Crystallizing the Difference

Currency in Crisis

The poltical realist in us says the golden rule is "he with the gold makes the rules". Germany has the gold (financial prowess) so it sets the rules as the "first among equals" in the euro zone. It is insisting on the austerity and economic restructuring as the only real way to deal with a debt crisis.

We argued that 3 No's characterize the investment climate in Europe.  No euro zone joint bond.  No ECB sovereign backstop.  No euro zone break up.  We concluded in this formulation that Germany is condemning the euro zone to a protracted period of stagnation, or worse, and social and political pressures. 

We identify one of the key issues, not only for Europe, but for most of the high income countries, is where the aggregate demand is going to come from when households and governments deleverage.   The German Bundesbank has responded today.

BBK board member Andreas Dombret was crystal clear and seemed to articulate the views of many policy makers in Germany.   Indebted countries, like Spain, should not be concerned about short-term growth and instead, through budget cuts, win back the confidence of investors. 

There is little use objecting to Germany's stance on the grounds that in condemns the euro zone to weak growth.  Germany, in effect, says they went through a painful decade of restructuring after the Berlin Wall fell.   Germany was the "sick man" of Europe.  And now it is seen by some as hyper-competitive. 

ECB monetary policy is too easy for it as the jump in inflation expectations in the IFO survey released earlier today shows.  Germany's persistant large trade surplus would seem to suggest that it has the benefit of a weak currency, which ironically seems too strong for peripheral countries to offset weaken domestic demand with foreign demand. 

Over the last several months, Germany has made some modest tweaks it austerity plans, which seem quite modest relative to the austerity elsewhere in the euro zone.  These measures include an introduction of a limited minimum wage, a 6 bln euro tax cut and a 6.3% pay increase for public sector workers. 

In the US, the cuts on state and local levels were offset (not wholly but to a large extent) by increased Federal spending.  There are some signs that states have nearly completed their austerity restructuring (though without the kind of civil service reform we suspect is needed).  Just as the Federal government may soon go on a diet, the state and local governments may help blunt the potential fiscal drag.    

Europe does not have that fiscal mechanism.  Nor do the surplus countries show willingness to offset the austerity in the deficit countries.  One of the innovations of the old ERM was that countries with both weak and strong currencies shared the burden/cost of defending the currency ranges.  

As EMU unfolded and Germany's financial prowess was so great (in relative and absolute terms) , a new generation of German politicians seem less encumbered from the past, Germany has taken the view of creditor nations, like the US did at Bretton Woods and argue and cajole and force the debtor countries to bear the burden of the adjustment.   

Devaluation has been effectively blocked.  Fiscal transfers are banned.  Default is frowned upon.   Because of the ECB's bond purchases, and the debt owed to the IMF and other official entities, Greece defaulted (PSI) but not sufficiently to put its debt back on a sustainable path.    

Germany and the other creditor countries can continue to push the burden of adjustment to the debtor countries, but over time this will create a social and political backlash.  And in some ways this is the race:  who blinks first ?  Do the creditor countries bear a greater burden of the adjustment process or must the debt countries face social and political turmoil that would also jeopardize the entire experiment?