintain price stability within the Eurozone. The Governing Council in October 1998[13] defined price stability as inflation of around 2%, “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%” and added that price stability ”was to be maintained over the medium term”

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    13. Anonymous 5 October 2014 15:02

      "But then there is the no-bailout restriction which was blatantly and deliberately shattered, just ask Madame Lagarde. So rules can be broken at any time, anything goes."

      Sure: a lot of rules were broken. And many more will. The fiscal compact is arithmetically impossible to be fulfilled.

      Rules were just conceived based on wrong assumptions - such as expansionary austerity - and not taking into account the outcome of a world financial crisis (demand depression, liquidity trap etc.)

      Rules have to be thoroughly rewritten. Germany is likely to be unhappy about any kind of workable solution, in which case she should leave the Eurozone asap.

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    14. Massimo D'Antoni:
      Dear Sir, you are making a few claims that require substantiation.

      - Why is there no point to the common currency beyond the supposedly "benign and enlightened" engineering all the EZ countries? The German public has been sold the Euro to this day on the assumption that the Euro would reduce transaction costs. If you're saying that this is not the real motivation, this invalidates the legitimation given to the Euro project to a degree. (If we ignore for a moment that the real reason for the Euro's existence is that European elites have usurped european democracies and try to impose their vision of a united Europe on the masses. The Euro represents a forced marriage into a top-down Europe; this Europe today is not bottom-up by a long shot.)

      - What are you referring to with Germany's "superior ability to control wage inflation"? Germany's approach to wage negotiations? I heard of a study that said that Europe's different ways of settling on wages contributed differently to wage growth/inflation.

      - Please define briefly non-cooperative competition in the EZ context, why it applies to the current situation and why it should be prevented.

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    15. ''The 2% limit is in the ECB charter''

      '' it aims to maintain inflation rates below, but close to, 2% over the MEDIUM TERM”
      http://en.wikipedia.org/wiki/European_Central_Bank

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  7. Great anti-factual :) Now for a strategy to make it a reality!

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  8. The Northern countries would simply leave the eurozone.
    Your question ''why other Eurozone countries allow Germany to get away with it'' should be re-phrased into: why do the current deficit countries with high unemployment not leave the eurozone?

    There must be something that makes it attractive for them to stay in the eurozone otherwise they would have left already.

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    1. Great political capital spent by the ruling parties. Every country in Europe is ruled by those who were, mostly unquestioningly, for EU and Euro. Saying "you know what, Euro is actually bad" would mean political suicide for every politician who defended Euro.
      Last big crisis I can remember for Italy was in the early '90s. Italy devalued Lira by almost 50%, and economy soon recovered and grew quickly. If PIIGS had the method available, they would be recovering now.

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    2. ''Last big crisis I can remember for Italy was in the early '90s. Italy devalued Lira by almost 50%, and economy soon recovered and grew quickly. ''

      What were those same politicians that did do this devaluation thinking when
      they signed up for the impossibility to do this again?

      you blame politicians, but how large is the support of the general public to leave the eurozone in those countries?

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    3. They made a big mistake. Which is not a reason not to correct it now.

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  9. ''Without any "planning", as you call it, there is no point in having a common currency, ''

    can you please show the articles in the Lisbon treaty that define this planning? (apart from the no bailout clause)

    '' except that it allows Germany to exploit is superior ability to control wage inflation and obtain unduly competitive advantages at the expenses of peripheral countries.''

    right. What about ''superior'' ability of education, innovation, structural reforms, good governance, tax planning, natural resources, access to capital, etc, etc. Maybe they would help with obtaining ''unduly competitive advantages at the expenses of peripheral countries'' too? what do you propose? A central eurozone government that is going to run the governments of all eurozone countries that are too competitive?

    ''if countries are required to compete in a noncooperative way, much better that each keeps its own currency and its own central bank''

    You are absolutely right. And what continues to amaze me is that the people now complaining should have been aware of what they signed up to. You can't change the rules afterwards, if it becomes clear they don't suit you. At least not with a democratic vote in all eurozone countries. And that vote is going to be no, and this makes this a pointless discussion.

    The euro = D-mark, everybody knew this, and everybody wanted this. If it turns out it doesn't work for you, why not just leave?

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    1. sorry, this was in reply to Massimo D'Antoni

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    2. Come on, you can't be serious. Rules have been changing continuously since we have the euro. The euro contract is an incomplete one, which is adjusted according to bargaining power. By not doing anything to correct the external surplus Germany is breaking the rules on imbalances, and still nobody seems to care.

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    3. That may be because the mirror side of the trade surplus are net capital exports and a lot of countries wouldn't want to see a reduction of German investments.

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    4. Not German Investments. It's just German financial credits. A balanced trade means you take goods in exchange for goods, which is sustainable. Credits in exchange for goods it's not.

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    5. "Credits in exchange for goods it's not."
      Worser than that is exchange of credits for future goods, which are not deliverd.
      Even worser are credits exchanged against flops!

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    6. Check out Germany's NIIP. Mainly the result of Germany's current account balance.

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