Calling on Germany

In the New York Review of Books, George Soros has written an excellent long piece on the future of the European Union in light of the Eurozone economic crisis. If what happens in the EU in any way affects your life (and it almost certainly does), you should read it. There is a lot to ponder over in there, including a brief history of European cooperation, an astute diagnosis of the economic problems, and a bold call for action that is unlike anything that has been said anywhere else. It is also written from the perspective of a heartfelt supporter of the idea of a united Europe.

It is that call for action that gathered the most attention in the press, making several newspaper headlines. Soros is quite blunt: he says straight out that at every stage in the crisis, Germany's intention has been to do the absolute minimum required to avert disaster — with the end result that no resolution has been reached, and the can is just a few metres further down the road.

The policies pursued under German leadership will likely hold the euro together for an indefinite period, but not forever. [...] If and when the euro eventually breaks up it will destroy the common market and the European Union. Europe will be worse off than it was when the effort to unite it began, because the breakup will leave a legacy of mutual mistrust and hostility. The later it happens, the worse the ultimate outcome. That is such a dismal prospect that it is time to consider alternatives that would have been inconceivable until recently.

In my judgment the best course of action is to persuade Germany to choose between becoming a more benevolent hegemon, or leading nation, or leaving the euro. In other words, Germany must lead or leave.

Strong words indeed, and not an angle I have seen advocated (explicitly) by anyone else yet. He then goes on to explain a bit more.

Since all the accumulated debt is denominated in euros it makes all the difference who remains in charge of the euro. If Germany left, the euro would depreciate. The debt burden would remain the same in nominal terms but diminish in real terms. The debtor countries would regain their competitiveness because their exports would become cheaper and their imports more expensive. The value of their real estate would also appreciate in nominal terms, i.e., it would be worth more in depreciated euros.

The creditor countries, by contrast, would incur losses on their investments in the euro area and also on their accumulated claims within the euro clearing system. The extent of these losses would depend on the extent of the depreciation; therefore creditor countries would have an interest in keeping the depreciation within bounds.

The eventual outcome would fulfill John Maynard Keynes’s dream of an international currency system in which both creditors and debtors share responsibility for maintaining stability. And Europe would escape from the looming depression. The same result would be achieved, with less cost to Germany, if Germany chose to behave as a benevolent hegemon. That would mean (1) establishing a more or less level playing field between debtor and creditor countries and (2) aiming at nominal growth of up to 5 percent, in other words allowing Europe to grow its way out of excessive indebtedness. This would entail a greater degree of inflation than the Bundesbank is likely to approve.

Whether Germany decides to lead or leave, either alternative would be better than to persist on the current course. The difficulty is in convincing Germany that its current policies are leading to a prolonged depression, political and social conflicts, and an eventual breakup not only of the euro but also of the European Union. How to persuade Germany to choose between either accepting the responsibilities and liabilities that a benevolent hegemon should be willing to incur or leaving the euro in the hands of debtor countries that would be much better off on their own? That is the question I shall try to answer.

As I said, go and read the full argument.

One thing that is generally accepted by everyone is that the ultimate resolution of the Eurozone crisis can only come about through a relative decrease in the wages and prices in debtor countries (Spain, Italy, Portugal et al.) compared to Germany, in order to restore their competitiveness. This can happen in one of two ways: slightly higher inflation in Germany than in other countries, or deflation in other countries and stable prices in Germany. Most people also agree that achieving this entirely through deflation in debtor countries is not only highly unlikely to work, but also exacts a terrible and unnecessary human cost.

This is why Soros argues for Germany to make the sacrifice and accept moderate inflation. He accepts that this is a very hard pill for the Germans to swallow:

[T]he Bundesbank remains committed to an outmoded monetary doctrine that is deeply rooted in German history. Following World War I, Germany had a traumatic experience with inflation; consequently it recognizes only inflation as a threat to stability and ignores deflation, which is the real threat today.

The genuineness of this fear of any inflation is not in doubt. Nevertheless, if you think about it, it is a little bit strange. It is often argued that the Weimar inflation was one of the driving factors behind the rise of the Nazis, and that this contributes to the national psychological scarring. But surely this is the wrong historical lesson. As a few people have argued before, the period of the most dramatic growth in the Nazi share of the vote — from 2.6% in 1928 to 37.8% in 1932 — was long after the awful inflation, and coincided almost exactly with the Great Depression, during which the deflationary policies of Chancellor Brüning dramatically increased unemployment and lowered national income. If we must bring the Nazis into it, we should at least draw the right conclusions.

Thankfully, since Soros wrote his piece, events have moved quickly in Europe and it looks as though a combination of the ECB, the German courts, Spanish firmness and Angela Merkel's surprising new attitude have gained the upper hand over the president of the Bundesbank. Which is just as well, because as Kevin O'Rourke pointed out two years ago, looking at the massive unemployment, civic unrest and success of extremist parties in Europe today would not otherwise leave much room for optimism.