Commentary Type

Exorcising Ghosts of Inflation and Unification from German Economic Policy (transcript)

Adam S. Posen (PIIE)

Revised and Excerpted Lecture delivered at the American Academy in Berlin
Kurt Viermetz Distinguished Visitor Annual Lecture in Economics


I see something of a parallel today between German macroeconomic policymaking and German foreign policymaking in terms of the overhang of historical legacies. There is this sense in German foreign policy that it has taken a while for Germany to get back to being, a "normal" nation, to exhibit the kind of leadership and even self-interest that is concomitant with its role in Europe, with its democratic institutions, with its strengths. This, of course, has to do with its historical legacy. This is understandable, and in some ways, commendable, but it has also been something of a loss for the rest of the world, particularly for its European neighbors. Perhaps as a result of the eurocrisis, German self-constraint has, for some time, been of declining relevance. Yet, even in European discussion, there is something of a parallel set of self-imposed blinders in economic policymaking in Germany.

Not that there were any crimes committed by German economic policy since the war--not by any means. If anything, the success of the Deutsche Wirtschaftswunder was the recognized source of Germany's strength and pride during the postwar years. But similarly there were historical images, very searing memories, that have shaped the German economic debate today. These have foreclosed the consideration of certain policy options that would behoove the Germany government, the Bundesbank, and the European institutions they play a part in, to consider opening back up. There really is a ghost still haunting German economic policy; but it is nothing real.

I want to emphasize the existence of two historical ghosts, but they come from a common misconception.  What German economic policy fundamentally misses is that reality sticks, that the real side of the economy is much more persistent, much less fragile or susceptible to manipulation by policy than people think. This means that inflation fears are vastly exaggerated, and are just a ghost, for if the real side of the economy is sticky, for most cases, inflation is actually pretty sticky, too.

The second ghost that has been lurking around Germany since I first lived here, in 1992, is this idea that unification—however you want to call it—was this very costly, politically necessary but economically unfortunate situation. This to me is the second ghost, because reunification in pure economic terms went much better than some German people often give it credit for. This, again, has to do with how much you think behavior can be altered by policy, how sticky you think reality is.

The policy implication of my argument, and the place where my views may elicit controversy, is that the Euro-area is hurting now more than it has to because these two ghosts are informing and guiding German economic policy. It would be good for everyone to get past this.

Let me start with the point that economic reality is sticky. The first thing a macroeconomist is taught is the difference between what we call in economics the "nominal" and the "real." The "real" is what it sounds like: how productive you are, how many workers you have, how many resources you have; management practices are also real. Then there is the nominal, which is the price you put on something. It's exchange rates, the movement of prices, what we call inflation or deflation. You can have things that move the nominal but that should not affect the real, at least not persistently.

Interestingly, for many years, however, there has been this notion that if you get the nominal stuff right, you will induce certain positive behaviors by private actors and by elected officials on the real side. What does this mean? It means that there were people out there saying, "If we really enforce price stability, and we really make credible a monetary commitment, then those feckless southerners—the Greeks, the southern Italians, the Spanish—they will have no choice but to adapt." In fact, this is one popular way of looking at German postwar and especially post-reunification experience: Because we kept a hard monetary basis, we forced institutional changes, we forced structural reform, so we forced positive development. You can't hide.

This notion played a crucial role in the discussions leading up to the adoption of the euro—not uniquely in Germany, but throughout Europe. In economics-speak this was given the name of "The Endogeneity of the Optimum Currency Area," by Jeffrey Frankel and Andrew Rose. The basic notion was, whatever the faults of Greece, Italy, Spain, if you got them within striking distance of good behavior—which is what the Maastricht Criteria were about—and you put them in the monetary union, they would, over time, converge. They would, over time, have labor practices and pricing practices and behaviors that would increasingly be like those of Germany, the Netherlands, Austria—the core. This was as legitimate, ex ante hypothesis. It is one that a number of us disagreed with at the time, but it was a legitimate hypothesis, as well as an aspiration. It has since proven to be a pure aspiration.

In 1998 and 1999, I was a fellow at the Center for Financial Studies, in Frankfurt.  Heading into the launch of the euro, I gave a lecture there that was titled "Why EMU Is Irrelevant for the German Economy." The main thing I argued in that paper was that nothing you do on the monetary side will turn the Italians into Swedes. Full stop. Or, as I put it slightly more colorfully in a subsequent publication, you're not going to fish for herring in the Adriatic, and you're not going to plant olive trees in Stockholm, whatever the common EU agricultural policy. This isn't just a bit of cultural snootiness. This is the idea that it is extremely difficult for governments with the best of intentions—whether it's through active intervention, or whether it's through setting up this set of very hard criteria in monetary and budget constraints—to get people and institutions to change their behavior.

How do we know this? Let's look at the example of the United States. In the US, we had enormous divergence between the southern states—the states of the old Confederacy—and the northern states and eventually California. The famous economists Robert Barrow and Xavier Sala-i-Martin, among others, did some fascinating work on this, particularly during the run-up to the euro. And what they found was that, plus or minus a decade, it took a hundred years for income levels and commercial behaviors to converge between most of the south and the north in the US. That is a hundred years in a country with no language differences, no borders, high labor mobility, and with the absolute credibility of monetary union, because, frankly, if you try to secede, armies will invade you. (It's not merely an option; the US government is legally compelled to invade a seceding province).

And yet, these state economies didn't converge. Similarly, we look around to Germany's neighbor to the south Italy. We are all aware how there is this marvelous band of companies and businesses in northern Italy, which looks very much like Bavaria: very efficient, world-leading small firms, very sophisticated financing—and you go south of Rome and you're in a different world. Again, a hundred-plus years, and very little convergence.

Now, one way of interpreting this is to say, "Well, that is because you were too soft. Italians were too busy giving transfers to their South, or the Americans were too busy giving transfers to their South—buildings dams, or levies in New Orleans, and so on. That removed the pressure." You can try to argue that, but the scale of this stickiness is so big, and the scale of the transfer not that great by comparison, that it is unpersuasive to do so.

These are not institutions that lightly go away. Like James Robinson and Daron Acemoglu argue in Why Nations Fail, there are patterns of colonialism that go back to the 16th, 17th, 18th century that are still affecting national economies today. So, again: humility for policymakers. There is only so much you can change, whether you call it "structural reform," "austerity," "monetary discipline"; there is only so much you can accomplish.

What does this mean for inflation, ghost number one? The risks of inflation going up quickly, or in the long term, are smaller than are usually recognized in Germany. The issue is not that inflation is harmless; it certainly has its harms. The issue is, realistically, when you are facing choices, how much risk do you think there actually is of inflation occurring. I don't want to pretend that there is some kind of exact, scientific, precise answer, but there is more of a historical record to draw on than most people acknowledge. This historical record is not often taught to German economic elites.

If you look at German monetary history, there is there is this historical period of mass unemployment, hyperinflation, a host of human misery embodied in these numbers, all the terrible events of early 20th century German history. It repeats in much smaller form right after the war, in a burst of high inflation. But let's point out two other things: First, there is this long period where inflation doesn't arise or move around. This is a period in which you have strong unions in Germany, you have oil shocks; you have currency movements, you have risks from the Soviet Union, you have risks from the Soviet Union going away, and you even have unification—something I'll come back to later.

Inflation is actually quite sticky when you don't have huge political breakdowns. Focusing on this period of the 1920’s in Germany-- this horrible, horrible period—is economic solipsism instead of a good basis for current policymakers. To pretend that this source of the German hyperinflation is anything other than the political breakdown at the time is misleading; there is nothing economic that causes this situation on its own. You can say it was because the money supply grew too fast, or you can say it was because the central bank lost independence, but that is just telling you what happened technically. The cause was the breakdown of civil society, or at least of political decision-making, not the effect.

For comparison, too, the US is an inflation sinner, with huge inflation in the 1920s, and then the supposedly horrendous 1970s, which were pretty bad, but realistically not so terrible, and since then we have this long period of not much inflation. And that's with Jimmy Carter and Arthur Burns, labor unions, the declining dollar throughout almost the entire period. Not much action. Then we have the benighted UK, whose inflation during the 1970s was much more prolonged than in the US and in Germany, but even there it then stays down for thirty years.  It is very difficult to argue that inflation is just around the corner, and that the only defense against inflation being just around the corner is to be eternally vigilant.

What about the other ghost, unification? I will not presume to project upon German citizens how they actually feel about unification. There is plenty of public opinion polling data out there. But I do know from my interactions from various German government officials and various German citizens that there is a sense that it was extremely expensive and took longer to converge than it could have.

There seems to be a common story that goes something like the following: Chancellor Helmut Kohl told us there would be beautiful waving amber grain and green fields and rapid convergence of Eastern Germany to Western Germany. And while the Western Germans would have to pay a certain amount up front, it would be paid back a hundredfold. And Hans Tietmeyer at the Bundesbank said, "Look, we're buying Ostmarks at a very high exchange-rate to real marks, but if we don't, everyone who can is going to leave Eastern Germany and move west." And between these two—between the aspirational inspiration of Helmut Kohl and the cold-blooded realism of Hans Tietmeyer, which probably Helmut Kohl shared in private, a deal was made that basically priced Eastern Germany out of employment.

So Eastern Germany comes in to union, and the exchange rate dictates that if you were being paid, say, eight Ostmarks an hour, you were going to get six Marks per hour henceforth.  It turns out, however, that given the vast overestimation (by the CIA and others) of the productive capabilities of Eastern Germany, that you can only produce two Ostmarks per hour of value at your East German shampoo plant or Trabi factory, or whatever it may be. So you are, as William Jennings Bryant had it, "nailed to a cross of gold." There is no way you can get gainful employment unless you cut your wages massively. But it turns out there are labor agreements, and the East Germans are not allowed to cut their wages massively. So you end up with large unemployment in Eastern Germany. As a result, there was the Solidaritätssteuer, the solidarity tax, and for 20 years Western Germans have been shipping a big chunk of their income East.

A lot of that is factual. A lot of that makes sense. But what I worry about is the part that has become the ghost haunting current policy. It takes on a particular spin that says, "We, the West German policymakers, didn’t blow it by getting the exchange rate wrong. We blew it by being too generous to the East Germans. If we hadn't transferred so much money, if we didn't pay for all these Arbeitsprogramme, they would have had to adapt; and they would have sought employment faster. Therefore, today, when the Greeks, or the Portuguese, or the Spanish come to us and say, 'Hey, give us a break,' we are going to err on the side of going easy because we know it didn't work at home. We have to be tough to induce them to behave better."

This is an inaccurate view of history, although it does seem to shape today’s German economic policy. The mistake was getting the intra-German exchange rate wrong and forcing the bulk of the adjustment on eastern German workers.  That is what is being repeated in the Euro Area today.

Reality is sticky. Germans had as much real convergence as one possibly could have expected in 20 years. Not only was there political success, there was this economic success – and it came from treating all Germans as Germans.  This was largely the result of the generosity of the transfers to and the public investment within eastern Germany.  It was made harder by the too high exchange rate and the relatively high unemployment in eastern Germany.

To the euro area: Economists and economy policy makers remain prisoners of past ideas, all of us—This results in Germany what I will call the Haunted View of the Euro Area Crisis.  The Haunted View claims that the absence of European fiscal rules and institutions results in insufficient fiscal and wage discipline. The Irish put up their wages too fast, and they were the most productive. When the Spanish, and the Portuguese, and the Greeks put up their wages too fast, and spent too much, they were in deeper trouble still. This is the core of the problem on this view. So, you have to play tough. If you engage in brinksmanship from the Merkel government and from the European Central Bank, you will induce structural reforms in the periphery. Always do just enough to avert the crisis but never enough to let off the pressure. Structural reforms will in turn cause convergence and make everything better – and the debts will get repaid.

I believe there is a more realistic and productive view. What really happened is that there were a bunch of bad loans made. Some were made by Spanish and Irish banks; some were made by West LB, for example, and other northern European including German banks. These bad loans went bad. And when bad loans go bad, you have to decide who is going to pay for them. Almost all of it is being shifted onto the south (which includes Ireland, for this purpose), who were the borrowers.  Almost none of these losses are been borne by the lenders, in northern Europe.  This means recession until the borrowers can pay off the loans in hard euro currency. And a large part of why Europe has taken this course is that German-led discussions believe there is a high inflation risk from looser policy, and a gain to be had inducing structural reform – both of which are ghosts.  Therefore the economic problem of the euro area is the mistaken policy ideas.

If you believe that real economic things are not going to be affected very much by being tough, that these so-called structural reforms are not going to have much positive impact in the near term, that it will take years to get convergence, then you have to ask: Why is it worth it to impose things this way? Why can't you undertake a policy approach that does not put as much adjustment on the South? Why not have helpful transfers on the scale that took place within Germany?  Why not make up for the too high exchange rate with other policy measures?

Many colleagues in Europe say to me, "You Americans, you Brits—you massively underestimate how much support there is for this approach. Nobody is rioting in the streets in Ireland. There are a few protests in Spain, yes. But in reality they are voting for center-right governments that are pursuing austerity. They are gritting their teeth that they are going to get through it.”  I do not deny a word of that. I give can give you reasons why that has happened.

But that's not good enough. The fact that people are willing to settle for this, the fact that Europe means enough for them, or that as young unemployed people they don't have enough political clout to mess up the plan, does not mean that the plan is the right plan. Yes, there is political stability and thus majority acceptance of these policies in the south.  But that is just too low a bar for success.  Absent the ghosts of inflation and unification past, German economic policy might see that and aim higher for the euro area.

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