It may seem odd to invert the typical proposition by which it is suggested that the countries of the periphery, headed by Greece, should be sent packing from the common European market. Yet, remember this, the institutions of the European Union, including the common market and currency, allow Germany to exploit her latent comparative advantage in a much broader field than the home market alone. Ultimately, the question which needs to be asked is, "How do we overcome the gap between European core and periphery without handicapping German economic performance?"
The answer comes in both taking measures now to accommodate the massive hardship in the periphery in the short term, while demanding in the long term that steps be taken to transplant the sources of German comparative advantage in other member states.
Plus ça change
Black Wednesday is no bank holiday, however it should not be an event lost to history. On September 26, 1992 a group of speculators, most famously including George Soros, set about attacking the fundamentally unsustainability of the mechanism linking European currencies through an assault on the British pound sterling. A little more background here.
First, the collapse of the Bretton Woods system of fixed exchange rates pegged to the US Dollar, and by proxy gold, presented the threat of competitive devaluation for intra-European trade. The experience of the 1930s, in which countries attempted to decrease the cost of their products in foreign markets through currency devaluations, haunted the policymakers of that time. Thus you get an attempt to restore a system of fixed exchange for intra-European trade after the loss of a global system provided as a public good by the US government.
Second, the snake in a tunnel makes it show. This was an attempt to peg several European currencies to a ±4.5% variation band against the dollar, i.e. the tunnel, and ±2.25% band against one another, i.e. the snake. The first attempt ultimately collapse in the early 1970s. So, round two was a bit more flexible. In the late 1970s, another go was made with the establishment of the Exchange Rate Mechanism (ERM I) which reinstated the snake while removing the tunnel. In practice, German monetary orthodoxy meant that this system pegged other European currencies to the Deutschmark. Thus, we arrive at the installation of the gnomes in Frankfurt as the managers of the European monetary system. I know that other here can point out the details of this all, but I hope to keep this brief and accessible.
This is the system which persists until the early 1990s. Most currencies float within the ±2.5% band, while the Italian Lira is allowed to hold to a ±6% band. Britain stands outside the system until 1990, at which point it makes the decision to enter the system. A short two years later, the UK is forced out, with the Italians on their heels, by the speculative attack which culminated in Black Wednesday.
I can't give a full rendering of what happened that day here, but suffice it to say that attempts stay in the snake with the Germans adhering to monetary orthodoxy led to inflation as banks hiked interest rates in order to draw buyers for the Pound. Moreover, a strong currency put exports under pressure. The parallels to the present crisis should be fairly clear. For many other EU countries, attempts to adhere to monetary orthodoxy are broken by the social consequences that they create. Black Wednesday ultimately led European leaders to double down with the creation of the Euro hoping to create a system rigid enough to persist when under attack. A single currency fit the bill, because it creates a high cost for member countries to opt for exit.
In the present crisis, the inability of the countries of the periphery to devalue means that the underlying issue of the strength of German comparative advantage grows relative to the periphery. Greece, Portugal, and Spain suffer because the inability to devalue leaves them little ability to close the trade gap. (At least in the short term, the longer term case is more complex.) Simultaneously, the pricing of debt instruments in Euros precludes the resort to debt elimination through inflation.
In the short term, something has to be done to unleash the peripheral economies from the chains which the gnomes of Frankfurt have bound them by. A "reset" of the rate of exchange between member states is needed. As the history here has shown, this is by my count is the third time that the deficiency of monetary integration without compensating measures to integrate the economic institutions which underlie comparative advantage in the member states. This brings us back to Germany.
How is it that Germans have squared monetary orthodoxy with the social consequences this policy creates?
Austerity as Luxury
Repeat after me please. German monetary orthodoxy is a luxury underwritten by the ability of private economic institutions to dissipate its social consequences. Ok. What the hell does that mean? This.
We've seen that monetary orthodoxy forecloses the road to competitive devaluation and stimulus through a program of reflation. As a result, the social consequences of this hit hard, leading to unemployment, drops in tax revenue, and a whole other mess of other things.
The first point that I would like to make about the German economy, is that there is something to the argument made by the Austerians resentment in the periphery seeks to punish success. Germans are not racially superior, rather they are the beneficiaries of national economic institutions which allow them to compete more effectively in down markets and mitigate the social consequences of monetary orthodoxy.
The analysis that I'm going to offer here is rooted in the Varieties of Capitalism paradigm. It all comes down to innovation and institutions. German comparative advantage is rooted in incremental innovation, which means that rather than constantly inventing new types of products, the focus is on figuring out how to improve existing products and manufacture them more effectively. The German model is typically referred to as a coordinated market economy. (CME) I'll get to more on that in a second. Rather than falling prey to a destructive notion of creative destruction, CMEs rely upon a drive to creative accumulation. Incremental improvement means investing in capital equipment/worker skills and cooperating with other producers in the field to lower the cost of inputs, increase the market for outputs, and building the stock of knowledge.
In practice, this is manifested in the role of associations in the German economy. The system of collective skills training is under attack, but the truth of the matter is this system creates a broader pool of skilled labor which receives a lower wage premium over unskilled workers because the cost of training is borne by the firm, or rather the firms that form a sectoral association. This system is most highly developed in the metalworking sector, but pops up elsewhere. Collective training regimes mean that a firm can invest in employee training in general skills without worrying that other firms will simply offer higher wages to poach trained employees. The individual firm is able to lower the cost of training through cooperation within the association. At the same time, the system allows workers to gain skills at no direct cost to themselves. In terms of knowledge, collective R&D increases the level of general knowledge in an industrial sector, allowing individual firms to adapt this to their production. This all is the source of German comparative advantage.
The flip-side is that liberal market economies (LMEs) like Britain forgo this process of creative accumulation in exchange for limiting the ability of established players to get in the way of creative destruction. Sure the Germans may make a better mouse trap, the argument goes, but the British will be able to create genetically engineered viruses placed in bait that will eliminate the need to catch mice one at a time by killing them all in one fell swoop. Of course this means that those British workers who manufacture mouse traps will be made redundant. Yes, that poor bastard may find that he now makes a little over 6 quid an hour instead of the fat ten he used to pull down, but hey progress gentlemen.
LMEs embrace creative destruction, in all socially devastating glory. CMEs dissipate it through a reliance on incremental innovation with the institutions to match. LMEs ride the product cycle, creating the appearance of prosperity for all as new products, only to crash as the product market matures, because they don't do incremental innovation. Spain, Greece, Portugal, all exist in a sort of categorical purgatory because the economic institutions that they have fit neither mode well meaning that they can't compete against either. This is the long term issue for those economies. They have to embrace one model or the other.
The attraction of the German model is that focus on incremental innovation, flattening the impact of the product cycle, is that it mitigates the social consequences of economic downturns, allowing the luxury of monetary orthodoxy. CME institutions create consistent comparative advantage, on the one hand, and allow the private sector to mitigate the social impact of downturns on the other. If you've invested money in training a guy how to do complex welding, you want to figure a way to keep him on the job. If you let him go in a downturn, you have to train someone new to do the same job when the economy perks up. So you try short time work to spread out a limited number of worker hours over a broader number of employees, rather than having the same amount of work done by the number of workers it creates full time employment for. Workers, and the state, benefit, because the cost of adjustment is shared with the firm rather than being placed on the state through the dole, or the worker where no safety net exists.
In the long term, the countries of the periphery must converge on one of these two models. The German, or CME, model relies on a strong society, or rather sectoral associations, placing the management of the consequences if downturns in the private sector. The Anglo-Saxon, or LME, model relies upon a strong, either to feed them when they are hungry, or beat them when they are mad. I prefer the German model, because it offers the prospect of equity without reliance upon the state. The problem with the state as economic manager is that those at the top may opt for the stick as much as the carrot.
What is to be done?
We've identified both a short term and long term issue with the maintenance of monetary orthodoxy while there is a trade gap between European core and periphery. We can do something about this.
First, there has to be a "reset" to bring the value of the currency into line with change in relative national price levels.
Remember, before the Euro was introduced, the rate of exchange between all users was set.
As a reminder:
A "reset" would essentially serve the same purpose as the many earlier attempts to square the desire to create exchange rate certainty with the reality that national price levels fluctuate too much for this to be stable in the long term. Long term convergence requires recognition of short term divergence in order to maintain the European project.
Many of the stories surrounding a return to the drachma focus on the hassle of exchanging bills and coins, but the truth of the matter is that the portion of the money supply which has a physical existence is minimal. I know the graphic is ancient, but the point remains, currency is a small part of the total money supply. What I'm proposing is a bank holiday during which the rate of exchange given in the prior graphic is "reset" to reflect contemporary reality.
For example, consider this example. A product costs one euro prior to the reset. During the bank holiday, the national rates of exchange are change, first by conversion to the old national currency, then by reconversion at the new rate to euros. In Germany, that euro is changed back into DM, yielding 1.96 DM. The rate of exchange is reset so that the DM appreciates to 1.5 DM per euro. The DM amount is converted back to 1.3 euro. Meanwhile in Spain, a similar process is unfolding. Our euro is converted to 166.4 peseta. The rate of exchange is reset to 200 peseta per euro. The peseta amount is converted back to 0.83 euro. Currency in circulation is unaffected, but bank accounts, debt instruments, and prices in the economy are.
So now lets talk impact. The same 10 euro/hr wage in Germany and Spain has now been changed. In Germany, the new wage rate is 13 euro/hr, while in Spain it is 8.3 euro/hr. This has two effects. First, the increase in German buying power means that workers now have an incentive to increase consumption. Second, the decrease in Spanish wages means that cost dependent work moves to Spain. Operations that had been shed to Turkey or North Africa return to Spain, supplying the European market with cheap exports of consumer goods.
Now bank accounts and debt. First, if we adhere to a rule of country of residence, this means that the flow of cash from accounts in the periphery to the core is pointless. If Spaniards moving their money to a German account have their balance converted to peseta, not DM, it doesn't matter where their money is the effect is the same. Now debt. If debt is converted in the country in which the underlying asset is located, you essentially create a haircut for holders of peripheral debt in the core. One euro of debt comes 0.83 euro of debt through the reset.
The point of having a reset is to achieve the ends of leaving the Euro within the system of the Euro so that currency uncertainty is limited It also encourages labor and capital to flow accordingly. The German economy has an underlying comparative advantage that still means that there will be demand for foreign workers, while at the margin work outsourced to extra-EU countries is repatriated to the EU periphery.
This is a short term measure to avoid total collapse, while preparing for long term change. We talked about skilled Spanish and Portuguese workers migrating to Germany. This helps to take workers out of the pool of unemployed in one country while filling demand in another. National unemployment programs in the periphery could act as employment agencies for skilled workers, charging an agency fee per hour above and beyond the wage rate. Educating those workers cost money, and creating an agency fee allow the peripheral states to pay of the debt created training them.You expedite the process of immigration, but you force the recruiting country to pick up the tab for training.
In the long term, the answer lies in either replicating the economic institutions that underlie German comparative advantage, or compelling member states that adopt the LME model to have the state resources to allow public management of the ups and downs created by it. It's been the inability to replicate German institutions, and he drift towards the LME model which has really screwed Portugal and Spain over. An EU program to aid in the creation of the economic institutions that facilitate incremental innovation, producing consistent economic performance with a minimum of social hardship would act to converge the periphery to the model at the core. This would lessen the need for future "resets."
If we really expect a common European market to persist, complete with the monetary orthodoxy desired by the countries at the core, then the social consequences of this policy must be mitigated. Unspoken in the current debate is the ability of the German economy to accomplish this through the private sector, which only serves to confuse the underlying issues. Recognition of this aspect of the discussion around monetary orthodoxy would help the German public realize the disadvantage the Greeks and others find themselves at, while forcing the peripheral countries to address their underlying inability to compete. And to manage the consequences downturns privately so as to avoid public deficits.