Euro Crisis: German Unit Labor Cost repression is the primary cause of periphery stress


In the above graphic note that France has closely tracked the agreed EU inflation target of 2%, while Germany violated the agreement, largely by repressing wage increases (and hence Unit Labor Costs).

Heiner Flassbeck has been studying the impact of Germany’s wage deflation policy for at least six years. E.g., from 2006 he wrote:

The European Monetary Union can only function if nominal wage increases in all member countries are in line with the inflation target set by the monetary authorities. Given the close correlation of unit labor cost growth (nominal wage growth minus productivity growth) and inflation, the implicit rule of the monetary union asks for real wage growth in each member state following strictly national productivity progress and for unit labor costs not exceeding and not undershooting a 2 percent growth path in each member state.

Violations of this rule will either lead to inflation or deflation in the union as a whole or to deviations of national real exchange rates and national levels of competitiveness bearing grave long-run consequences for the appreciating countries. This kind of aberration started with the beginning of the currency union in 1999–with Germany, due to its deflationary wage policy, being the main culprit. Without fundamental changes in wage policies throughout Europe, a deflation or a transfer union, comparable to the German transfer union after unification, is an imminent danger.

That quote is from “Are German workers killing Europe? In other words, have their low relative wages created a “beggar-thy-neighbor real devaluation”* policy highly destabilizing to the Eurozone?

A much more detailed investigation is in Intereconomics vol 46, 2011, Flassbeck and Spieker, The Euro – a Story of Misunderstanding.

From the very beginning of the European Monetary Union the crucial institutions, the European Commission and the European Central Bank, led by mainstream economic thinking, were not up to their task of controlling the core of the system effectively. A huge gap in competitiveness among the member states has arisen due to German wage-dumping policy on the one hand and, on the other, wage growth in Southern Europe which is above the growth of productivity plus the infl ation target of 2%. A European-wide coordination of wage policy is the only promising way to close this gap. However, as wages and competitiveness are not high on the agenda of the politicians responsible and their advisers, time to save the euro is running out.

For another perspective on the same core problem, see Michael Pettis “If no trade reversal now, then when?“. Prof. Pettis puts it this way:

Europe’s underlying problem is not budget deficits or even unsustainable debt. These are mainly symptoms. The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral countries have diverged by anywhere from 20% to 40%. This divergence has made the latter uncompetitive and has resulted in the massive trade imbalances within Europe.

Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances. While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs. Of course if they don’t resolve this problem, the problem will be resolved for them in the form of a break-up of the euro.

The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus. It could boost disposable household income and household consumption by cutting income and consumption taxes, and as German household income grows relative to the country’s total production, the national savings rate would automatically drop and the trade surplus contract and eventually become a deficit. Or Germany could engineer a massive increase in infrastructure spending.

I highly recommend a careful read of both Pettis and Flassbeck.

On the mis-diagnosis of the Eurozone’s crisis

Klaus Kastner continues to offer sound advice (and yes, Special Economic Zones are a vital part of the solution)

(…) The necessary medicine has been outlined here many times before, and I repeat the most important steps:

1. Reduce dependence on foreign funds by reducing the current account deficit. 2. Substitue imports of consumption goods with new domestic production.
3. Promote exports by allowing Special Economic Zones where exports can be produced competitively.
4. And, finally: attract foreign investment, attract foreign investment and, again, attract foreign investment so that the need for loans from abroad can be reduced.

Greece, if she acts cleverly, could transform herself into the role of a trendsetter who explains to the surplus countries that the best way to help the Greek economy is to help it to develop on its own (instead of killing it with exports to Greece). The price which the surplus countries would have to pay for that is less exports to the Periphery. That would appear to be a very reasonable price to pay when comparing it to the alternative of losing 3-digit BN EUR loan amounts.

Read the whole thing »

Three Europeans debate the debt crisis

Indeed, let us imagine that, tomorrow, the ECB follows every editorialists’ advice and comes in to mop up a third of Spanish and Italian debt in a bid to get yields fixed at, say 5%. Will our Spanish and Italian bondholders a) jump at the chance to get out of their positions with a smaller loss than forecast? Or b) sit tight and allow themselves to be transformed into junior bond holders? — Louis-Vincent Gave

Don’t miss John Mauldin’s latest. Personally, I think that predicting the outcome of any of the “Euro fixes” is so complex that it is beyond most professionals (certainly it’s beyond my reach). That said, here are some guys with lots of confidence in their prescriptions:

Today’s Outside the Box is a rather philosophical debate between my friends at GaveKal, which they have graciously shared with us. It is important to note that Charles Gave, Louis-Vincent Gave and Francois-Xavier Chauchat are French. Louis served in the French army, studied at Duke, and has lived in Hong Kong for over a decade. Charles (his father) is the quintessential French patriot and patrician right from central casting, whose voice has the authority of God. Anatole Kaletsky is supremely British and one of the most influential economic thinkers in Europe. (…) These are Europeans vigorously debating the European future as only good friends can.

I found these comments by Louis-Vincent Gave to be the most persuasive — on the theme that Europe is a LONG ways from any resolution that will put an end to financial market volatility:

(…) In all our previous debates, and in The Divergence in European Spreads—Why Now?, I argued that there were four possible resolutions to the European crisis:

1. The first was for troubled countries to leave and redenominate their debt in their local currencies, thereby avoiding a default but imposing massive foreign exchange losses on foreign bondholders.

2. The second was for Germany to leave—though this seemed highly unlikely as this would in essence bankrupt every German bank, insurance company and pension fund (whose liabilities would be redenominated in DM and whose assets would remain in Euros).

3. The third was for the weaker links to default and restructure their debt.

4. The fourth was for the ECB to become far more aggressive in its purchases of troubled-country bonds and swell its balance sheet.

Now up to just a few months ago, the Europtimists kept arguing that all these events were just not going to happen. Instead, the more likely scenario was one of deep structural reforms combined with some fiscal transfers and a little bit of help from the ECB. Such a combination, I was told in many meetings and even in some of our internal debates, would help to keep the Euro-show on the road.

Fast forward to today, and every Europtimist (see the latest The Economist) is now arguing that solution 4 has to be the answer. Obviously, this is also what Anatole is arguing for by equating the German resistance to such an outcome to an “act of war.” So already we have witnessed quite a paradigm shift. But is it now too late for this? In other words, have Europe’s debt crisis and deflationary-bust moved beyond the powers of an ECB’s magic wand? (…)

Read the whole thing »

Also very useful is Keith Hennessey’s analysis Three layers of the European debt crisis.

Euro breakup not so far-fetched…

…writes Eric Burroughs in his latest column. Take a look at his analysis of the Euro – Swiss Franc hedge:

(…) How do you hedge against the potential collapse of a single currency used in a $13 trillion economic zone plus trillions more of securities and derivatives? Not easily. A splintering or breakup of the euro has gone from unimaginable to a risk that can’t be ignored altogether. Europe’s inability to get ahead of the crisis now means a sovereign debt crisis is fast becoming a banking one. The solutions — a super sized EFSF rescue fund, Eurobonds, a commitment to fiscal union — are there to be had. But the political will is lacking.

Back to the hedging. The options market is the obvious place to turn, especially deep out-of-the-money options that typically mean you don’t have to pay a lot upfront to protect against a doomsday scenario. For the euro, this has been most apparent in the euro/Swiss franc FX options market where the hedging for downside protection against the euro has been intense. The extreme implied vol skew towards EUR/CHF puts reflects big demand for such protection. The Swiss franc is bearing the brunt of the selling not just because of the franc’s perceived safe-haven status, but also because Asian central bank diversification of dollar holdings has kept euro/dollar surprisingly high for all the single currency’s worries. (So in some ways, the Swiss National Bank can blame its counterparts in Asia for making the pressure on the franc so acute. ) The franc is the Alpine haven as the European project threatens to tear apart at the seems, and the SNB’s attempts to get extremely unconventional in fighting this battle — flooding liquidity and creating negative short-term interest rates — are only partially working. The below surface now shows more demand for short-term EUR/CHF calls in case the SNB succeeds, but the steep skew towards out-of-the-money puts is one of the best gauges for showing the extreme nervousness over what the endgame really is in Europe. When the skew starts to normalize, then the market may be convinced that Europe is getting a handle on this crisis. We are far from that point.

Felix Salmon interprets Burroughs:

(…) The chart is showing how expensive it is to buy options on the EUR/CHF exchange rate — that is, the number of Swiss francs per euro. When the Swiss franc strengthens, as it has been doing of late, the exchange rate goes down. The current exchange rate can be seen in the middle the “Delta” axis, where it says “ATM” — that stands for “at the money”. So everything to the left of that line — the PUT contracts — shows the price of a bet that the Swiss franc is going to strengthen. And everything to the right of the line — the CALL contracts — shows the price of a bet that the Swiss franc is going to weaken.

Now the Swiss franc has appreciated a lot against the euro of late — you could get more than 1.5 Swiss francs to the euro this time two years ago, while a couple of weeks ago the exchange rate dropped to as low as 1.03, and it’s still at 1.12 right now. To put it another way, a 100 Swiss franc meal in Zurich would have cost you €65 two years ago, €76 one year ago, and €89 today. At this point, the Swiss franc is so strong that the Swiss National Bank is doing everything in its power to try to weaken it. So the time to bet on a strengthening Swiss franc was clearly in the past.

But just look at the chart — it’s much higher on the left-hand side, the PUT side, than it is on the right-hand side. That’s known as “skew”, and it means that the market is decidedly bearish on EUR/CHF. If you want to bet that the exchange rate is going to go back up, that will cost you quite a lot of money. But if you want to bet that the exchange rate is going to continue to decline, that’s going to cost you an absolute fortune.

And in fact the market seems to think that even if the Swiss National Bank manages to weaken the Swiss franc in the short term, over the long term its efforts won’t count for much. The lowest parts of the chart — the cheapest bets of all — are the ones saying that the Swiss franc is going to weaken over the long term of 18 months to 2 years. Meanwhile, the highest parts of the chart — the most expensive bets you can make — are the ones saying that the Swiss franc is going to strengthen a lot over the long term of 18 months to 2 years.

(…) But the main message of the chart is that people are almost irrationally worried right now. The Swiss franc is a classic flight-to-safety play, a bit like gold or Treasury bills. (…)

Greece: now what?

The Greeks know they are being lent money just so they can work very hard for lower wages and higher taxes in order to pay it back at great cost. This arrangement is in place because of the second thing the Indignati know well, the fact that the outstanding Greek debt is mainly owned by French and German banks.

In the London Review of Books John Lanchester, author of Whoops!, offers an appraisal of how the Greek default will unwind into a Euro bustup. I agree with Lanchester that the empirical evidence is that “you can’t cut your way to growth”. So the new Plan A is not going to work.

The middle class “Indignati” want Greece to default. The EU wants to protect the on-paper solvency of their banks. Lanchester’s worry is that the Greek default will domino through Ireland and Portugal to Spain. I agree that would be seriously unpredictable and chaotic – but I don’t see why it is a sure thing that Spain goes down too. But if the German voters decide they are done with shouldering the burden, then the Euro is finished.

(…) I speak of the Greek default as a sure thing because it is: the markets are pricing Greek government debt as if it has already defaulted. This in itself is a huge deal, because the euro was built on the assumption that no country in it would ever default, and as a result there is no precedent and, more important still, no mechanism for what is about to happen. The prospective default could come in any one of several different flavours. From everybody’s perspective, the best of them would be what is known as a ‘voluntary rollover’. In that scenario, the institutions that are owed money by the Greek government will swallow heavily and, when their loan is due to be repaid, will permit their borrowings to be rolled over into another long loan. There is a gun-to-the-side-of-the-head aspect to this ‘voluntary’ deal, since the relevant institutions are under enormous governmental pressure to comply and are also faced with the fact that if they say no, they will have triggered a proper default, which means their loans will plummet in value and they’ll end up worse off. The deal on offer is: lend us more money, or lose most of the money you’ve already lent.

This is, at the moment, the best-case scenario and the current plan A. It reflects the failure of the original plan A, which involved lending the government of George Papandreou €110 billion in May last year in return for a promise to cut government spending and increase tax revenue, both by unprecedented amounts. The joint European Central Bank-EU-IMF loan was necessary because, in the aftermath of the financial crisis of 2008, Greece was exposed as having an economy based on phoney data and cheap credit. The cheap credit had now dried up, and Greece was faced by the simplest and worst economic predicament of any government: it couldn’t pay its debts.

There is a good moment in one of the otherwise terrible Star Trek movies, in which Spock quotes an ancient Vulcan proverb: ‘Only Nixon could go to China.’ Similarly, it is probably true that only George Papandreou could confront the fundamental economic structure of the modern Greek state, since his father Andreas did more than anyone else to build it. Andreas Papandreou took Greece into the EEC in 1981, and subsequently the Greek government created a client state in which direct subsidies and transfers from the EEC were supplemented by easy loans from Western European banks. Money poured into Greece, and was used to fund a huge boom in public-sector jobs, most of them linked to political patronage. Various forms of corruption permeated the system, where cash gifts in fakelaki or ‘little envelopes’ were a fact of life, and where, crucially, the rich regarded paying tax as something that only the poor and stupid would ever choose to do. This latter fact meant that Greece was in certain vital respects a country without a functioning version of the social contract. To outside observers, all this was largely familiar, but the younger Papandreou, on becoming prime minister in 2009, was the first prominent Greek politician to admit it and promise to challenge it head-on. ‘Corruption, cronyism, clientelistic politics; a lot of money was wasted basically through these types of practices.’ Papandreou’s admission was jaw-dropping: everyone knew it was true, but since when do prominent politicians say very unpopular things which everyone knows to be true? The EU lent Greece the money to fund Papandreou through his programme of cuts and crossed its fingers that this would buy enough time for the deficit to narrow – the deficit being the gap between what Greece was spending and what it was raising in tax.

That was the old plan A, and it didn’t work. Papandreou made deep cuts across public-sector spending, but two things went wrong. One, the Greek economy kept crashing. Economists have varying theories about the practical effects of ‘austerity’, meaning sharp cuts in public spending. To an outsider, it’s a little alarming how they differ about something so big and basic as the effect of large public spending cuts. But if you ignore the economics and look at the history, it seems to be the case that you can’t simply cut your way to growth. (There are a couple of contentious counter-examples, but this is the broad rule.) Holding public spending flat while other parts of the economy grow is historically a more valid model – and, by the way, holding public spending flat is in itself a huge struggle, being roughly what Mrs Thatcher did in the UK. So the first problem was that the Greek cuts led to a worsening of the Greek predicament: the economy kept contracting, and unemployment hit a record high of 16.2 per cent. The second problem was that those richer Greeks who had never fancied paying their taxes showed no increased desire to do so, and, much worse, the state showed no new ability or desire to make them. Without the ability to raise more tax, the old plan A was invalid.

So this is the new plan A: the Greeks borrow another €120 billion, the bondholders allow their debt to be rolled over, Papandreou’s government introduces further austerity measures and privatisations, rich Greeks start paying their taxes, the Greek economy recovers, and by the time the next huge chunks of debt repayment are due – from mid-2012 – Greece can afford to pay back its lenders and the crisis is over.

Does that sound plausible? It shouldn’t. This scenario is somewhere on the spectrum of unlikely to impossible, because while nobody questions Papandreou’s intentions – he is the only politician I’ve ever known to tell his electorate so consistently things they don’t want to hear – the Greeks are showing clear signs that they are unwilling to submit to the programme. Protests against the measures began with furious far-left agitations of a sort with which ordinary Greeks are weary, and which consequently may even have helped Papandreou, but the protesters now include the ‘Indignati’, middle-class Greeks who have had enough austerity already, thanks, and who take a Dario Fo attitude to Greek debt: can’t pay, won’t pay. The vote on the latest round of austerity measures took place in the middle of a 48-hour general strike.

(…)  This feeling, which is strong enough in Ireland and Iceland, and which will grow steadily stronger in the UK, is so strong in Greece that the country is heading for a default whose likeliest outcome, by far, is a decade of misery for ordinary Greeks.

There is one country in particular where this disconnection between the political, the personal and the economic poses an acute threat to the world economic order. That country is Germany. The economists speak of ‘macro-economic imbalances’, the fact that German interests and, say, Greek or Irish or Spanish interests are not in alignment. The German economy is too big and too powerful for the health of its neighbours, unless European monetary policy is somehow ameliorated to help the smaller, weaker countries stay in step.[*] Interest rates which, during the first decade of the euro’s existence, suited German manufacturers, caused toxic credit bubbles to grow in Greece and Ireland and Spain. The consequences of those credit bubbles could take another decade to unwind, ten years of hard times for the citizens of those countries, who will spend most of it sweating to earn the tax money to pay back the German banks whose lending fuelled their bubble. German savings go to German banks to lend to other countries so that they can buy German goods from German companies who then save their earnings in German banks who lend it to . . . and so on.

This system is not elegant but it is probably sustainable, as long as German taxpayers are willing to pay for the busts and bailouts which will inevitably ensue. (…) The downmarket German press has been asking why Germans should work until 69 to fund the retirement of Greek public sector workers who knock off at 55.

Read the whole thing »

Euro in Crisis

Megan McArdle (and Martin Wolf) argue convincingly that the EU monetary union has about a 50% chance of staying as defined. Here are selected excerpts — you will need to read both original articles to understand the arguments:

I’ve been making the argument for a long time–at least seven years in print, and in private before that–that the eurozone looks about as stable as the Unabomber. Especially when you have a fiat currency, you need to think about what makes an optimal currency zone–the largest unit that can easily share a unit of money. The euro countries are not an optimal currency zone: their economies do not move in sync, and they are not fully integrated.

(…) In today’s Financial Times, Martin Wolf finally says what I’ve been thinking: “the eurozone, as designed, has failed.” As the PIIGS teeter on the brink of insolvency, the central banks are financing their banks–and the governments–by accepting discounted public debt as collateral. And because of the interlinkages between creditor-nation and debtor-nation banks, practically speaking, the Bundesbank is now guaranteeing all that debt. Cosigning a loan for someone with shaky credit is a very risky activity; there’s not much evidence that it works better at the international level. The picture Wolf paints is pretty dire:

(…) Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel. The alternative would be a politically explosive operation to recycle fleeing outflows via public sector inflows.

(…) Unless their economies rapidly start to mend, continuing in the euro will be economic suicide for the PIIGS once the backdoor subsidies stop. In this week’s column, Robert Samuelson notes just how dire things are “Already, unemployment is 14.1% in Greece, 14.7% in Ireland, 11.1% in Portugal and 20.7% in Spain. What are the limits of austerity? Steep spending cuts and tax increases do curb budget deficits; but they also create deep recessions, lowering tax revenues and offsetting some of the deficit improvement.” Add on top of this the drawbacks of an expensive currency and a tight monetary policy for a troubled economy, and they’d have to be crazy to stay.

Read the whole thing »

Europe: where are the big ideas?

Debt, sober growth and the welfare state will form a Bermuda triangle around the countries of Europe in coming years.”

That was a quote from Jacques Delors, thanks to Charlemagne at The Economist:

“the former European Commission boss who is revered around Brussels as a near demi-god, had some very tough things to say to El País, the Spanish daily.The interview offers fresh evidence for a pet theory of mine, that only federalists and Eurosceptics see the European Union with any clarity of vision, even if they come to different conclusions. The moderate middle view is the one I find unconvincing: the “glass half full” statements of Brussels based diplomats, Eurocrats and spokesmen.”

(…) here is the problem: Spain has put lots and lots of money into renewable energy, subsidising huge wind and solar farms all over the shop. Spain has also had tougher and more conservative banking regulation than almost anyone else. And Spain is currently staggering under the burden of something close to 20% unemployment. So of the many things you can say about Spain’s experience as a leader in banking regulation and wind farms, you cannot say it has that many lessons to give its neighbours on job creation.

The narcissism of cynicism

I recommend this short essay by Charlemagne/The Economist:

(…) Today, Europe suffers from the cynicism of the tax evader who assumes that his political masters are also stealing money, so why fund them? The insider who would rather be “furbo”, or sly enough to jump the queue, bribe the planning officer, pay off the environmental inspector or obtain a fictional job at the town hall, than “fesso”, or foolish enough to wait in line and obey the rules when nobody else is. I remember once asking someone in southern Europe why they opposed the privatisation of some terrible state monopoly. Privatisation would lead to “some idiot making a profit from me,” came the reply. But what if competition led to lower prices and better service, I asked. Was that not more important? No, I was told: allow businessmen in, and they will try to make money.

Similarly, I asked the Swedish political writer, Johan Norberg, why it would be considered a social gaffe to boast about tax evasion at a Swedish dinner party. His answer was that Sweden had never been feudal, with a system of landless peasants ground down by aristocratic landlords. For a very long time, Sweden had been a country of small farmers and yeomen, whose local governments were run by other people from more or less the same social background. So cheating the local authorities meant cheating your brother, or cousin, or neighbour.

In China, a country where the overwhelming majority have been all but powerless forever, it is striking how big a role cynicism plays in society, and the overwhelming fear of being tricked. A key battle-cry of the ordinary Chinese locked in argument with a taxi driver, a market stallholder or business associate is “Ni bie pian wo”, or “Don’t you try to trick me”. Watch any number of comedy films, especially those set in Chinese history, and the humour is all about trickery, fooling the rich and powerful, setting out to trick and being double crossed, and other revelations of humiliation.

I have heard similar battle cries covering political debates in Europe: the same angry insistence that someone will not be taken for granted by their bosses, or tricked by the government. Sometimes this is in European countries with long histories of something approaching feudalism. Sometimes it is in countries with long histories of foreign occupation, whether by the Ottomans, by the British, or the Soviet Union. In such places, you will endlessly hear that cheating the system under foreign occupation felt like a form of resistance, and has left deep roots of suspicion.

America feels different, and so do some parts of Europe. I am pretty sure at least some of that is to do with differing histories of enfranchisement and empowerment. [From The narcissism of cynicism]

Why the trans-Atlantic gap is deeper than it looks

From Charlemagne’s notebook

Depending on whether you favour arguments of the heart or the head, it is possible to believe the current mood of transatlantic drift matters a lot, or is not as serious as all that. The head says to be optimistic, and look at the long list of issues which the EU and America want to work on together. But the heart notes that things are not going well. In private conversations, European diplomats talk of their high expectations after the Obama administration took office. A year on, they say, on tricky dossiers from Iranian nuclear weapons to Russian relations with NATO, they have little real idea what America’s strategy is.

American officials, meanwhile, talk about their commitment to multilateralism as a gamble, which Europeans must soon repay with help on tougher Iranian sanctions, unity on Russia or more police trainers in Afghanistan, if America is not going to be tempted to go it alone.

What is going on? Here is a third, final theory, and it is not that cheery: a greater willingness to cooperate is not enough to fix some of the present differences in transatlantic opinion. Take two issues that loom larger than most: the war in Afghanistan, and efforts to limit man-made global warming. If you believe the public statements of leaders in Europe and America, these are essentially quantitative differences of opinion. If Europe could only promise x-thousand extra troops or policemen for Afghanistan, they seem to suggest, and if America could only bind itself to this or that percentage cut in its carbon emissions, all would be well.

(…) What does this mean? It means these disputes will get worse if they are left unresolved: people who think they face an existential threat become impatient and intolerant if others refuse to listen.

None of this will be easy to fix: Americans and Europeans cannot easily change the way they think. On Afghanistan and climate change, it would be a start for both sides to realise how far they remain apart.

Please continue reading…