Germany has historically pursued a policy of – what French economists have termed – “competitive disinflation”. This policy combines a commitment to low inflation and wage restraint with a reliance on export -led economic growth, limiting both the scope and the (perceived) need for (Keynesian) expansionary fiscal policies. With the creation of EMU, this economic model was extended from the “core” or German-led “deutschmark area” (DEM area) (Austria, Switzerland, Benelux) to the “peripherals” (Greece, Ireland, Portugal, Spain).
Upon entering EMU, the peripherals experienced a tangible drop in interest rates, contributing to a credit-fuelled economic expansion, while the DEM area economies, many of whom had entered EMU at overvalued exchange rates, faced relatively high interest rates and experienced an extended period of low growth. Combined with the constraints of the “Stability and Growth Pact”, this, not surprisingly, led the DEM economies to pursue a policy of competitive disinflation via wage restraint and export sector restructuring. Strong growth in the periphery and disinflation in the core led to widening current account deficits and debt accumulation in the periphery. This helped get us to where we are today.
Reassuring investors with regard to public sector solvency in the context of low growth, large fiscal deficits and a low level of international competitiveness is at present the peripherals’ most pressing challenge. With neither monetary nor exchange rate policy at their disposal, the peripherals will mainly have to rely on a fiscally-supported “internal devaluation” to generate higher economic growth in the short term. (Productivity-boosting structural reforms will help lift medium-term growth.) Such a policy will help address public sector solvency concerns. Greater demand from the surplus countries, whose public finances are on a much more solid footing, would at least somewhat help offset the effects of market-imposed fiscal tightening on growth in the deficit countries, for the greater the required disinflation, the greater the required fiscal adjustment. At some point, such a policy may obviously become self-defeating unless it is supported by long-term, low-cost official financing.
Germany does not face any immediate pressure to tighten fiscal policy - if the markets are to be believed. Putting off fiscal tightening would be unlikely to undermine German creditworthiness, which remains critical to backstopping EMU sovereign debt wobbles. However, Germany has committed itself to a, albeit modest, multi-year fiscal tightening. By institutional (constitutional) design, habit and, perhaps, cultural inclination, it will stick with a policy of competitive disinflation. In doing so, it will increase the adjustment burden of the peripherals.
Germany is visibly willing to act as a 'financial stabiliser', for good, self-interested reasons, ranging from the financial exposure of its banking sector over to a potential EMU sovereign default to preserving EMU for a variety of economic and political reasons. Germany’s policy DNA does not seem to allow it to act as a significant (discretionary) 'economic stabiliser' in terms of generating intra-EU demand, but it is willing to act – and, significantly, thus far allow the ECB to act – as a “financial stabiliser”.
Does this mean that a currency union based on “competitive disinflation” is inherently flawed? No. After all, the pre-1914 gold standard worked just fine – at least, as far as the major economies were concerned. It might, of course, be argued that the inter-war experience (incl. the Great Depression) offers a more relevant comparison. Two important lessons can be drawn from the experience of the 1920s and 30s (and/ or the post-WWII period): it is systemically destabilising for all major economies to pursue de-/dis-inflationary policies simultaneously; and domestic institutions differ in terms of their conduciveness to both sustaining “disinflation” and facilitating adjustment (e.g. fiscal rules, labour market institutions favouring wage moderation).
The implications for today’s situation are clear. First, an EMU that tilts towards a policy of “competitive disinflation” is viable as long as it can tap external sources of demand via, for instance, exchange rate depreciation. Second, the EMU as a whole is going to rely to a large extent on extra-EMU demand as an important source of growth. This is where the DEM area, accounting for more than 40% of eurozone GDP, with its greater openness, which incidentally is more geared towards extra-EU markets than in the peripherals, will have to act as a conduit for global demand to feed into higher EMU growth. Third, the peripherals will need to implement wide-ranging domestic reforms geared towards maintaining both fiscal sustainability and external competitiveness if the EMU’s internal economic, financial and political viability is to be assured. Whether this is both economically and politically feasible remains to be seen.
Recent proposals for how to avoid the next crisis have focused on the need for institutional reform at the EU level (e.g. EMF, fiscal union). However, even if some of these reforms do turn out to be politically achievable, it would be desirable to implement domestic reforms that allow the peripherals to sustain a policy of competitive disinflation over the medium term. Merely establishing a sanction mechanism at the EU level will prove insufficient as long as domestic institutions underpinning “competitive disinflation” have not been put in place.
EMU largely reflects German preferences – it is the German economic model writ-large. It is hence not surprising that the DEM area ended up outcompeting the peripherals inside EMU. With Germany unwilling to act as a significant economic stabilizer and only as a 'limited-liability' financial stabiliser , the peripheral countries will have no choice but to adjust (or to default). In the short term, emergency measures may do the trick; but if these policies are to be sustained over the medium term, they will need to be accompanied by domestic institutional reforms.