Tuesday, 2 September 2014

Germany's most important export is unemployment

Some time ago I posted a short piece entitled Austerity may be Wunderbar, the simple message in this blog was that Germany was the problem in the EuroZone not the solution.  Having joined the Euro at a grossly undervalued rate the German economy has been on the PIIGS back for the last fifteen years.  The net result of this competitiveness advantage was that in the years 1999-2008 German was able to re-boot its ailing economy by exporting cheaply to its European Partners where all control of credits markets had lapsed.  

It's not just cars, but unemployment, that Germany exports


The Germans are are still winning but now they are exporting unemployment and deflation to the rest of the EZ.  Paul Krugman sets out the history and today’s problem very nicely.  He tells us - During the years when Germany was gaining competitiveness (1999-2005), euro area inflation was running at around 2 percent, and inflation in Southern Europe was running considerably higher. So Germany could gain competitiveness simply by having lowish inflation. But these days German inflation is only one percent, euro area inflation is lower, and the only way for Southern Europe to gain ground is to have zero or negative inflation:


This unfair deflationary pressure is driving demand (already on the floor) lower and makes it almost impossible for the southern countries in the EZ to make the appropriate adjustment.  The argument Paul Krugman makes is that Europe (Germany specifically) needs is a good dose of inflation. This would allow southern Europe to lower prices compared to German and inflate their debts away at the same time- this would allow the PIIGS to devaluate against Germany over an extended period.  To gain competitiveness against Germany the PIIGS need deflation of 1-2% a year relative to Germany and German inflation will not reach 3% any time soon.  The problem is that the EZ is running out of time.  As everyone knows there is not a cat in hell’s chance of Germany agreeing to raise domestic inflation to save the highly indebted and unproductive economies of southern Europe.
So what do the weaker economies in the EZ do?  Politically, high unemployment, low growth and falling prices will force government to act sooner rather than later.  With interest rates at the lower bound and Germany set against QE there is not much room for maneuver on the monetary side of the equation.  The plan to use Blackrock (the US investment house) to design a new improved QE based on Asset Backed Securities (ABS) may just work but not unless it is accompanied with real structural reform.   Next up is fiscal stimulus, which looks like a non-starter, as all government signed up to the Stability and Growth Pact –SGP, and debts already out of sight - Germany is probably the only country in the EZ able to increase public spending and it should do so now! This leaves supply-side reforms, which are deeply unpopular in all Europe and probably only saleable to the good people of Spain, Italy and France if they are backed by some massive reflation from the ECB.

Mario Draghi is trying to find a way through this mess that would see a trade-off between quantitative easing, structural reform from Spain, France and Italy and more public spending from Germany. Without the successful execution of this heady cocktail exit and devaluation is still the first best option for Greece, Italy, France, Spain Portugal and even Germany.  Come on in all you short sellers!

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