By Marshall Auerback, a hedge fund manager and portfolio strategist. Cross posted from New Economic Perspectives
Given the German electorate’s long standing aversion to “fiscal profligacy” and soft currency economics (said to lead inexorably to Weimar style hyperinflation), one wonders why on earth Germany actually acceded to a “big and broad” European Monetary Union which included countries such as Greece, Portugal, Spain and Italy. Clearly, this can be better understood by viewing the country through the prism of the Three Germanys, which we’ve discussed before:Germany 1 is the Germany of the Bundesbank: the segment of the country which to this day retains huge phobias about the recurrence of Weimar-style inflation, and an almost theological belief in sound money and a corresponding hatred of inflation. It is the Germany of “sound finances” and “monetary discipline”. In many respects, these Germans are Austrian School style economists to the core. In their heart of hearts, many would probably love to be back on an international gold standard system.
Germany 2 is the internationalist wing of the country, led by Helmut Kohl. Kohl and his successors are probably the foremost exponents of the idea that Europe can rid itself of the “German problem” once and for all if Germany firmly binds itself to a “United States of Europe” and continues to construct institutions that broadly move the EU in this direction. It is questionable whether this vision has survived significantly beyond the tenure of Helmut Kohl himself.
One can see the inherent tension between these two Germanys. Bundesbank Germany would never allow vague, internationalist aspirations to dilute the goal of sound money, low inflation and fiscal discipline. One could envisage most looking askance at the Treaty of Maastricht and the corresponding threats to these ideals.
Which brings us to the key third variable in German politics: Germany 3, Industrial Germany, the Germany of Siemens, Daimler, Volkswagen, the great steel and chemical companies, the capital goods manufacturers. Clearly, these companies benefited substantially from the economic stewardship provided by institutions such as the Bundesbank, along with the broad adherence to Erhard’s social market economy. But they also recognized the benefits entailed by a completely open and integrated European market (still the largest component of their sales). Currency union, even if it meant admission of fiscal profligates such as Italy and Spain, also minimized the threat of competitive currency devaluation, given the implementation of a European wide euro (as opposed to the narrow currency zone which represented the limits of the Bundesbank’s internationalism). Industrial Germany rightly perceived that a broadly based euro zone which incorporated chronic currency devaluers such as Italy, permanently entrenched their competitive advantage. And with the support of this key component of German society, Chancellor Kohl, was able to embark on the huge institutional transformation embodied in the Maastricht Treaty.
One could argue that “Germany #3″ made a bad bet, but is this really so?
A few months ago it appeared that the German sentiment data taken in aggregate showed that German domestic demand was turning up and the risk of a German recession was behind us. This was corroborated by truly powerful increases in total German employment, which now stands at a 20 year low.
To be sure, since then we received some weak data on industrial production and real retail sales. This coupled with the big down-tick in the manufacturing PMI rekindled recession fears.
But the previous worrying data about the German economy appears to have been removed with the latest round of positive data with upward revisions. We now have much better data on factory orders and real retail sales. A few weeks ago Germany’s March industrial production was released. It showed industrial production rising a large 2.8% in March; additionally, there was more than a one percentage point upward revision to prior months.
Taking the constellation of German economic data in aggregate – real retail sales, factory orders, industrial production, total employment and the services PMI (which remains well above 50) – it is unsurprising that Germany’s preliminary 1st quarter GDP subsequently came in at 2%.Yes, the periphery remains a disaster, but Germany is still growing. It is also the case that the slowdown in Europe could eventually reach the core and China’s worrying loss of economic momentum and dent Germany’s growth momentum in the future. But for now, there is no significant fiscal restriction to speak of (unlike, say, Spain or Greece), domestic interest rates are super low, employment has been expanding rapidly. In short, it appears that, having absorbed a trade related and sentiment shock emanating from the European periphery, a domestic demand led expansion has probably resumed.
The point is not to celebrate the German economic model per se, but merely to highlight that for all of the gnashing of teeth and whining about “the cost” to Berlin of perpetually “bailing out” the “profligate periphery”, the reality is that Germany has done exceptionally well out of the euro zone and continues to do so.
“Germany #3″ in effect placed the right bet: by locking in chronic devaluers to a currency union (thereby precluding the traditional expedient of currency devaluation to regain export competitiveness), Berlin in effect entrenched Germany’s mercantilist model and consolidated the country’s dominance as the trade superpower of Europe. The benefits are self-evident, given the contrasting data between Germany and the PIIGS.
Of course, one can already hear Germany’s apologists proclaiming that this success is the product of taking “hard decisions” in the earlier part of this century, in particular, the so-called “Hartz reforms”. The Germans have always been obsessed with export competitiveness. In the period before the euro, they would devalue the Deutschmark so that they could increase the sales of their products to their neighbors. Once the Germans lost control of the exchange rate by signing up to the Economic and Monetary Union (EMU), they couldn’t perform this trick anymore. They had to manipulate other “cost” variables in order to sell goods cheaply. So starting in 2002, they focused on wage suppression and cutting into the social safety net for workers through something called the Hartz package of “welfare reforms,” named after Peter Hartz, a key executive from German car manufacturer Volkswagen.
Unlike the American Henry Ford, who created good, well-paying jobs because he knew that having a secure middle class was essential to having a market for his cars, Peter Hartz regarded the relationship between wages and the economy very differently. In his view, squeezing workers was the way to keep a country “competitive”, which is precisely what his “reforms” did. And it had disastrous consequences for the rest of the eurozone – (See here – http://www.slideshare.net/
[As an aside, the other inconvenient little truth is that the much vaunted Hartz “reforms” themselves are really devoid of any kind of democratic legitimacy. It was subsequently discovered that Peter Hartz himself had only secured the acquiescence of Germany’s workers by sanctioning illegal payments to Germany’s powerful works council (see here – http://news.bbc.co.uk/2/hi/
The Hartz measures have been extremely far reaching in terms of the labor market policy that had been stable for several decades. Bill Mitchell and Ricardo Welters noted (http://e1.newcastle.edu.au/
More to the point, Germany benefited from “first mover advantage”: they initiated these reforms in the context of a growing global economy. Demanding such wage repression in the context of a global recession makes such “reform” virtually impossible, to say nothing of the fallacy of composition problems, when all other countries seek to deflate their wages in order to gain the elusive export competitiveness.
All of this is now coming under threat, given the renewed perturbations afflicting the euro zone. Greece’s inconvenient outbreak of democracy has created a new wild card: a new Greek party, Syriza, head of the coalition of the radical left, has vaulted to prominence. Its new leader Alexis Tsipras, a previously obscure left-wing member of Parliament. led his grouping to second place in the recent national elections with the promise of repudiating the loan agreement Greece’s previous leaders signed in February.
From the birthplace of democracy, then, comes this horrible outbreak of genuine democracy. Naturally, in typical Brussels fashion, eurocrats are decrying this development. They are once again whipping up the “Greece to exit” frenzy and wheeling out all manner of mainstream economists who are issuing the most strident warnings that Greece needs the Euro and will walk the plank if it exits. Their earnest hope is that the new elections will result in the emergence of a new Greek Quisling, who will happily implement the Troika’s incredibly destructive austerity package, reforms which provide no hope of recovery for Athens or the rest of the euro zone. By contrast, Syriza represents a real threat to the current thrust of fiscal policy.
Alexis Tsipras is a good man. At least he’s a very good poker player. He hasn’t yet capitulated to this massive orchestrated pressure and made it clear up front in the Wall Street Journal Germany that there are options for the Greek people which the Germans won’t like: He is, in short, the first Greek politician to use the his country’s leverage over creditors.
Rule #1 in negotiations: You must demonstrate to your counter-party that you have credible options to walk away from the table/deal. He has, amongst other things, simply pointed out that the Greek state is quite close to a primary surplus. All that is needed are a few small reductions wages and pensions, and the Greek public sector could finance itself for the foreseeable future. Were it to exit the euro, all of a sudden Athens’s problem becomes the eurozone’s problem.
Yes, Greece only constitutes a mere 2% of Europe’s GDP. And yes, the eurozone authorities are said to be “making preparations” in the event of a “Grexit”. But then again, Lehman was a tiny investment bank which almost brought down the entire global banking system when it was allowed to go bust. And recall that Lehman’s bankruptcy occurred several months after the rescue of Bear Stearns. In theory, the authorities had ample time to construct back-stops to prepare for this eventuality, as is now being said in regard to Greece’s potential exit from the euro zone.
Would a firewall today be any more effective in “cauterising” the Greek wound and preventing the contagion from extending to Portugal, Spain, Italy and then to the core? Tsipras clearly understands this, and he could well be Greece’s next Prime Minister. It would entail massive firepower from the ECB, a “bazooka” that the ECB has hitherto been loath to supply.
In the meantime, the Greek election result has resulted in an acceleration of massive bank runs within the eurozone. There has been a steady flight of deposit funds from the PIIGS into German and other northern European banks (and perhaps to some banks outside Europe) for some time now. Data on the Target 2 financing of these deposit runs by the recipient countries apparently accelerated in the first four months of this year prior to the French and Greek elections. A recent statement by the Greek authorities suggests that the deposit run from Greek banks has accelerated, perhaps hugely, since the Greek elections. This has been denied, but under such circumstances one should never believe official denials.
Indeed, late last week, El Mundo reported that depositors had withdrawn one billion euros from the Spanish bank Bankia since its takeover by the government on May 9th. The odds are that this deposit run may have as much to do – or more to do – with a flight out of Spanish bank deposits in general that it has to do with any fears about holding deposits in a bank taken over by the Spanish government. In other words, this may be a sign that a deposit run caused by fears about euro exit has now spread in a significant way to Spain. Of course, the authorities are denying such, but under such circumstances one can never believe such denials.
Paradoxically, the very existence of a monetary union facilitates bank runs. If you’re a depositor at a Spanish bank in Barcelona, there is nothing stopping you from withdrawing that money and re-depositing it in at a local German bank down the street. There are no capital controls or border controls in effect. With no exchange rate risk! Bank depositors in all of the periphery countries now fear they will wind up with the old currencies which will be worth much less than the euro. These deposit funds go into German and other core European banks who then recycle the funds through the ECB and the national central banks back into the banks of the PIIGS that are experiencing the deposit runs.
Apparently this deposit run and its reflux back into the imperiled banks on the periphery accelerated in the early months of this year before the French and Greek elections. It apparently has accelerated further since. In effect, the System of European Central Banks is involved in an ever growing and massive bailout exercise which they are not publicly acknowledging.
The German response so far? “Oops. This guy is blackmailing us. What shall we do?” Because Germany as a creditor nation faces huge losses if the entire banking system starts to come under pressure, to say nothing of the end of their vaunted “wirtschaftwunder” as the entire eurozone implodes. Greece, by contrast, has already experienced 5 years of unremitting economic austerity. The country has been virtually reduced to the state of a barter economy. What has it got to lose at this juncture by refusing to roll over to the Troika?
To be sure, the Germans might well say, “Enough is enough” and leave the euro zone (which would probably destroy the currency union). The likely result of a German exit would be a huge surge in the value of the newly reconstituted DM. In effect, then, everybody would devalue against Berlin, shifting the onus for fiscal reflation on to the most vociferous opponent of fiscal activism. Germany would likely have to bail out its banks (particularly the Landesbanken). This might well be more politically palatable than, say, bailing out the Greek banks (at least from the perspective of the German populace), but it would not be without significant short term economic cost for Berlin. And in the interim, the likely currency shock would put an immediate halt to its export machine, as the built-in conferred by the euro zone would be dissipated in the event that Germany reverts to a newly reconstituted DM.
By accounting identity, a fall in Germany’s external surplus would mean a large increase in the budget deficit (unless the private sector begins to expand rapidly, which is doubtful under the scenario described above), so Germany will find itself experiencing much larger budget deficits. It will become a ‘profligate’ if it wishes to mitigate the effects of a collapse in its current account surplus. Quite a reversal in fortune.
So who holds the gun now?