Hard and Soft Options

Should we focus on what Angela Merkel says and ignore what she actually does? Or should we ignore what she says and focus on what she actually does? This is important, because the difference between what the German chancellor says and what she actually does is widening by the day.

We hear from the German government that it is ready to do whatever is necessary to save the euro, but actually it is doing as little as possible. Every time the Germans are asked to clarify what they mean when they talk about taking actions to save the euro, they spoof and bluster – but do very little.

This raises the question whether Germany actually wants to save the euro in its present form. And if it doesn’t, what does it want?

The working assumption of the European elite and Europhiles here in Ireland is that Germany will eventually subjugate its own interests for the greater good of European solidarity.

This means in reality that the Brussels mainstream view is that Germany will ultimately accept the responsibility for paying all or part of the debts of the rest of the eurozone. Such a prospect chills many millions of German people. The assumption of the europhiles is that Germany remains, in the words of the great chancellor Willy Brandt in the 1970s, “an economic giant but a political pygmy”.

What if Germany 40 years later in 2012, is a bit less of an economic giant and also a bit less of a political pygmy?

The europhile elite seem to be stuck in the 1970s or 1980s, when a divided Germany did not have either the “permission” or the “confidence” to stand up for itself. Germany has changed, but the European elite has not. The new Germany has moved on.

Ahead of today’s Greek election, it might be interesting to speculate that the German view of Europe could be quite different – and that Germany’s interests and those of Brussels are not indefinitely aligned.

Quite apart from why the Germans might not want go for the europhile solution, what if Germany has figured out that the solution – the mutualisation of eurozone debts – will not solve the currency’s problem?

Let’s try to see things from the German perspective. If I were German, I would suspect that the reason the periphery has huge debts is that they tried to have German lifestyles without the German work ethic. When you want something you can’t afford, you borrow to get it. This is the oldest trick in the book.

So, unless the Italians and Spanish and Irish are prepared to create products for sale at the same rate as the Germans do, we have to borrow to have the lifestyle the Germans have earned. We rent prosperity, rather than earn it.

How could you best see this?

Well, let’s look at Italy, because the relationship between Italy and Germany will become the crucial one with the eurozone. The choices made by these two countries will define the next ten years.

For far too long, Italy has been the butt of Anglocentric jokes and jibes, largely manufactured in the London press. But Italy is a proper economy with a proper industrial base, and a long heritage in manufacturing, design and finance.

However, since joining the euro, Italy has lost enormously vis-à-vis Germany.
Look at the chart. It shows how, until joining the euro, Italian industrial production and Germany industrial production more or less moved in tandem.

These two countries with their large industrial base were able to compete with each other, and the end products of this competition were proper jobs for millions of European citizens.

But since joining the euro, Italy’s industrial production has slumped, while Germany’s has soared. Why is this? It is because the Italians used to maintain competitiveness with Germany by regular devaluations of the lira, which obviously worked. Italian local costs would rise because the Italians tolerated higher inflation than the Germans. Every so often, to rebalance things, the Italians devalued the lira and got a boost to competitiveness, and this allowed Italian industry to compete.

This is not in any way unusual. Successful devaluations have been at the heart of the industrial policy of many countries. Italy, Sweden, Finland, Spain and Ireland are cases in point.

Without devaluations, Germany is simply too strong. The reason why Germany is so strong is that its productivity is so much higher.

Its cost of capital is low and the workforce is highly productive, generating more stuff per euro invested than anywhere else in Europe.

This gives the Germans a competitive edge. The more productive German worker should be “rewarded” by having a strong currency, stronger than anyone else. But in the eurozone, the German worker isn’t rewarded with a stronger currency that would mean he could go on cheaper holidays to Italy.

The surplus the German worker makes doesn’t go into his wages, it goes to German banks.
Then this gets recycled because the less productive Italian borrows the surplus German cash to maintain his lifestyle, which he is no longer earning.

Ultimately, Italy takes on more and more debt.

Now, if the EU forces Germany to accept the mutualisation of all debts, will this solve the underlying problem – which is the falling Italian productivity vis-à-vis the German worker?

Of course it won’t.

In fact, by backstopping the Italian’s debts with the German money, it gives the Italian the incentive to borrow more, not less. This leaves the German picking up the tab.
Therefore, in the context of punishment and reward, not only is the German not being rewarded for his hard work and superior productivity by being paid in a stronger currency, but he is actually being punished by being asked to dig deep to pay Italian debts.

This interpretation is how the world looks from the perspective of a German worker and voter and it explains why, in the latest You-Gov survey, 69 per cent of Germans want Greece to leave the euro zone.

It seems reasonable to suggest that what Germany wants is a stronger, tighter euro to protect it from the implications of continuous infusions of cash to the periphery. This is a core euro centred around Germany. Then the EU can let the Italians and others revert to devaluations, which will work.

This solution makes perfect sense if you are German. As for chancellor Merkel, this approach – moving towards a core hard euro and a periphery soft euro – could explain her behaviour of the last few weeks. Putting Germany first might leave Merkel isolated in Europe, but she would be very popular at home.

You decide what is the priority for an elected politician who is facing an election next year and who wants to get voted back into office.