A decade ago, the Economic and Monetary Union (EMU) replaced 17 European currencies with the euro, locking their nominal exchange rates together. Germany decided its wage and price structure was too high. This made it more likely Germans would buy imports and that other countries wouldn’t buy German goods. Painfully the Germans slowed their wage and price rises relative to their competitors’ until they got their levels into balance; the German economy has prospered since.
Other members of the EMU have not been so rigorous and are now struggling with the consequences of excessive price levels. They have borrowed to maintain domestic demand, for they import too much and cannot sell enough exports. International lenders are increasingly uneasy about the ballooning debt, so they hike their interest rates. The vicious circle of higher debt and higher interest rates continues until the debt-ridden country defaults. The more prudent lenders say, “I told you so”, while those who hung in there for the high interest rates take a haircut – their loans get devalued; this has already happened with Greece and may happen to others, including Italy.
Having the European Central Bank lend to the potentially defaulting countries cannot be the long-term solution, because this does not address the underlying problem. The Germans are quite right on this point. Moreover, fiscal measures such as less government spending and more taxation are not enough unless wages and prices also come down. It is difficult to do this quickly, so a prudent European Central Bank might offer some cover if it really believed a country was on track. (Does one believe a democracy will stay on track past the next budget? The Germans did.)
There is a potential contradiction here. If the debtor countries lower their internal price level to make them more competitive, then Germany – among others – will be less competitive; its exports will fall and imports rise. As the debtor savings rise, other countries’ savings must fall. Since Germany is the biggest saver in the EMU, its economic prosperity will be compromised.
The official German position, expressed by Chancellor Angela Merkel, is that the deficit countries must be more fiscally austere. There is no hint that the Germans will increase their public spending or cut their taxes. Yet if they do not want to collapse Europe into a serious recession, the surplus countries must be more fiscally relaxed. German economists are as good as those anywhere else in the world, so they must be well aware of the orthodoxy of the previous few paragraphs.
There is growing impatience from some European leaders at the inconsistency in German thinking. Italian Prime Minister Mario Monti, who describes himself as the most German of the Italian economists, has criticised the German stance. He is not saying Italy should abandon the painful adjustment he is implementing, but that it cannot be done alone. Germany has to do its share of the adjustment too.
When the International Monetary Fund was set up nearly 70 years ago, English economist John Maynard Keynes suggested the international monetary system should make economies with external surpluses take adjustment measures as well as the deficit countries. The US, then running a huge surplus, was having none of this, and the system ended up with only the deficit countries having to adjust (as, apparently, is required in Europe).
Today, however, the US is running a huge deficit, and US economists are looking more benignly on Keynes’s proposal, arguing that China with its huge external surplus must reduce its savings. Here on the margins of the world, New Zealanders can but be fearful that political stupidity will lead to international economic disaster – as has happened too often in the past.
But there is a practical issue. Were New Zealand to join Australia in a monetary union, we could end up with a similar – albeit smaller – disaster. Currently, unlike the countries of the EMU, we can also change the exchange rate to get the right price relativities (although we would still need to make a painful fiscal adjustment). The EMU countries can’t change their exchange rate, while those outside it, such as the UK, can. The fate of the EMU countries looks murkier.