Posted by: Dirk | January 24, 2013

Austerity for all?

Jens Weidmann, president of the German Bundesbank, warns of currency wars, according to a FT article:

“Whether intended or not, one consequence could be the increased politicisation of the exchange rate,” he said, according to a text of his speech provided by the Bundesbank. “Until now the international monetary system got through the crisis without competitive devaluations and I hope very much it stays that way.”

This contrasts with what other members of the ECB say, for example vice president of the ECB Vítor Constâncio in this speech:

I will start by briefly recalling the key features of a good international monetary system and on this basis, I will try to define what are, in my view, the main weaknesses of the present system (or “non-system” as many describe it). This will allow me to dwell upon the possible evolution over the medium run of some of the main components of the international monetary system. When concluding, I will assess whether such an evolution may prove to be an adequate response to the challenges we are confronted with.

So, what Mr Weidmann describes as the international monetary system coming out of the crisis unharmed Mr Constâncio describes indirectly as an international monetary non-system. In a non-system, the adjustment burden of countries in balance of payments trouble (lack of foreign money for public or private sector) lies with the debtor. In an actual international monetary system, the burden is shouldered not by one single group of countries but by all countries through, well, an international monetary system. Bretton Woods was one: if US imports were too high, the exchange rate of the dollar was shifted down, as a result of which the Bundesbank took a loss on their dollar reserves. So, net exporter Germany paid a part of the burden of adjustment.

The core issue is that of (macroeconomic) imbalances. Inflation was low in most countries during the so-called moderation. However, economic imbalances built up. One global imbalance is that of (Asian export platform) China and the US, the other is among members of the euro zone where Germany is a surplus country and Spain and Greece are deficit countries. Now the big question is how to bring about adjustment.

Mr Weidmann and the Bundesbank are in favor of internal devaluation, which means that the deficit countries have to bring their price level down through government spending cuts and lower wages. The Economist shows how this has worked in the euro zone.

rebalancingSo, before the crisis Germany went into austerity mode. Suppressed wage growth and government spending led to a cut in nominal compensation per employee relative to the European average by 18%. Since demand elsewhere in the euro zone was high, this policy led to a re-orientation towards exports.

Now Mr Weidmann would like to see austerity policies in all deficit countries as the preferred tool of adjustment. However, this adjustment has caused mass unemployment in the European deficit countries and falling GDP with no light at the end of the tunnel so far. This, I believe, is the background of the conflict in the ECB. Some, like Mr Weidmann, are calling for internal devaluation policies, while others, like Mr Constâncio, are more open to other ways of economic adjustment.

By the way: there is a clear distributional effect of this choice. Adjustment by austerity leaves capital owners in surplus countries unharmed (at least it seems so to people who do not understand the paradox of thrift) while it hurts workers in the deficit countries. Adjustment by exchange rate changes leaves nominal wages untouched, but some capital owners in the surplus country lose because their investments in the deficit country are now worth less in domestic currency. However, while there is proof that the second avenue works the first – austerity – is without theory. There is no theory of expansionary austerity – it is all wishful thinking. And so it has turned out in reality, where those countries which undertook austerity reforms did not outgrow those the others.

When the euro system was introduced, many feared that some people in the ECB would think along national lines only, favoring policies that benefit only their country. It seems that this situation has now arrived.



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