How Germany benefited from Eurozone

As the Eurozone tethers on the brink of collapse, questions are being raised about Germany's reluctance to play a more aggressive role in stabilizing the situation. More specifically, about its opposition to a lender of last resort role by the ECB and even some form of fiscal transfers to the peripheral economies.

Critics find this German attitude surprising since the German economy is one of the biggest beneficiaries of the monetary union. The far reaching labour market reforms and wage restraint exercised in Germany over the last decade enhanced its labour market competitiveness over the other Eurozone economies.

The tight embrace of a single currency meant that Germany's competitors did not have access to the most conventional instrument used to address trade competitiveness - exchange rate devaluation. In fact, far from exercising similar reforms and wage restraints to match Germany, the peripheral economies experienced a decade of asset bubble and/or debt driven economic boom, which drove up labour wages. The graph below shows how wages remained more or less stagnant in Germany, even as it rose elsewhere.



Labour market was not the only source of distortions. The monetary union and the attendant boost to their sovereign risk ratings meant that the peripheral economies suddenly had access to very cheap capital, a major share of which came from German and French banks. This too went towards fuelling asset bubbles (Spain and Ireland), wage price spirals (Portugal), government spending (Greece and Italy), and a consumption boom. Thanks to its increasing competitiveness, Germany provided the natural supplier for consumption booms in these countries. German exports ballooned.



So, as I have blogged earlier, among other things, the recovery path for the peripheral economies will certainly have to involve efforts to restore labour market competitiveness. This can be achieved either through internal devaluation or wage moderation in the peripheral economies or inflation in the core economies. Given the magnitude of re-balancing required, it may be necessary to have both.

But even with all this and without some form of radical debt restructuring and extendend period of monetary accommodation by the ECB, the survival of the Euro project looks increasingly in doubt.

Postscript

Paul Krugman points to the importance of export growth in Germany's economic growth of the last decade. A large share of these exports are to fellow Eurozone members, including the PIIGS. As the consumption elsewhere tanks, German exports will take a hit. It is impossible to expect consumption in these economies to regain its strength any time soon. In the circumstances, the only option left is for a massive German fiscal stimulus. This would not only keep aggregate demand in Germany up, but also provide an anchor for imports from the weak peripheral economies. In other words, German pump priming could boost growth both domestically and in the rest of Eurozone.

There are obviously two issues of concern. One, what magnitude of stimulus would be required to have any meaningful impact? Two, does Germany have the fiscal fire-power to sustain a big bazooka?

Update 1 (10/12/2011)

Nowhere has the benefits of euro integration more apparent than in the labour market as the graphic below shows. The German unemployment rate has steadily fallen since 2006, while that elsewhere has risen. German unemployment rate fell from 9.6% (4 million out of work) at the end of 2006 to 5.5% (just 2.3 million people out of work) today, both the figures being the lowest since the 1991 reunification.



As Floyd Norris writes, "It held down its labor costs during the boom, strengthening its competitive position relative to other members of the euro zone. The fact that those countries were in the euro zone helped to depress the currency’s value relative to other currencies, which made German exporters even more competitive."

This is a stunning statistic about the contrasting fortunes of the two parts of Europe,

"Put another way, at the end of 2006, 32 percent of the unemployed workers in the euro zone were Germans. Now the figure for Germans is 14 percent. The peripheral countries’ share went to 61 percent from 39 percent."

The meaning of the gold price surge

Conventional wisdom on the surging gold prices has been that it is in indicator of inflation wary investors fleeing to a traditional safe asset. Accordingly, conservatives have invoked the recent spike in gold price in support of their advocacy for fiscal consolidation.

Paul Krugman has an interesting post, where he argues that contrary to conventional wisdom, deflationary fears may be driving gold prices. He points to the famous Hotelling Rule which says that people have an incentive to hold onto an exhaustible resource (by storing it or keeping it unextracted) because of rising prices. Economically this means that "a mineral deposit in the ground has the same significance as a bond, and is in some sense interchangeable with such a financial instrument".

A consequence of this Rule is that, assuming negligible storage costs and the major part of the stock has already been extracted (so the choice is between storing it for the future or selling it now), the "real price must rise at a rate equal to the real rate of interest". If the real rate of interest is lower, as is the case now, people have an incentive to "hoard gold now and push its actual use further into the future" because the lower rates reduces the return on investment of the sale proceeds. This translates to higher prices in the short run and the near future. Krugman writes about its implications,

"(T)his... 'real' story about gold, in which the price has risen because expected returns on other investments have fallen; it is not, repeat not, a story about inflation expectations. Not only are surging gold prices not a sign of severe inflation just around the corner, they’re actually the result of a persistently depressed economy stuck in a liquidity trap — an economy that basically faces the threat of Japanese-style deflation, not Weimar-style inflation... And if you view the gold story as being basically about real interest rates, something else follows — namely, that having a gold standard right now would be deeply deflationary. The real price of gold 'wants' to rise; if you try to peg the nominal price level to gold, that can only happen through severe deflation."

In other words, since interest rates are low and rational expectations are for an extended period of low rates (and therefore low inflation), people prefer to hoard or store gold, thereby boosting gold prices in the short-run. This analysis would see the increase in gold price as a signature of deflation.

In another post Krugman also makes the distinction between gold and other commodities, in so far as their applicability to this hypothesis. Unlike gold, most other natural resources, including oil, does no conform to atleast one or both of the assumptions - negligible storage costs and most stock has been extracted out.