07/10/2012 Leave a comment
As you are no doubt aware, the Eurozone is going through a bit of a tough time at the moment. While the economy in Germany has remained resilient throughout the crisis, many other Euro members have not been as lucky. Take Spain for example. Here’s how Spanish unemployment compares with German unemployment during the crisis:
Yes, it’s awful but we all know how this happened, right? The Spanish government borrowed far beyond its means during the good years, running up huge debts and when the economic crisis hit they couldn’t afford to pay it off. How do we know this? Well, Angela Merkel told us. Anyway, it’s easy enough to prove – the IMF database has everything we need. So let’s grab the data and see how terribly irresponsible Spanish government borrowing was during the good years of the Euro:
Oh. So if Spain was doing the precise opposite of plunging itself deeper into debt, what exactly is going on?
At the moment Spain is a deeply ill patient and Germany is her self-appointed doctor. Not only has Germany (as we’ve just seen) misdiagnosed the cause of the problem but they have also prescribed austerity as the cure.
I’ve talked before about the fallacy of attempting to solve a depression with austerity and we need not go through those details again to know why it is a fallacy. What I do want to think about though, is why Germany has been so quick to misdiagnose the cause of Spain’s problems and for four years has chosen not to look at the numbers in the graph above.
There is a theory about this but to understand it we first need to travel back in time to the 28th of June 1919.
On that day in history, Germany and The Allies marked the end of war by signing The Treaty of Versailles. The treaty, amongst other things, laid out the reparations that Germany would have to pay The Allies in compensation.
At the time that the treaty was signed the British economist John Maynard Keynes described the reparations not as a compensation but as a “deliberate impoverishment”, and went on to predict (rather chillingly) that they would lead initially to mass poverty and then on to vengeance and another war.
When the reparations began, Germany soon didn’t have enough Marks to buy the foreign currency needed to make the repayments so they printed more Marks. Each time they did this the value of the Mark decreased, so that the next time they went to the printing press, they had to print more Marks than last time. Inflation turned into hyperinflation and the value of the Mark fell off a cliff and then kept going in spectacular fashion.
At the end of The First World War, one US dollar was worth about nine Marks. By the end of 1923, one US dollar was worth 4.2 trillion Marks. Inflation was so high that prices were doubling every two days. Saving money was a pointless exercise, so people spent it as soon as it was in their hands. Workers were paid hourly so they could hand the money to their families to go out and spend immediately while they could still get something for it. If someone went to the pub intending on having a couple of beers, they would buy their two beers on entry for fear that otherwise the second would be more expensive by the time that they came to order it. To help to put this into perspective, here’s a fifty billion mark postage stamp.
Living through such a period is almost unimaginable for us and it is little wonder that the current generation in Germany have such an inherent fear of inflation. A leader who would even give a hint of allowing some of it would immediately become deeply unpopular.
So how, you may ask, does this have any bearing at all on the current crisis in the Eurozone? Sadly, the solution that is needed, inconvenient as it may be, is German inflation.
During the good years of the Euro, Spain’s economy did well. Adoption of the single currency led to huge capital inflows from German banks to Spanish banks. The German banks’ perceived risk of lending lots to Spanish banks (and the Spanish banks’ perceived risk of borrowing lots from German banks) reduced significantly (and erroneously) once they were all using the same currency. The German banks thought that since they were both on the same currency now, lending to Spain was like lending to Germany. The Spanish banks eagerly accepted the German loans and invested them in the Spanish housing bubble (they didn’t call it a bubble at the time). As more and more money passed from Germany to Spain the bubble grew, Spanish wages increased and Spanish prices increased.
This is how relative Spanish and German prices changed throughout this period:
And this is how relative Spanish and German labour costs changed throughout this period:
As you can see, during this time the cost of Spanish workers became much higher relative to their trading partners in the north. When the financial crisis hit and demand dropped off, this left Spain with a deeply uncompetitive economy. Production of goods and services for export to Germany, France and other economies in the north is simply too expensive now.
This is the primary problem that needs to be solved in order for Spain to recover and you might note, it has nothing to do with government spending.
So now we understand the problem, what’s the solution? Well, one solution would be Spanish deflation but deflating your way to competitiveness is extremely difficult because it means everyone taking pay cuts and people don’t really like taking pay cuts. The Spanish government could start by cutting the wages of all public sector employees (and deal with the riots) but how do you convince the private sector to do the same? Also, Spanish deflation effectively increases their debt burden*, which means it’s pretty unworkable in any case.
There is another option – inflation in Spain (and Italy, Portugal, Ireland**) that is low relative to the Eurozone as a whole. The Eurozone economy is dominated by Germany so essentially this means German inflation. We’re not in any way talking hyperinflation but something like inflation of 1% in Spain and say 5% or 6% in Germany would start moving things back toward competitiveness.
With the horrors of 1920s hyperinflation still ingrained in German minds, Angela Merkel will have no easy task in pushing such a policy through and her current policy of blaming the problem on Spanish government spending in the good years and prescribing austerity as the cure has certainly helped to maintain her popularity with German voters.
Sadly though, Angela Merkel being popular won’t be enough to save the Euro.
*Although Spain’s debt wasn’t high during the good years it is high now due to their economy collapsing. It’s important to understand the the high debt was caused by the crisis rather than the other way around.
** You might have noticed I didn’t mention Greece. They actually did borrow beyond their means for a sustained period and relative deflation is not sufficient to save them. From what I can see they are pretty much done for.