Germany should be happy to let Greece go

February 21, 2012

When the Greek crisis began, there was much talk of contagion as the greatest short-term risk. In my view, this worry is almost irrelevant because bondholders are in any case facing a haircut of over 70%, so the question of default or bailout is now merely a technical detail.

From a longer term perspective, there is also little reason for the Germans to panic over a Greek default, even if it ultimately leads to the disintegration of the euro zone. The line peddled by a number of commentators and politicians that Germany has “done very well out of the euro zone” begs the question of how well it would have done without the euro zone, a question to which I do not know the answer – but nor does anyone else.

The implicit or explicit claim is that, with floating exchange rates, German trade would have suffered as the DM appreciated against the currencies of its neighbours. This is nonsense, a case of how, in the world of popular economics – what one colleague famously called D-I-Y economics – exchange rates occupy a position of exaggerated importance (If those who study the subject were given the same importance, I’d have had a peerage by now).

If exchange rate appreciation were so damaging and depreciation so beneficial to a country’s trade, the Swiss would by now be the poorest country in Europe and the Italians the richest. The reality is that, while there may be short term dislocations, the effect of changes in the value of a currency are ephemeral. Devaluations are self-defeating because they push up costs until the country’s terms of trade are back where they started, and the opposite for appreciations: a rise in the value of a country’s currency makes its imports cheaper, reducing its inflation rate and restoring its competitiveness as time passes. The process of adjustment seems to take some six or seven years, which might seem a window of opportunity worth seizing for opportunistic devaluation. The fly in the ointment, however, is that the more rapidly a currency depreciates, the more agents in the economy wise up and start anticipating the next depreciation, speeding up the adjustment and thereby narrowing the window of opportunity for exporters.

In other words, exchange rate flexibility smoothes the road, but does nothing whatever to change the destination. Moreover, the effect of exchange rate changes is smallest for countries with the most efficient labour markets, which includes Germany ever since its reforms of ten years ago, so there is every reason to suppose that it would adjust quickly anyway, just as it did in the 1970’s and 1980’s when the DM rose in value almost continually without seriously damaging the country’s competitiveness.

As far as Greece is concerned, making it competitive inside the euro zone will require a so-called internal devaluation – mainly a reduction in wages – whereas outside the euro zone a relaunched drachma could be allowed to float downward. The only difference is that in the former case, Greek workers will have to get by on fewer Euros than they have been used to, whereas outside the euro zone they would be paid in devalued drachmas, which would mean a cut in their living standards of the same order of size (is there such a thing as a Hobson’s Choice between Scylla and Charybdis?).

For Germany (and for the rest of Europe, including Britain), the real danger is that euro zone disintegration might be followed by the collapse of the single market, the only truly valuable component of the EU edifice. As a nation very reliant on its external trade, Germany needs market access – no reasonable person wants to go back to a world of protectionism, quotas and  non-tariff  barriers to trade, but it is an ever-present threat as populist politics take hold in Europe. But even then, the German carmakers have demonstrated in the last couple of years how capable they are of compensating for sales lost in Europe by higher volume in the emerging markets of Asia and Latin America, and there is every reason to suppose that the formidable German capital goods sector will prove just as adaptable.

It should not be forgotten that, back in the early 1990’s, agreeing to EMU was the price extracted from Germany by its neighbours for their acquiescence in its reunification. The no-bailout clause was inserted in the Maastricht Treaty to put a ceiling on that price, to ensure that it would never include what is now being asked of Germany. If I were a German taxpayer, I would be livid at what is being proposed – and, I suspect, so would most of the people outside Germany who are accusing Frau Merkel of excessive prudence, arrogance, and worse. Instead, they should admire her meanness. It is always refreshing to see a European politician finding it difficult to be generous with other people’s money.

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