The myth of the pro-German ECB

The ECB likes low inflation.  So does Germany.  That has led many people to wrongly assume that ECB policy is somehow pro-German.

In the long run the trend rate of inflation makes no difference; money is super-neutral.  Greece and Italy are no better or worse off with a 2% trend rate of inflation, or an 8% trend rate (except for second order effects such as the distortions produced by the taxation of nominal income from capital.)

I recall attending a European economics conference about 6 or 7 years ago, and hearing German academics complain that ECB policy was appropriate for high-flyers like Spain and Ireland, but too tight for Germany.  At that time Spain and Ireland had relatively high inflation (Balassa-Samuelson effect), and since the ECB was targeting average inflation, this meant slow-growers like Germany suffered from an excessively tight policy.

People forget that as recently as 2005 (when the world economy was doing well) Germany was viewed as the sick man of Europe.  Unemployment had risen steadily to nearly 12%.  It was viewed as a failed economic model.  Too rigid, unable to adopt to the post-industrial 21st century.  No one was talking about ECB policy favoring Germany, just the opposite.

How quickly things change, and how soon we forget.  Germany is not doing better because it’s favored by the ECB; they were too tight for everyone in 2009.  Rather it’s because labor market reforms put their wage costs in line with the ECBs tight money policy after 2005.  It was a successful “internal devaluation.”

Here is graph showing the unemployment rate in Germany:

It may have been inevitable that the euro would crash and burn, but it might just as well been in 2005 when Germany was weak and Spain was strong.  The problem is one-size-fits-all, not a pro-German slant.

This WSJ article discusses how Sarkozy is trying to emulate German labor market reforms:

The government’s employment proposal is designed to stop the job hemorrhage by providing companies with a buffer to keep their staff while still cutting payroll when business shrinks. During the 2009 recession, Germany limited job losses in part because of a popular subsidy program for short-hours work, known as Kurzarbeit. At the peak, in May 2009, as many as 1.5 million workers were in the program. German unions also have made wage concessions to preserve jobs.

.   .   .

The French government’s idea to increase work-time and pay flexibility is likely to meet much more resistance.

“All labor unions will say ‘No,’ because that would amount to making workers pay for the economic downturn,” said Mourad Rabhi, a leader at CGT, France’s second-largest union. “And in France there isn’t the same climate of mutual confidence between workers and companies, as in Germany.”

BTW, I agree with Tyler Cowen that Germany is well placed to do well in the future.  Tyler mentions good governance, which in my view is partly related to cultural factors like civic virtue.  But the relative performance of Spain and Germany around 2005 shows that these factors aren’t very useful for short term predictions.  So don’t assume the current perception that Germany is the “strong man of Europe” will hold forever.  History teaches us to expect the unexpected.

PS.  Tyler Cowen is pretty cagey.  He didn’t actually say he agreed with the quotation he provided; rather he said he hasn’t made up his mind.  But the quotation he provided was his own words.  I need to remember to do predictions that way in the future.   🙂

PPS.  The always interesting Ambrose Evans-Pritchard has some cheerful predictions for 2012.

The Eurozone must not “move forward”

Suppose you are headed home and your GPS leads you down a blind alley.  A dead end.  A cul de sac.  What do you do next?  One solution would be to back out and take another route.  But the alley is narrow and hence backing out would be difficult.  So you decide to “move forward.”  Get the pick axe and shovel out of the trunk, and start demolishing the buildings that are blocking your path.

The policy elite of Europe thought it would be a great idea to have a single monetary unit for 17 different countries, which have very different policy needs.  This was to be done through the wise leadership of unelected technocrats, who would put aside all messy political calculations and focus single-mindedly on low inflation.  Unfortunately things didn’t work out, just as all previous attempts to put multiple economies into a fixed exchange rate straight-jacket eventually failed.

So do they propose abandoning the experiment?  No.  Many of the same people who brought us the euro now want to double-down on some sort of fiscal union, which might involve eurobonds.  Fiscal union would be like the euro on steriods.  All the current problems would be multiplied 10-fold.  German taxpayers would be asked pay for wasteful government programs in Greece and Sicily, even as German voters would have no say in how the money is spent. That’s a recipe for non-stop discord, for a revival of nationalism.  Recall that the taming of nationalism was the central political goal of the EU, which was created to prevent a repeat of the horrors that Europe experienced in the first half of the 20th century.

The beauty of the EU is that it’s currently a highly decentralized system, with EU spending being somewhere around 2% of GDP.  It’s sort of like the US federal government in the 1920s.  Now you might complain that the 1920s was followed by the Great Depression.  That’s right, and that’s why faster NGDP growth is a necessary condition for any sort of resolution of the debt crisis.  (I say necessary, not sufficient.)

Many people seem to be under the illusion that Germany is a rich country.  It isn’t.  It’s a thrifty country.  German per capita income (PPP) is more than 20% below US levels, below the level of Alabama and Arkansas.  If you consider those states to be “rich,” then by all means go on calling Germany a rich country.  The Germans know they aren’t rich, and they certainly aren’t going to be willing to throw away their hard earned money on another failed EU experiment.  That’s not to say the current debt crisis won’t end up costing the German taxpayers.  That’s now almost unavoidable, given the inevitable Greek default.  But they should not and will not commit to an open-ended fiscal union, i.e. to “taxation without representation.”

In addition to not being rich, Germany is fairly heavily taxed, like all other Western European countries.  If taxes were at US/Japanese/Australian levels, it might be possible to extract more revenue without killing the goose that lays the golden egg.  Even at current German tax levels it may be possible to extract a bit more revenue.  But there is certainly much less room for maneuver.

The EU must not move forward, it must move backwards.  That’s because the EU in the 1990s was a much sounder institution.  If it ain’t broke, don’t fix it.  The European Monetary System circa 1998 wasn’t broke, and should not have been fixed.

PS.  Karl Smith scolded me yesterday for my post on Keynes and stocks during 1937.  He argued that this is a very serious topic that affects the lives of millions.  I completely agree.  When I use humor it is to make a point.  I was trying to show that Keynes would have agreed with my claim that there was nothing in the so-called “fiscal contraction” of 1937 that would have led a reasonable Keynesian in early 1937 to expect a recession in late 1937.  Why is this important?  Because there were two great cognitive errors that caused our current recession.  One was made by those (mostly on the right) who didn’t see an AD problem.  The other was made by those (mostly on the left) who saw the AD problem but assumed fiscal stimulus was the best way to address the problem.  Obama was obviously in the second camp.  Fiscal stimulus is extremely weak for all sorts of reasons.  If Obama had focused on stocking the Federal Reserve Board with reliable stimulus proponents back in 2009, we might be far better off today.  Instead he completely ignored monetary policy and instead relied on ineffective policies such as deficit spending.  That’s a very serious mistake, and that mistake was the ultimate target of my post.  I left some additional comments over at Karl’s post.

I’m actually glad that Karl feels so passionately about this issue.  I wish more people felt that way.

Is it 1936 already?!?!?

Well that didn’t take long.  I have to admit that when I made this prediction eight days ago I didn’t really expect it to happen so fast:

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

First a bit of background.  In the late 1920s and the early 1930s the Bank of France hoarded vast quantities of gold.  This raised the value of gold, which meant deflation (once the US and Britain stopped offsetting the French hoarding after October 1929.)  An international financial crisis ensued, with one country after another leaving the gold standard.  Britain in 1931, the US in 1933, etc.  At first France got off lightly, as their currency had been undervalued on the eve of the Depression.  But by 1936 the deflation in France was so bad that even they had to devalue.  In each case countries didn’t begin recovering until they had left the gold standard.

In the modern world things seem to move much faster than during the long agonizing 1931-36 collapse of the gold standard.  Today German bonds were hit hard:

The debt crisis that began more than two years ago now risks engulfing Germany. The Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments rose to an all- time high as Germany failed to find buyers for 35 percent of the bonds offered at an auction.

Germany is of course the France of the 21st century.

It’s now quite possible that the Fed may have to move toward NGDP targeting before they would have liked.  The Fed cannot allow another collapse of NGDP like we saw in 2009.  The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate.  I have no doubt that Ben Bernanke of all people understands this.

Perhaps the Europeans will come together and do something dramatic in the next few days.  But if not, the Fed must be prepared to hold an emergency meeting and do whatever it takes.  To quote David Beckworth:

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always close return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

It’s Bernanke’s moment of truth.

PS.  Also check out Beckworth’s post showing the non-German NGDP in the eurozone.  And people wonder why the eurozone is having a sovereign debt crisis.

HT:  Joe2

Eighty years ago

In my research on the Great Depression, I noticed that an interesting correlation developed in the middle of 1931.  But first a bit of background.  Germany had major debt problems after WWI, partly due to the unfortunate Allied decision to impose large war reparations.  After a series of negotiations, Germany issued “Young Plan Bonds” in 1929 to help finance these debts.  There was initially a high level of confidence in these bonds.  However as the Depression worsened, Germany’s manufacturing sector was hit quite hard.  Banking trouble developed.  And the Nazi party began to make political gains, partly due to its opposition to war debts.

In the middle of 1931 the price of Young Plan bonds suddenly became highly correlated with the US DJIA.  Indeed the actual correlation was even stronger than estimated in the table below, as the markets closed at different times.

Table 5.1  The Relationship Between Variations in the Dow Jones Industrial Average (DLDOW), and the Price of Young Plan Bonds (DLYPB), Sept. 1930 – Dec. 1931, Selected Periods, Daily.

Dependent Variable – DLDJIA

Sample                       Number of     Coefficient                       Adjusted     Durban-

Period                      Observations    on DLYPB   T-Statistic   R-squared   Watson

1.   9/14/30 – 9/30/30        14             .5492            2.18           .225          2.69

2.   12/31/30 – 3/20/31      65             .1202            0.71          .000          2.19

3.   3/20/31 – 5/1/31          35             .5714             2.12          .094           2.59

4.   5/1/31 – 6/19/31          41            -.1084           -0.54          .000          1.94

5.   6/19/31 – 7/30/31        34             .4559             5.05          .426           1.96

6.   7/30/31 – 9/17/31        40             .3554            3.78           .254           2.39

7.   9/17/31 – 11/6/31        41              .2888            3.85          .257           2.40

8.   11/6/31 – 12/30/31      43             .2801            3.72          .234           2.33

9.   12/30/31 – 3/31/32      75              .2617            4.03          .171          1.80

10.  3/31/32 – 6/30/32       77             .3152             3.75          .147           2.30

11.  6/30/32 – 9/30/32       76             .0799             0.66          .000           1.92


Those R2 figures for late 1931 and early 1932 may not look that impressive, but they are actually extraordinarily high, especially for daily first differences of asset prices.  If you read the NYT year end report on stocks, by month, there is no discussion of Germany in the first 6 months.  In the final six months Germany is mentioned in every single monthly summary.  People saw what was happening.  Furthermore, the correlation tended to jump up at times with heavy German news, further evidence of the direction of causation.  So that’s not really at issue, the dispute is over why German debt problems impacted US stock prices.

Those who don’t believe monetary shocks are important would point to German debt held by US banks, or the fact that Germany is an important export market of the US.  But then why did the correlation suddenly jump up when the debt crisis began to coincide with stresses on the international monetary system?

My view is that the German crisis led to a loss of confidence in their currency and perhaps other currencies as well.  This led to gold hoarding, as gold was the ultimate source of liquidity, the medium of account in most major economies.  More demand for gold means a higher value of gold, and that means deflation for any country on the gold standard.  And according to the supposedly “discredited” Phillips Curve, deflation means job losses and lower stock values, even in real terms.

How could we test this theory?  Ideally you’d want a country that’s way too small to have any direct real effects on the world economy.  But big enough where it might cause a chain reaction, which would lead to an increase in demand for the ultimate source of liquidity in the 21st century world economy.  Which is, of course, the US dollar.  Ideally it would be a tiny country of no more than 10 million people, containing little villages with donkeys walking down the street.  Not a big industrial powerhouse like Germany, which might have important real effects.

Then you’d want to see if financial turmoil in that small country could dramatically impact stock values in the US, even though US banks held relatively little of that country’s debt.  And dramatically impact stock prices in East Asia, which is part of the dollar bloc but has even less of that country’s debt.  In other words, a country like Greece.

As far as I’m concerned, my conjecture as to what happened in 1931 is now pretty much confirmed.  When I see daily reports of the effects of Greece on the world economy, it seems just like Germany in July 1931.  When I see it spread to Italy, it seems just like Britain, in September 1931.  When I see daily reports of Italian bond yields in the US media, it seems just like news of the Young Plan bonds, which was reported almost daily in the US financial press during 1931.  Yes, it’s 1931 all over again.

So what is the solution?  I hate to tell you this, but the problem is even harder to solve today than in 1931.  Yes, most countries were tied down by gold in 1931 (what Barry Eichengreen called “golden fetters.”)  But at least they had their own currencies, which could be easily devalued.  Now even that option is gone.  And despite all the pain, 70% of Greeks oppose giving up the euro.  This crisis isn’t ending anytime soon.

And I really don’t even know what the optimal solution is.  In isolation, you could argue that Greece should leave the euro, just as one could recommend that the UK devalue in 1931.  But the British devaluation made things much worse for those countries still on the gold standard.

So maybe Greece should just tough it out.  But then in retrospect the attempt of the major countries to “tough it out” in the 1930s was what made the Great Depression so great.  Most economic historians think the optimal solution was for them all to have devalued right away.  But if even Greece is highly reluctant to devalue, just imagine those countries that are still nowhere near in as bad shape.

The real lesson of 1931 is like that old joke about the guy who asks directions to Dodge City, and is told “first of all, if you want to go to Dodge City you shouldn’t be starting from here.”  The best solution to the euro crisis is to not set up a single currency in the first place.

Tyler Cowen has recently done some very depressing posts discussing the way the euro crisis is likely to play out.  I don’t have a strong opinion on this issue, because every alternative seems unacceptable.  But I will say that his scenario is not all that unlike the way things actually did play out in Europe during 1931-36, as the first to leave were the weakest countries, but by 1936 even France devalued.  In monetary terms, France was the Germany of the 1930s.  French hoarding of gold made the gold standard crisis worse, just as German demands for tight money at the ECB are making the euro crisis worse today.  By 1936 the deflationary effects of French policy rebounded against France herself, in a weird sort of cosmic justice.  Something to think about in Berlin.

PS.  I don’t want to push the comparison too far.  The Greek government really did behave recklessly in the years leading up to the 2008 crisis, hiding the scale of their debt problems.  And Italian voters kept electing Berlusconi, with predictable results.

PPS.  I apologize if I haven’t answered your email.  Still very busy, but feel a need to keep posting.

Evaluating German NGDP growth

Kantoos has a German language blog that shares my quasi-monetarist perspective.  He recently sent me an english version of a post that has this graph showing German NGDP and unemployment:

You’ll notice that German NGDP growth is less stable than US growth, even before the recent recession.  Here are a few observations, with the caveat that I am not an expert on Germany.

Smaller economies tend to have more unstable real and nominal growth.  Although Germany is big in absolute terms, it is small relative to the US.  For instance, Germany had 8% real growth in the second quarter, and the slightly smaller UK economy just reported negative 0.5% growth in the 4th quarter.  US RGDP growth doesn’t tend to show such big swings.

Because Germany is part of the eurozone, nominal and real GDP movements are more independent than in the US. Thus suppose the ECB targets 2% inflation.  In that case fast growing eurozone members will have higher NGDP growth than slower growing members, even without higher inflation.  In fact, inflation is usually higher in faster-growing economies.

After the reunification boom, Germany had a difficult period from 1994 to 2006.  Notice that nominal growth was slow and unemployment was in the 10% to 12% range.  It is reported that during this period Germany went through a painful process of adjusting nominal wages downward, to reflect the slow NGDP growth (and inflation, which was lower than elsewhere in the EU.)  Ironically, during this period ECB policy was arguably too tight for Germany, and too easy for fast-growing Spain and Ireland.

Here’s what I found most interesting.  It seems to me that this graph might help explain Germany’s relatively good performance during this recession.  Notice that NGDP growth picked up sharply in 2006, and then NGDP fell sharply in late 2008.  Current levels of German NGDP look very similar to what would have occurred if you extended the fairly straight trend line from 1997-2006.  My hypothesis is that the wage restraint practiced by German unions during the difficult years of high unemployment may have carried over into the 2006-08 boom.  If so, wages may be closer to equilibrium than in the US, where current NGDP is far below the trend line of the past few decades.

This is a very tentative hypothesis.  It is dangerous to look for trend lines, as the eye tends to spot patterns that aren’t really stable.  In addition, I am relying on news reports about German wages, not hard data.  I would add that the low unemployment rate overstates Germany’s success.  Output has fallen sharply in Germany, and many workers had to accept shorter hours.  Still most observers think that Germany has recently done better than other major developed economies, and the temporary nature of the 2006-08 NGDP bulge may partly explain why.

Germany could probably benefit from a bit faster NGDP growth, but from a “level targeting” perspective they may be closer to long run equilibrium than most other developed countries.

PS. Interested readers should also read the Kantoos post, as he covers other topics that I am not qualified to discuss.