The Heart of the Euro Problem: A Response to INET's Rob Johnson

Dear Robert,

Your blog entry in defence of the euro report of the INET Council on the Euro Zone Crisis makes a number of good points. The best is your hope that I will better know in the future who my friends and foes are. Believe me, I do. I answered to the report because I very much appreciate the initiative of INET to encourage thinking outside the box. However, because of my general appreciation I thought it is necessary to signal that a diverse group organized by INET doesn’t necessarily produce new thinking.

There is a lot to be said about this report but I do not want to go into any detail. The core of your response touches the most crucial point, namely the role of capital flows and my position that it has not been these flows but rather direct government intervention in the labour market that brought about the divergence of competitiveness in Europe. I may be oversensitive concerning that point, but I have fought for years now a widespread ideological position in Germany that uses “capital flows” as an instrument to distract attention away from the real failures of German politics in the euro zone.

By the way, I have been warning consistently about the destructive German approach to the European Monetary Union (EMU) since 1997. In 1999, as deputy to the German Finance Minister, I even suggested a new institution to hold a ”macroeconomic dialogue” with the sole purpose of avoiding real appreciation and depreciation inside the Union. That institution was indeed founded and meetings took place twice a year. However, the result was meagre because it was boycotted by most of the mainstream in economics and the orthodox thinkers in the European institutions, including the EU Commission and the ECB.

When the problem became obvious, towards the end of the first decade of the last century, it was the Bundesbank and the ECB who spearheaded the defence of the German approach on the grounds of “catching-up” for the losses during German unification and similar untenable arguments. Honestly, to see today that my forecast, sad enough, has come true that those who proposed implicitly the destructive course seek an easy way out by blaming “capital flows” surely raises my level of sarcasm and that is what was reflected in the article in the FTD.

But before going into the capital flow matter, let me repeat the main reason for the euro crisis one more time. That small piece of sound and rigorous analysis (not necessarily new) is indispensable to understand what is going on and to draw the right conclusions.

 A currency union at its core is about harmonization of inflation rates as all countries give up national monetary policies and explicitly agree on a common inflation target (close to under two percent in the EMU). From here the argument is absolutely straightforward.

First, we have very strong evidence that inflation rates are highly correlated with unit labour costs (ULC, for the overall economy, of course, not for industry). Second, we know in general that the development of ULC is much more the result of exogenous factors than the development of price changes, which leads to the conclusion that ULC growth determines inflation to a very large extent. Third, we know specifically (or should know) that the biggest country in Europe, Germany, even before the official start of EMU, had decided to dramatically change the course of its wage policy.

In a tripartite agreement in 1999 government and negotiating partners on the labour market agreed not to allow growth of nominal wages along the lines of productivity growth and the inflation target of two percent (hitherto the traditional German approach) for the future but to remain clearly below that line. This has being applied and has been enforced by the “flexibilization of the labour market” in the first years of the Red-Green government. This implied that German ULC growth and its inflation rate would systematically remain below the commonly agreed inflation target in EMU.

As no other country had a similar arrangement it implied also that over time huge discrepancies in inflation rates and huge real appreciations of other countries (against those like Southern Europe that would slightly overshoot the inflation target but even against those like France that would strictly stick to the target) and huge unsustainable imbalances would be the result. One big country permanently gaining international market shares and increasing its surpluses and the others permanently losing and going deeper into deficit is a scenario for collapse if corrective forces do not come into play sooner or later. 

And so it happened. But it is not “the interdependence between capital markets and transitory demand booms and their irreversible impact on wages that is the core of the European story” (your blog on page two). The German undershooting has nothing to do with “over-lending” to the deficit countries and it is surely not the result of “under-lending” to the surplus countries?

It is the result of a political campaign trying to make Germany fit for an alleged challenge of the “competition of nations” and it was sold exactly under that banner to the German population. Even without any of the booms you mention in the deficit countries, the euro was bound to fail.

I could stop just here because for any reasonable person it is obvious that a monetary union under these conditions will be in big trouble over time. That it was the biggest of all financial crises that would trigger the outbreak of the crisis is only of interest for historians. As has been the case in so many financial crises in Asia and Latin America before, the crisis was unavoidable due to unsustainable competitive positions.

What makes it much worse than former crises is the simple fact that exchange-rate changes are not available to close the gap in competitiveness. Europe has produced the biggest imbalances in history exactly at the time when it has given up the main instrument to correct such imbalances.

Any analysis of the euro crisis that comes without mentioning this core point, in my view, is completely useless. And if it mentions this crucial point only in passing and in an asymmetric way (“deficit countries [why only mention deficit countries?] suffered a real appreciation that was very costly…” p.5. INET report) it is less than useless.

You see, reasonable people are one thing, economists are something else. Do you believe that those economists all around the world, who were euphoric about the German approach to “flexibilize” its labour market, would now quickly admit that they were wrong (and they were because inside Germany the approach was a disaster and externally it is a disaster in the making)? Would you expect them to give up the most important of their beliefs, the one about the ability of the labour market to find equilibrium if only governments stop intervening?

Orthodox economists cannot even take note of the undeniable correlation between ULC and inflation without being in danger of losing their strongest belief. Only a tiny bit of logic is necessary to recognize that this simple correlation breaks the link between real wages and employment and with it the whole neoclassical labour market nexus. The other day, I had a public discussion with one of your council members, Lars Feld, and he could not even look at my correlation chart (ULC and inflation) because he knew that it would break his intellectual back.

Dear Robert, my response is getting too long. I wanted to make a number of additional points to explain why the analysis of capital flows is a bit more complicated than most economists tend to think. I wanted to show that in the concrete situation of the monetary union there was definitively no causality between interest rates and net capital flows. I wanted to demonstrate in more detail that Spain could have financed its real-estate boom without net capital inflows. I only will mention that “under-lending” cannot explain the German position.

I also wanted to ask how it can be that private lending to deficit countries was the mainspring of the imbalances but now that it is gone (even has turned around into capital flight) the German current account surplus vis-à-vis the EMU partners is still there. And finally and most importantly, I intended to explain that the position of many Keynesian economists, who defend the dominance of investment against the dominance of savings in internal affairs but easily accept the other way round when it comes to external affairs, is inconsistent.

But, all this is too much and is pointless in light of the incredible political and economic challenge that Europe is facing right now. Europe is in acute danger of breaking apart if economists do not unite around a clear and unambiguous message. But this message has to recognize and to name the elephant in the china store and not just try to mend one more time some of the many cups that are already broken.

Heiner Flassbeck

Geneva