Wednesday, December 8, 2010

Just Blame Germany

It has become fashionable to blame Germany for the current crisis in the Eurozone. Most arguments encompass one or more of the following: Germans don't consume enough, Germany has a large current account surplus which hurts the rest of the Eurozone, Germany has conducted a beggar-they-neighbour policy over the past decade via internal devaluation and wage restraint, Germany exerts pressure on the peripheral countries to engage in way too strong deflationary austerity measures which renders their situation even worse, Germany refuses to pay for the periphery via more financial help be it in the form of a substantially larger EFSF or the introduction of EuroBonds, Germany is pushing ahead with its plans to introduce a sovereign default mechanism from 2013 onwards which leads investors to sell their peripheral debt now.
First, the arguments which blame Germany on the basis of their economic behaviour over the past decade seem mostly wrong: yes, Germany has a current account surplus, a relatively high savings ratio/low consumption, a highly competitive economy and it engaged in substantial internal devaluation via wage restraint. What we should not forget though is that a) just as the peripheral countries were profiting from very low real yields during the past decade amid the German economic malaise, Germany suffered from too high real yields amid the periphery's boom which rendered its economic weakness even worse and most importantly b) if Germany would not have done the corporate restructuring/budget consolidation/structural reforms, the German economy would be in a much worse shape at present. It would not be competitive (and therefore not have a current account surplus) and it would have a much larger fiscal deficit. As a result, if Germany would currently not have a current account surplus it could as well not be a net exporter of capital. Furthermore, if it would have a significantly higher fiscal deficit, it would as well suffer from the risk of rating downgrades amid an unsustainable debt path. Given that the German economy constitutes close to 30% of Eurozone GDP, the health of the German economy and the German sovereign is vital for the survival of the overall Eurozone. Would Germany still be economically sick, then approx. 50% of the Eurozone would be mired in deep depression with no one being able to help. It is great news that Germany could overcome its chronic weakness and is now in a state where it can provide stability to the Eurozone periphery.
Looking ahead, it remains my expectation that Germany will continue to outperform in economic terms as domestic consumption can pick up again. The low level of unemployment should lead to increasing real wage gains. Furthermore, the low level of unemployment coupled with the end of the structural reform period leads to an improvement in household sentiment and as a result an increase in the willingness to consume/a reduction in the willingness to save. This is further strengthened by the historically low level of real yields. The combination of a rising sum of wages and a lower savings rate should significantly fuel consumption growth over the next 2-3 years. This will lead to an improving internal balance within the Euorozone and eases the pressure on the periphery to restore competitiveness via significant deflation.
If there is one sensible argument to blame Germany relating to the past decade, then it is that they did not bring their banking system in order. The German domestic banking sector remains highly fragmented and barely profitable, a key reason why German banks have engaged in such massive investments in Eurozone peripheral debts. Would there have been more private banking mergers and would politicians have forced a consolidation of the Landesbanks and a change in their business model, the German banking sector could be much more resilient now. But it is not and that remains the key weak point of the German economy!

Additionally, I also think that to blame Germany for the latest surge in peripheral yields misses the point somewhat. Germany wants to introduce a default mechanism for states from 2013 onwards. Some observers suggest that this is the reason why investors have started to dump their peripheral bond holdings and blame Germany for talking about potential default. However, it is mostly the same obsevers who have been suggesting that there is no way around the perihperal countries defaulting anyway (and maybe leave the euro). The only thing which the German proposal changes is that they want to have an institutional set-up for the limits of Eurozone sovereign solidarity.

Overall, one should also not forget that if Germany does not demand any austerity measures/reforms in exchange for financial support, then nobody will. It seems that the smaller core countries (for example the Netherlands, Austria, Finland) have a similar line as Germany but in the current negotiations dont have the same power. As a result, if Germany were just to bail-out the rest of the periphery then yes, the peripheral debt crisis would be solved for the time being. But the prize to pay would be a massive rise in moral hazard issues, risking an even bigger debt crisis further down the road where no-one would be able to lend support.

Finally, I remain in favour of some sort of Eurobond (I suggested earlier joint issuance for the part of debt being within the Maastricht Treaty criteria) and do hope that Germany will give in on this. But also here, it matters a great deal that incentives to conduct a sustainable fiscal policy and to remain economically competitive become stronger and are not weakened further.

But to repeat: the biggest mistake by Germany is that it did not restructure its German banking sector. Germany is the voice of the fiscally sustainable and economically competitive countries. If these countries do not have this strong voice anymore, then the door to a fiscal union with much higher moral hazard issues as well as a higher propensity towards inflation and a lower propensity towards innovation and productivity is open. Germany has shown that they are able to negotiate, stand back from their toughest demands and support the common currency project if need be and so far it does not look likey they are deviating from that course.

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