Reciprocity is vital for harmonious relations between countries, yet it rarely happens. One glaring recent example of a lack of reciprocity is India’s retrospective imposition of capital gains tax on foreign companies overturning 50 years of practise and several supreme court judgements. Contrast this xenophobia and capriciousness with the UK’s willingness to allow Indian companies to buy significant parts of the UK’s industrial sector without penalties.
This sort of behaviour happens all the time in the area of trade and is part of the rough and tumble of global commerce. More serious, is a lack of reciprocity in legally binding supranational entities. The inability to achieve remedies through unilateral actions becomes a cancer to harmonious relationships.
When the history of the eurozone comes to be written in a few years time, one of the key roots of its failure will be the lack of reciprocity between Germany and the periphery. I cannot see how this won’t lead to a huge political rupture at some juncture.
At the beginning of the eurozone, Germany entered with an overvalued exchange rate. As we all know, Germany undertook a significant restructuring of its industrial base, improving labour competitiveness in the first 6–7 years of the euro’s life. This restructuring was not achieved in isolation. It was helped considerably by two interlinked factors.
Firstly, for many countries, especially the periphery, interest rates fell to levels not seen for at least a generation. Not surprisingly, this set off an economic boom which produced high levels of capital expenditure, property investment and surging trade deficits. The weakness of German domestic demand was offset for German corporates by the strength of demand in most of the rest of the eurozone.
The second interlinked factor was that inflation in the periphery was significantly higher than in Germany, enabling Germany to regain labour price competitiveness simply by allowing competitor wages rages to rise more quickly than its own. Unfortunately for the periphery, productivity did not rise rapidly enough to compensated for wage inflation, so competitiveness, both in a European and a global context was eroded. If countries had retained their own currencies, then exchange rates would have moved to accommodate these changes in relative prices, as they have for the UK, which shared many of the same features as the eurozone periphery.
Not only was the lack of currency flexibility an issue, but the “one size fits all” interest rate policy of the ECB turned out to be a “one size fits none” policy. Rates were too low for the booming periphery. While they might have been somewhat high for Germany, differential inflation and strong export demand eased the burden.
So we can characterise the history of the first 7–8 years of the eurozone as one where the imbalance of starting exchange rates were worked out by excessive demand growth and high inflation in the periphery helping Germany in its adjustment of lowering its relative wage costs. This process had largely run its course by 2007/8. Indeed, the global financial crisis revealed that Germany had become very competitive in both a European and global context.
Marching forward to 2010/12, we now see that the role of Germany should be reversed. For the periphery to regain competitiveness, it needs Germany to have strong domestic demand, a property boom, higher inflation and to run a trade deficit with the rest of the eurozone. This would reciprocate the boom conditions that prevailed in the periphery that allowed Germany to restructure relatively painlessly. Instead we see a growing reluctance to accept the flip side of the benefits that Germany has enjoyed in the euro system.
It seems that Germany was very happy to allow the “profligacy” of the periphery to benefit the German economy as it was going through its transition, but now that the boot is on the other foot, it will not allow stronger domestic demand, higher inflation or higher imports to help the periphery trade its way out of its problems. “All for one but none for all” when it comes to Germany’s turn to reciprocate.
In fact, it gets even worse. Instead of leaving things as they are, German policy is now gearing up to prevent any boom in Germany from developing. We already have the debt brake in the constitution, but now other measures are being enacted specifically to dampen any rise in property prices and growth in consumer credit. With a friend like this, who needs enemies?
In one sense, I don’t blame the Germans for looking at the shambles that the credit boom produced in Spain an Ireland and wanting to prevent a recurrence in Germany. However, Germany accepted the benefits, now it should take some responsibility. Unfortunately, the domestic narrative in Germany appears to be one of German virtuosity and periphery profligacy. The unwillingness to acknowledge the role played by the boom in the periphery in helping Germany in the early difficult years of the eurozone is a significant block to a rational policy mix to enable the eurozone to survive.
Not only are German politicians in denial over economic history, they are also in denial over basic economic reality. Unsurprisingly, Germans want the debts run up by the periphery to be repaid. What they don’t seem to grasp is that the only way that this can be achieved is through Germany running a trade deficit with those countries. It’s not an economic theory, it’s a simple accounting fact.
In the end, the Achilles heel of the eurozone and the broader European project is the denial that sovereign states, when push comes to shove, will act in their own interests. Altruism is in short supply in international relations.
The eurozone is not dead yet, but the fundamental inconsistencies and paradoxes have yet to be solved. Germany’s actions suggest they are insoluble. For the eurozone to work, Germany needs to act in an altruistic manner which appears impossible given the domestic political background. LTRO has bought time for the politicians to come up with a solution, but it has also produced a deadline and a mechanism for the breakup of the euro.
The deadline will come in two years time when markets start to factor in a refinancing of the LTRO largesse. The mechanism for breakup is that the LTRO is producing the re-domestication of sovereign debt. Spanish and Italian banks are loading up on domestic sovereign debt, playing the carry trade. As current debt matures and is refinanced through the domestic banking system, there will be a natural unscrambling of assets within the eurozone. The asset side of bank balance sheets will become increasingly domestic. If this process continues, then the eventual splitting of the eurozone will be much easier.
Like Mark Twain’s death, the demise of the eurozone has been prematurely reported on a number of occasions. Because commentators have cried “wolf” on many occasions doesn’t mean that one day the wolf will not appear.
lemmings can teach nothing 