An important development happened in Europe this week: The German economy officially began to crack.
On Thursday, Germany had a very bad Flash PMI report, showing an accelerating decline in manufacturing and service output.
On Friday, a survey from the well-known Ifo Institute showed business confidence in Germany collapsing.
Throughout the crisis, Germany’s economic performance has been nothing short of miraculous. Even as its peers have been heading into depression, the German economy chugs along, and unemployment has ground lower and lower.
Here’s a look at unemployment in Germany going back to 1997. Eat your heart out, world.
Against this backdrop, it’s understandable why Germany has been reluctant to endorse anything that might, you know, change the status quo. No monetary or fiscal stimulus has been tolerated. When the ECB does do something, the German bundesbank objects.
The German ability to withstand the latest bout of crisis has lead to a textbook example of a country — as they say — sipping its own Kool-Aid. Merkel thinks austerity and the hard euro has worked just fine for Germany, and so she can’t imagine why it won’t work for Greece (or Italy, or whoever). It’s just a matter of needing the proper discipline.
But what has only been getting more attention recently is the way in which Germany thrived over the years because the peripheral countries went into debt for the purpose of buying German goods.
Here’s a look at household debt-to-GDP in Spain (blue line) vs. household debt-to-GDP in Germany (red line) between 2005-2010. Germany’s debt is going down the whole time, in part because Spain’s is going up.
What the Euro did was create a bubble in peripheral countries that allowed for mass consumption of German goods. Relatedly, Germany benefited from the fact that the Euro was cheaper than the Deutsche Mark otherwise would have been, thus giving it an export boost.
Again though, the German line will be that its practiced austerity and engaged in labour market reforms that would work for everyone else, if only they would bite the bullet.
The truth of the matter is that not only has the Euro been a perfect form of stimulus for Germany all these years, it has also benefited from more explicit forms of public stimuli.
As Richard Koo recently pointed out, the ECB cut rates aggressively after the tech bubble collapsed (a bubble that at least in Europe only happened in German). The lower rates didn’t help the German economy directly, but the rates did help stoke the bubble in the periphery, since there never was a post-bubble bust in those countries. Instead, the low rates just helped to heat up already hot economies, further creating a credit boom and demand for more German goods.
But wait, these ECB rate cuts following the collapse of the tech bubble had another effect.
The countries of southern Europe, which had not participated in the IT bubble, enjoyed strong economies and robust private- sector demand for funds at the time. The ECB’s 2% policy rate therefore led to sharp growth in the money supply, which in turn fuelled economic expansions and housing bubbles.
Wages and prices increased… leaving those countries less competitive relative to Germany.
In short, the ECB’s ultra-low policy rate had little impact in Germany, which was suffering from a balance sheet recession, but it was too low for other countries in the eurozone, resulting in widely divergent rates of inflation.
As Germany became increasingly competitive relative to the strong economies of southern Europe, exports grew sharply and pulled the nation out of recession. Germany’s trade surplus quickly overtook those of Japan and China to become the world’s largest, with much of the growth fuelled by exports to other European markets.
Here’s one of Koo’s chart showing wage divergences. It’s well known that wages in the peripheral countries rose a lot faster than in Germany (and this is supposedly one of the arguments for internal devaluation, and an argument that Germany has done better) but Koo argues that this is essentially the result of the post-2000 interest rate cuts.
The reason German wages didn’t rise by as much is because in a balance sheet recession (which is what the US is in now, and which is what the German economy had post-bubble) monetary policy doesn’t work as well.
You can click the image to enlarge.
So the whole idea of Germany being disciplined about wage growth, and the periphery going hog wild giving everyone raises is a myth.. it’s really more about the ECB stoking their economies on behalf of the Germans post-2000 bubble.
And so now, finally, the magic is wearing off and Germany will be soon forced to confront the fact that it doesn’t have a miracle economy that can thrive on the basis of its worker productivity and government discipline alone.
Prior to recently, it would have been insane for Merkel to do anything to change the status quo in Europe, since it was all working so well. Thus her neighbours have been collapsing (to varying degrees) thanks to a reticent ECB and an inability to juice the economy. This has lead to a global crisis. Now Merkel is trying the other shoe on, and it could be just what Europe needed to get onto a new path.
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