German ghost of inflations past haunting European stability: Posen

April 15, 2013

“Reality is sticky.” That was the core of Adam Posen’s message to German policymakers on their home turf, at a recent conference in Berlin.

What did the former UK Monetary Policy Committee member mean? Quite simply, that the types of structural economic changes that Germany has been pushing on the euro zone are not only destructive but also bound to fail, at least if history is any guide.

Posen, who now heads the Peterson Institute for International Economics in Washington, argued Germany’s imposition of austerity on Europe’s battered periphery is the product of an instinctive but misguided fear of an inflation “ghost” that has haunted the country since the hyperinflationary spurt of the Weimar Republic in the 1920s and 1930s. However, Posen offers a convincing account of modern economic history that shows inflation episodes are rather rare events associated with major political and institutional meltdown — and not always around the corner.

The risks of inflation going up quickly, or in the long term, are smaller than are usually recognized in Germany. The issue is not that inflation is harmless; it certainly has its harms. The issue is, realistically, when you are facing choices, how much risk do you think there actually is of inflation occurring. I don’t want to pretend that there is some kind of exact, scientific, precise answer, but there is more of a historical record to draw on than most people acknowledge. This historical record is not often taught to German economic elites. […]

Inflation is actually quite sticky when you don’t have huge political breakdowns. Focusing on this period of the 1920’s in Germany — this horrible, horrible period — is economic solipsism instead of a good basis for current policymakers. To pretend that this source of the German hyperinflation is anything other than the political breakdown at the time is misleading; there is nothing economic that causes this situation on its own. You can say it was because the money supply grew too fast, or you can say it was because the central bank lost independence, but that is just telling you what happened technically. The cause was the breakdown of civil society, or at least of political decision-making, not the effect.

Another German “ghost,” argues Posen, is the notion that reunification with East Germany in the 1990s would have been less painful if harsher measures had been imposed during the integration process. This makes Germany’s dominant elites keen on imposing truly onerous spending cuts on southern states in the name of competitiveness and “convergence” to the north. Yet Posen maintains this ignores a long arch of history suggesting structural changes take decades, even centuries — not months or years — to run their course.

Economists and economy policy makers remain prisoners of past ideas, all of us. This results in Germany what I will call the Haunted View of the Euro Area Crisis. The Haunted View claims that the absence of European fiscal rules and institutions results in insufficient fiscal and wage discipline. The Irish put up their wages too fast, and they were the most productive. When the Spanish, and the Portuguese, and the Greeks put up their wages too fast, and spent too much, they were in deeper trouble still. This is the core of the problem on this view. So, you have to play tough. If you engage in brinksmanship from the Merkel government and from the European Central Bank, you will induce structural reforms in the periphery. Always do just enough to avert the crisis but never enough to let off the pressure. Structural reforms will in turn cause convergence and make everything better – and the debts will get repaid.

I believe there is a more realistic and productive view. What really happened is that there were a bunch of bad loans made. Some were made by Spanish and Irish banks; some were made by West LB, for example, and other northern European including German banks. These bad loans went bad. And when bad loans go bad, you have to decide who is going to pay for them. Almost all of it is being shifted onto the south (which includes Ireland, for this purpose), who were the borrowers. Almost none of these losses are been borne by the lenders, in northern Europe. This means recession until the borrowers can pay off the loans in hard euro currency. And a large part of why Europe has taken this course is that German-led discussions believe there is a high inflation risk from looser policy, and a gain to be had inducing structural reform – both of which are ghosts. Therefore the economic problem of the euro area is the mistaken policy ideas.

There in lies the rub, or rather, the stickiness. Posen’s line of argument, which emphasizes humility on the part of policymakers about how big an impact they are truly able to have, places the former Fed staffer, an American, on unusual intellectual grounds. At the Bank of England, from which he stepped down just last year, Posen tended to lead a dovish, activist camp that believed aggressive monetary policy could have a meaningful positive effect on growth and employment.

Clearly, he doesn’t feel the same way about Germany’s preferred approach to “competitiveness” reforms:

If you believe that real economic things are not going to be affected very much by being tough, that these so-called structural reforms are not going to have much positive impact in the near term, that it will take years to get convergence, then you have to ask: Why is it worth it to impose things this way? Why can’t you undertake a policy approach that does not put as much adjustment on the South? Why not have helpful transfers on the scale that took place within Germany? Why not make up for the too high exchange rate with other policy measures?

Many colleagues in Europe say to me, ‘You Americans, you Brits — you massively underestimate how much support there is for this approach. Nobody is rioting in the streets in Ireland. There are a few protests in Spain, yes. But in reality they are voting for center-right governments that are pursuing austerity. They are gritting their teeth that they are going to get through it.’ I do not deny a word of that. I give can give you reasons why that has happened.

But that’s not good enough. The fact that people are willing to settle for this, the fact that Europe means enough for them, or that as young unemployed people they don’t have enough political clout to mess up the plan, does not mean that the plan is the right plan. Yes, there is political stability and thus majority acceptance of these policies in the south. But that is just too low a bar for success. Absent the ghosts of inflation and unification past, German economic policy might see that and aim higher for the euro area.

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