Tuesday, May 28, 2013

28/5/2013: Germany Might Have Caused the Euro Crisis... but...

CNBC today cites a piece of research (http://www.cnbc.com/id/100769233) that argued that "Germany's insistence on keeping wage growth in check has given the country an unfair competitive advantage vis-à-vis its euro zone peers and is preventing troubled countries from returning to growth, a new study argues."

This non-sensical argument cuts across any reasonable understanding of competitive advantage and the role of economic policy in driving this advantage. Germany undertaking structural reforms neither prevented other states from doing the same, nor imposed any costs (or reduced competitiveness) of other states. The authors of the report and the CNBC should go back to Economics 101 to brush up on their understanding of the competitive advantage concept.

In the nutshell, it is not Germany that caused the crisis - based on competitive advantage argument - but the peripheral states' lack of reforms to deliver their own competitiveness improvements.

However, the mere idea that Germany has 'caused' the crisis in the euro area still merits consideration. There are two strands of thought on this that are potentially valid:
1) Germany actively suppressed domestic demand and thus reduced aggregate demand within the euro area: while true to the point that German domestic demand was and remains too weak, this hardly implies any negative slipovers to the peripheral economies of the euro area, unless someone makes a compelling reason as to why German consumers should be buying vastly more Greek feta cheese or olive oil, and paying vastly more for their purchases; and
2) euro area construct itself induced asymmetric development within the common currency area: Germany, as the core driver of euro area creation is, thus, to be blamed for some failures of the construct.

The latter is a preferred explanation in my opinion and there is an interesting paper from the CEPR (published in March 2013: CEPR Discussion Paper No. 9404) titled "Political Credit Cycles: The Case of the Euro Zone" by Jesús Fernández-Villaverde Luis Garicano and Tano Santos that actually confirms my gut instinct.

The authors "study the mechanisms through which the adoption of the Euro delayed, rather than advanced, economic reforms in the Euro zone periphery and led to the deterioration of important institutions in these countries. We show that the abandonment of the reform process and the institutional deterioration, in turn, not only reduced their growth prospects but also fed back into financial conditions, prolonging the credit boom and delaying the response to the bubble when the speculative nature of the cycle was already evident. We analyze empirically the interrelation between the financial boom and the reform process in Greece, Spain, Ireland, and Portugal and, by way of contrast, in Germany, a country that did experience a reform process after the creation of the Euro."

Some more beef from the paper, as CEPR is password protected site:

Per authors, "Before monetary union took place with the fixing of parities on January 1, 1999, the conventional wisdom was that it would cause its least productive members -particularly Greece, Portugal, Spain, and Ireland1- to undertake structural reforms to modernize their economies and improve their institutions. [However], due to the impact of the global financial bubble on the Euro peripheral countries, the result was the opposite: reforms were abandoned and institutions deteriorated. Moreover, …the abandonment of reforms and the institutional deterioration prolonged the credit bubble, delayed the response to the burst, and reduced the growth prospects of these countries."

How so?

"In the past, the peripheral European countries had used devaluations to recover from adverse business cycle shocks, but without correcting the underlying imbalances of their economies. The Euro promised to impose a time-consistent monetary policy and force a sound fiscal policy. It would also induce social agents to change their inflation-prone ways. Finally, … it would trigger a thorough modernization of the economy."

Germany actually is an example of what the euro was supposed to deliver:

"Faced with a limited margin of maneuver allowed by the Maastricht Treaty and with a stagnant economy, Germany chose the path of structural reforms, giving a new lease on life to German exports. But this did not happen in the peripheral countries. Instead, the underlying institutional divergence between them and the core increased. The efforts to reform key institutions that burden long-run growth, such as rigid labor markets, monopolized product markets, failed educational systems, or hugely distortionary tax systems plagued by tax evasion, were abandoned and often reversed. Behind a shining facade laid unreformed economies.

"The common origins of the financial boom are well understood. The elimination of exchange rate risk, an accommodative monetary policy, and the worldwide easing in financial conditions resulted in a large drop in interest rates and a rush of financing into the peripheral countries, which had traditionally been deprived of capital. Furthermore, demographics in Ireland and Spain favored the start of a construction boom with some foundations in real changes in housing demand, the opposite of Germany, where demographics depressed housing demand. … the percentage of the population between 15 and 64 increased dramatically in Ireland and, to a lesser degree, in Spain between the mid 1970s and 2007. In France and Germany, the peak happened about two decades earlier. Since then, both countries have experienced a slow decay in this segment of the population. These demographic trends were accompanied by an increase in the employment to population ratio and, thus, resulted in strong rates of growth even in the absence of productivity gains."

The paper identifies "two channels through which the large inflows of capital into the peripheral economies led to a gradual end to and abandonment of reforms":

  1. The first channel "is the relaxation of constraints affecting all agents. It has long been observed in the political economy literature that for growth-enhancing reforms to take place, things must get “sufficiently bad” (see Sachs and Warner, 1995, and Rodrik, 1996). And, as the development literature has emphasized, foreign aid loosens these constraints by allowing those interest groups whose constraints are loosened to oppose reforms for longer. As explained in section 2, Vamvakidis (2007) also finds that this mechanism operates when debt grows, rather than aid."
  2. "The second mechanism is more novel. It affects the ability and willingness of principals to extract signals from the realized variables in a bubble, where everything suggests all is well. A sequence of good realizations of observed outcomes leads principals to increase their priors of the agents’ quality. When all banks are delivering great profits, all managers look competent; when all countries are delivering the public goods demanded by voters, all governments look efficient (this mechanism applies both to real estate bubbles, as in Ireland and Spain, and to sovereign debt bubbles, as in Portugal and Greece). This information problem has negative consequences for selection and incentives. Bad agents are not fired: incompetent managers keep their jobs and inefficient governments are reelected. The lack of selection has particularly negative consequences after the crisis hits. Moreover, incentives worsen and agents provide less effort."

Combining the two channels: "Both of these mechanisms, the relaxation of constraints and the signal extraction problem, led to a reversal of reforms and a deterioration in the quality of governance in these countries. Somewhat counterintuitively, this observation implies that being able to finance oneself at low (or negative) real interest rates may have negative long-run consequences for growth."

There is little new here:

  • "Other economists have already pointed out that the financial cycle reduces future growth, simply because of the debt overhang (Reinhart and Rogoff, 2009; Bernanke, Gertler, and Gilchrist, 1999)." [Note: the R&R 2010 controversy does little to dispel the core argument of financial cycle transmission of adverse debt effects, as I am arguing in my forthcoming Village magazine column - stay tuned for later link posting on this blog];
  • "Also, researchers working on resource booms have suggested mechanisms that delay growth that apply here by analogy (a financial bubble is, in a way, a form of a resource boom). Grand, ill-conceived government programs involve lasting commitments that lead to higher taxes in the long run."
  • "Also, the “Dutch disease” suffered most clearly by Ireland and Spain (with land playing the role of a natural resource here) spreads, whereby human and physical capital moves from the export-oriented sector toward real estate and the government sector. But in our view, the reform reversal and institutional deterioration suffered by these countries are likely to have the largest negative consequences for growth."
  • The idea also relates to Rajan (2011), "who links the real estate bubble in the U.S. with an attempt by politicians to shore up the fortunes of a dwindling middle class." 

The authors "emphasize, instead, that in Europe the real estate boom interacted with the political-economic coalition that blocked reforms, allowing large policy errors to remain uncorrected and institutions to deteriorate."

Thus, if Germany did 'cause' the crisis in the euro periphery, it is solely by not enforcing the discipline required within a common currency area - too little stick too much carrots from Berlin was the problem, not too little imports of peripheral products into the core.

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