Brinksmanship and Grexit

Henry Farrell re-ups his view of the eurozone as being a game of brinksmanship between Germany and Greece. I objected to this characterization back in February, and I still don't think it's the best. Take this:

If there weren’t any possible resolution, there wouldn’t be any incentive to engage in crisis bargaining. What we’re seeing suggests that the players on both sides think that there is a real chance of catastrophe, but also a real chance of a deal.

Whether or not there is a possible resolution is most likely private information. (Or, more accurately, neither side knows the truth.) Let's look at this from Germany's perspective. Who are they negotiating with? For all intents and purposes Greece does not have a government that is capable of negotiating. Any future Greek government also has an inability to make a credible commitment to uphold any negotiated settlement in the future, which is why Germany had previously asked for all political parties in Greece -- whether in the government or not -- to approve of the previous bailout program. It is not clear right now who "Greece" is, much less what it is willing to accept.

Nor is it necessarily clear (to me) that Germany believes that there is a real chance of catastrophe for them if Greece exits. Perhaps there is, but it's probably not an economic catastrophe. At this point it might be cheaper to shore up the banks than to keep funding Greece indefinitely. Remember that Greece's creditors have already taken very large haircuts. Remember that European banks have had years to prepare for this, and European regulators have (presumably) been forcing them to do so. Euro governments, the ECB, and the EFSF would lose something on the order of €200bn from a full Greek default, of which €75bn would come from Germany. This is not nothing -- about 3% of Germany's GDP -- but it isn't enough to sink Germany either.

More likely Germany is worried about the political ramifications of a break-up of the eurozone, but in that case they should be interested in ensuring that they are not blamed when that happens. This implies that they will engage in negotiations right up until the end, and perhaps even after it, to demonstrate that they made a good faith effort to keep the monetary union intact even if they believe that there is no possible resolution that actually keeps the monetary union intact.

Farrell:

At a guess, Greece has considerably more bargaining leverage than it might seem to at first. One useful index of bargaining strength is relative levels of sensitivity to breakdown/catastrophe/failure to reach a deal. It’s plausible that Greece is relatively indifferent to breakdown at this point – years of grinding austerity inside EMU seem barely preferable to the costs of exiting the euro. In contrast, Germany could see the collapse of the euro (and consequent very serious economic costs) if a Greek exit leads to the collapse of confidence in Spanish, Irish, and worst of all, Italian banks. If I were to lay a bet on which side is likely to fold first, I’d be putting my money on the Germans.

Again, it's not clear who "Greece" is or what their bargaining position is. As Daniel Davies says in comments on Farrell's post, there is no reason to think that Greece is indifferent between staying in or getting out. Something like 80% of Greeks say that they want to stay in. Even Tsipras has stated no intention to exit. The best case scenario of leaving -- probably Argentina -- is not very good, and I wouldn't be optimistic about the best case scenario obtaining in this case. So how much leverage does that really give Greek leadership? If their citizens want to stay in, and the costs of leaving are extreme, then Germany can demand quite a lot.

Nor is it clear that a Greek exit would lead to a collapse in Spain, much less Italy, or that such a thing could be avoided even if Greece stays in. The fundamentals are crap either way. It's not clear that a collapse in these countries would be devastating for Germany. They've maintained economic growth thus far, and capital flight from the GIPSIs would likely move into Germany, giving them further fiscal flexibility to deal with their banks and macroeconomy.

Right now the political dynamic in Europe is about who gets the blame for a Greek exit. If blame cannot be assigned in a politically satisfying way then they will continue to muddle through. However the greater the costs associated with keeping Greece in, the more likely the blame will shift away from Germany and the more likely that Germany will refuse to pay on any terms that are acceptable to Greek leaders.

Edward Hugh writes of the choices:

Right now there are two, and only two, options on the table: help Greece with an orderly exit from the Euro (and crystallise the losses in Berlin, Washington, etc), or print money at the ECB to send a monthly paycheck to all those Greek unemployed. This latter suggestion may seem ridiculous (then go for the former), but so is talk of printing to fuel inflation in Germany (go tell that old wives tale to the marines). If Greece isn’t allowed to devalue, then some device must be found to subsidise Greek labour costs and encourage inbound investment – and remember, given the reputational damage inflicted on the country this is going to be hard, very hard, work.

The second of those is not palatable. It would wreck what remains of the political integrity of the Euro project, which has already been corrupted by the less-than-democratic approach to the bailout. Political integrity is not about keeping Greece in on whatever terms... moral hazard is a real risk and the original institutions designed to combat moral hazard (eg Stability and Growth Pact) have been obliterated as has the independence of the ECB. In other words, it's not clear what political integrity Germany would really be fighting for. The entire EU social contract has to be re-written anyway, at least implicitly.

Given that, Germany may wish to re-write it on more stable terms.

There is a very real chance that over a medium term time horizon Germany would be better off with Greece out of the eurozone. If that's the case then this isn't a brinksmanship game.

EU Fiscal Union Is Highly Unlikely, con

Edward Hugh reports that the Germans are laying down the gauntlet on the Greeks:

Only yesterday, German Finance Minsister Wolfgang Schaeuble informed members of the parliamentary budget committee that Greece is now perched on a "knife's edge". This follows hints from other leading German politicians (including Angela Merkel herself) that a Greek euro exit is no longer the unthinkable taboo topic which it had been to date.  

As if all of this wasn't clear enough, the Dutch Prime Minister Mark Rutte suggested yesterday in an FT article that expulsion from the Euro Area should be available as a disciplinary measure of last resort.

For detail on why things are coming to head now, see the link. The gist is that the "voluntary haircut" component of the most recent Greek bailout isn't working the way it was intended, and neither Greece nor Germany (and other Euro creditors) are especially interested in yielding to the other at this juncture. They may continue to muddle through as they have previously, but hopes that the recent bailout-plus-haircut approach is going to be sufficient have been weakened.

Wanna Bet?

“Politics cannot and will not simply follow the markets,” [Merkel] told German public television on Sunday in her first interview after returning from holiday a week ago. “The markets want to force us into doing certain things - and that we won’t do.”

That is in reference to eurobonds, which Merkel (along with 75% of German citizens) does not support. She understandably does not want to share Germany's credit rating with heavily indebted countries. But markets have been making Germany make political decisions for several years now, and that will continue. Merkel never wanted the EFSF. Merkel never wanted the compromising of the ECB. Merkel never wanted Germany to be on the hook for the whole eurozone. But markets have forced her hand at every juncture, and is still.

The current EU policy of muddling through is precisely about "following the markets". Intervention is only done when markets force the hands of EU leaders. This makes perfect sense in game theory where every intervention is unpopular with at least one set of voters. In such a model markets would not only influence politics, politics would be very difficult without them. The fact that markets can alter the equilibrium makes it a very important political actor. Anti-neoliberals may view this as a tragedy ("markets undermining democracy"), but recall that the problem has arguably gotten this dire because of too little bond market discipline during the 2000s, not too much.

On Michael Lewis on Germany

Michael Lewis continues his Euro-crisis tour, this time popping up in Germany. Like previous installments in Iceland and Ireland, Lewis has found a curious (and probably grossly exaggerated) cultural trait that -- whaddyaknow? -- has surprising relevance for the crisis. In Iceland it was fear of underground elves; in Ireland it was fairies. In Germany? The duality of scheisse. (I'll let those of you that have forgotten your foreign curse words from middle school look it up.) Also Hitler.

As always with Lewis it's a very interesting piece. Also as always, I'm not sure he gets to the true center of his subject. Actually, that's not true. He does, but usually very briefly and with a key component left out. He mentions Germany's willingness to accept the eurozone as a sort of penance for the Holocaust, but not that it was related to European reticence over reunification. He mentions that other countries used Germany's credit rating to borrow more than they should, but chalks up Germany's frugality to some inherent character trait, perhaps related to long memories of the 1920s hyperinflation. Humorously, he allows his translator/chauffeur to blow apart his thesis midway through -- "How do you generalize about 80 million people? You can say they are all the same, but why would they be this way? -- but then continues on with it anyway.

But a few things come out from the article anyway. First is the unsophistication of German bankers, at least relative to their American counterparts. This, too, is a common thread running through Lewis' discussions of Iceland and Ireland. Second is the fact that German bankers took AAA ratings at face value. Of course so did lots of other investors, including American bankers, which undercuts his "German unsophistication" argument, but whatever. Third is the politics, which he barely touches on but which is obviously the most important aspect of the creation of the crisis and the responses to it.

In Lewis' story, Germans are austere and hard-working while Greeks are lavish and lazy. Of course this view is common, but it is also highly questionable. For example, did you know that on average Greeks work later in life than Germans, French, or Italians? Or that a substantial amount of Greek's debt was accumulated by borrowing from France to buy French weapons to deter Turkey? Greece has a major problem with tax collection and productivity, but many of these concerns are caused by or exacerbated by the German dominance of the ECB and Euro economy. Lewis writes that Germany has become Europe's daddy, but don't the parents get some blame when the children misbehave?

Lewis also presents contradictory views of the German political environment. On the one hand, Germans are portrayed as docile and demure, eager to demonstrate their commitment to Europe and the international community, willing to sacrifice quite a lot to those ends, shamed by displays of nationalism, and almost masochistic in the "memorialization" of their own ugly past. On the other hand, they are PISSED OFF at the rest of Europe and aren't going to take any more of this scheisse from the rest of the continent. Well, which is it?

Lewis' essay is fun reading, but I'm not really sure how much can be learned from it. As always there is a bit of financial mechanics for the uninitiated, and some interesting characters that tell interesting stories -- look for the one about Commerzbank, Deutsche Bank, and the urinals in the men's bathroom -- but give no clear sense of why things happened, much less what's going to happen. Lewis is interested in narrative not analysis, and his sense of politics has always been immature. He's much more interested in culture, and especially the culture of Wall Street and the ways in which it differs from other cultures. Which is all fine and good, I guess, but it limits the importance of what Lewis can say.

PS: I now see that Kevin Drum and Felix Salmon had a similar reaction, except more revolted.

Schelling and the Euro

Ryan Avent:

It's really a mess. But one thing should be clear: it's in the interest of all the negotiating parties to be as apocalyptic in their warnings as possible. If the Greeks don't draw a hard line, they get a raw deal, and the same goes for the European Union, and the constituent governments, and the ECB, and the IMF. Ultimately, everyone expects that the negotiators will back down and an agreement will be reached, but in the mean time it's worth it to negotiate like a madman. The big downsides to this are, first, that it gives everyone reading newspapers a fright. And second, when so many parties are playing this brinkmanship game, there's always a risk that something goes awry and a deal isn't reached. Frankly, Europe isn't giving markets a lot of reason to be confident that the process of handling Greek insolvency is actually, underneath all the posturing, under control.

The logic of brinksmanship was put famously (and well) by Thomas Schelling. He described nuclear deterrence as two countries, chained together, dancing closer and closer to the edge a cliff, over which they'd both tumble if one of them slipped. And I've written similar things along those lines over the past year or so. At this point, however, I wonder how well the metaphor fits. The Greek political economy does not remotely resemble a unitary actor, at this point. Tens of thousands rioting in the streets, government turnover and possible recall, etc. It looks like Greece is racing full-steam towards the edge, attached to the rest of the EMU by a fairly thin cord, while Germany and France stand well back from the edge, holding scissors and debating whether and when to cut loose.

It's unclear whether this puts "Greece" at any bargaining advantage, because it's unclear what "Greece" represents and therefore what it desires. More accurately, there is an internal battle in Greece over the value of Euro membership. Germany and France can alter the terms of that membership on the margins, mostly by buying time, but they can't change the game. Even if some elites wanted to, Germany and France are limited by their domestic polities as well.

We need a new metaphor.

The Politics of Stealth Bailouts and Plausible Deniability in the Eurozone

My post yesterday on how the German banking sector can likely withstand a restructuring of Greek debt touched on, but did not dwell on, another important aspect of the Euro crisis: it's not just the banks in the Eurocore that own debt in the periphery, but also the governments. I wrote "The taxpayers have already loaned Greece a lot of money, either directly or via the ECB" and quoted a Der Spiegel report that said:

Taxpayers might need to step in, as might the savings banks that are owned by municipalities.

In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.

This latter point is the subject of this Martin Wolf column that has made the rounds of the blogosphere (Salmon, McArdle, Krugman) and yielded the above graphs. Wolf's column is provocative -- he begins with "The eurozone, as designed, has failed." -- but makes a very important point about the centrality of the European banking system to the broader regional economy:

The role of banks is central. Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. In the eurozone, for example, currency in circulation is just 9 per cent of broad money (M3). If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds. A euro in a Greek bank is today no longer the same as a euro in a German bank. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system. This is, of course, what the federal government has prevented in the US.

The ECB doesn't technically have legal authority as a lender of last resort (although it's taken on part of that function since 2007), so domestic central banks as well as the US Federal Reserve have had to fill that role. The upshot? Central banks in the Eurocore, such as the German Bundesbank, are now heavily exposed to debt from the periphery. At current rates of lending they're likely to run out of cash by 2013, and unlike the US Fed, they can't just print more. This is becoming a slow-moving liquidity crisis, in other words, and as London Banker wrote a few days ago, liquidity crises (such as occurred in the Fall of 2008) are really nasty. As Wolf notes, this is serious business:

Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door.

In a sense this is already a fiscal transfer, since debtor countries are spending the funds on financing the state, and the creditor central banks don't have a printing press. So why, given that a fiscal transfer was needed, was it done in a way that risks the solvency and credibility of Eurocore central banks? Because they are unelected. Such a large transfer plan on top of the EFSF is unlikely to have been approved by voters in the Eurocore, as my post from yesterday indicates. And as Hans-Warner Sinn notes (via Henry Farrell's Twitter), the size of these hidden transfers "dwarfs the parliament-approved bailouts extended to Greece, Ireland and Portugal." It's easy to see why European leaders would opt for a bailout mechanism that was less transparent, and that involved non-elected actors pulling the strings: it allows bailout financing to continue, but with plausible deniability.

Sinn draws an analogy between the situation in the Europeriphery and Britain in 1992, when Soros sank the pound by selling it off. Eventually, the British Treasury ran out of marks and francs to exchange for pounds, and was forced to devalue. Soon, writes Sinn, there won't be enough funds in Bundesbank to cover the borrowing in the periphery. At that point, the Euro will collapse like the pound. If Sinn is right, then the Euro has two years. I've been saying for awhile now that 2013 was key to the Euro's future. 2013 is officially when haircuts begin, and when new bailout lending ends. It's also when the "stealth bailout", through the central banking system in the EU, can no longer sustain itself. At that point, either the peripheral economies have righted the ship by balancing the budget and/or regaining access to private credit markets, or they exit the Euro.

So right now it's a waiting game. The Eurocore doesn't want a restructuring, which would cost taxpayers (and banks) billions, if it can avoid it. The Europeriphery doesn't want the economic collapse that would accompany a Euro-exit. But both of them want the other to pick up more of the tab. But there's not much more the periphery can pick up, with unemployment above 11% in Portugal, 14% in each of Greece and Ireland, and 20% in Spain. And there's not much more the core can pick up without risky the solvency of their domestic central banks. More direct fiscal funding mechanisms look to be politically impossible. Maybe one of those things changes by 2013, but I wouldn't bet on it.

Euro Developments

First, the ECB is quarreling with Berlin:

The cold war between Berlin and Frankfurt reached a new high last week. Should Germany implement its plans, the ECB would have to cut off funding for Greece, the monetary watchdogs warned. The consequences for Europe's banks and the Greek economy would be devastating.

The mere suggestion of what the Financial Times called the " central bank equivalent of nuclear deterrence" was enough to prompt German Finance Minister Wolfgang Schäuble to withdraw the German proposal immediately. A debt restructuring, Schäuble admitted sheepishly, could lead to a repeat of the events triggered by the bankruptcy of Lehman Brothers in September 2008.

In addition to revealing how serious the euro's problems are, the slugfest proves how much of its reputation the Frankfurt-based ECB has lost in the euro zone's strongest economy.

In the past, the central bank was seen as the undisputed economic authority in Germany. Anyone who opposed the monetary policy experts was quickly marginalized. Today, however, the central bank must threaten with the most drastic of measures just to force the German government to toe the line. A majority of German economic politicians and economists see the ECB's crisis strategy as unrealistic and contradictory.

But would a Greek restructuring really be so devastating for Germany? It would have some costs, but at this point these would be manageable:

A debt reduction -- known as a "haircut" -- of as much as 50 percent would be an expensive proposition for Greece's creditors. With around €330 billion ($467 billion) in loans, that would mean cutting as much as €165 billion. Most of Greece's debt is with foreign creditors, and so foreign banks and governments would have to take massive hits over the loans Athens is unable to repay in full.

But what would this mean in reality for Germany? ...

The answer to all of these questions is reassuring -- at least at first glance. The consequences of a debt write-off against the government in Athens would be manageable for Germany. At the moment, some €25 billion in Greek debt is held by Germany's commercial banks and the so-called "bad banks" set up to take on toxic assets. This debt takes the form of either Greek sovereign bonds in their portfolios or loans made to the Greek government. ...

With a 50-percent haircut, the two bad [government-backed] banks would lose around €4.4 billion in total. Taxpayers would end up indirectly footing the bill. ...

Of mild comfort is the fact that the state would probably not have to come to the rescue of any private institutions. Commerzbank, Deutsche Bank and the DZ Bank, which acts as the central bank for Germany's roughly 1,200 partly state-owned co-operative banks, are (once again) in a position to be able to cope with possible shortfalls by themselves.

But that's just the banks. The taxpayers have already loaned Greece a lot of money, either directly or via the ECB:

But the situation looks different for the German government and the federal states. At the very least, the large exposure of KfW and the bad banks of Hypo Real Estate and WestLB could end up being expensive. Taxpayers might need to step in, as might the savings banks that are owned by municipalities.

In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.

However the Irish and Portuguese banking sectors are still exposed to Greece, and are much weaker than Germany's banking sector. Still, the fact that the Germany financial system has largely healed since 2008, and has already taken many steps to lessen their exposure to Greece, gives Germany a lot of negotiating leverage in the EU. And, as EU Monetary Affairs Commissioner Ollie Rehn says, political will for continued aid is running low in northern Europe.

In Brussels, we Finns are referred to as "English-speaking Germans," because we pursue the same economic policy principles: stability, sustainable growth and fiscal responsibility. The Germans aren't the only ones who are concerned. There is a certain aid fatigue in all of northern Europe. And we are experiencing a certain reform fatigue in southern Europe. As monetary commissioner, I feel this schizophrenia every day. We must try to build a bridge between these two camps.

Put it all together? Time is running out for Greece.

Germany's EU Policy Is Not Charity

The other day I pointed out this Economist article, which wins this year's "Most Rhetorical Subtitle Ever" contest: "Is Germany bailing out euro-area countries to save its own banks?" Yes. Yes it is. That fact alters the EU political economy quite a bit. But one bit I didn't mention the other, and the article does a good job of highlighting, is just how important this dynamic is:

Calculations by the Bank of England on losses that would arise from haircuts to Greek, Irish, Portuguese and Spanish debt suggests that a 50% haircut would wipe out 70% of the equity in Greek banks, almost half of it in Portuguese and Spanish banks and about 10% of the equity in German and French banks.

In other words, the periphery is most exposed to the periphery. But that's a lot of exposure from German and French banks as well. Enough for those governments to figure out how to lessen their banks' exposure. Right now, the solution appears to be: provide funding until 2013 -- thus giving the banks adequate time to recapitalize -- then pull the plug. Or, as Tyler Cowen puts it:

For instance, taking this approach, the Merkel government in Germany might acknowledge the status quo isn’t working and speedily recapitalize the German banking system, while letting Ireland, Portugal and others off the hook for some of the money. It’s easy to see why this policy isn’t popular in Germany, and indeed, for years German politicians promised to their voters that such an outcome would never happen.

Right, but the question isn't "Will there be a bailout?" It's "Who's going to get it?"

The EU Crisis In One Picture

The Economist has it on their cool "Daily Chart" blog. The full article is sub-titled "Is Germany bailing out euro-area countries to save its own banks?" The answer, of course, is "yes". This is why Germany is insisting on austerity throughout the union. This is why the ECB is intervening in bond markets. This is why the EFSF is providing loans until 2013, but not after. This is why Ireland, Greece, and Portugal are so unhappy. The entire EU response to the debt crisis is to construct policies that protect German -- and to a lesser extent French -- banks.

We've written about this before. When folks like Krugman are bewildered that the ECB's monetary policies are "one size fits one", they're absolutely right. But that's because this policy is about distribution, and about appeasing powerful domestic interests. Those are the banks.

Realism or Institutionalism? Wrong Question

So Henry Farrell got to this Stephen Walt piece before I could, and I agree with everything Farrell says. Especially this:

If (as Walt seems sometimes to be suggesting in this post), realism is nothing more than the claim that national interests predominate in explaining international outcomes, then realism is theoretically very nearly vacuous. Moreover, the candidate ‘rival paradigm’ explanations are, under this broad definition, actually realist too. They have quite as much to say about state interests, and perhaps more to say about power relations than Walt does. If Walt has an actual realist explanation of what is driving European states apart – one that would presumably be rooted in the security dilemma or some other systemic phenomenon – it would be very nice to know what it is. He certainly doesn’t tell us about it in the post as it stands.

Indeed, an institutionalism without interests makes no sense. Why else create institutions?

But Farrell missed one strand I'd like to emphasize. If Walt really wants to use the EU as a test of rival paradigms, he's going to lose. In fact, he's already lost. Realists (generally) claim that institutions are merely extensions of state power, and thus do not constrain the behavior of (powerful) states in any significant way.* And yet it's clear that membership in the EU has caused states to behave differently than they otherwise would. Rather than devalue and/or default, Greece and Ireland are engaged in austerity. Rather than let them devalue and/or default, Germany and France are bailing them out in the short-run, and are considering a range of Euro-wide fiscal policies that would bring policy convergence on a number of issues. None of these actions would be taken if the EU didn't exist. So the institution is something more than an extension of Franco-German power, even if Franco-German power is reflected in the institution. Saying that the EU will not do anything that France and Germany don't want it to do is not the same as saying that France and Germany would behave the same way if the EU did not exist.

Note that at least some of the old-school institutionalists that Walt seems to be referring to wouldn't like an argument like the previous sentence. But I don't know of anybody who still hews to a that functionalist of a line. Certainly not Keohane. So I'm not sure who Walt sees as his foil. As Farrell notes, he references Andrew Moravcsik and Barry Eichengreen but neither is really an institutionalist the way Walt seems to be describing.

(Moravcsik's book on the EU has "State Power" in the title, and in this paper and this paper Moravcsik attacks neofunctionalist approaches to the EU. Moravcsik is definitely a liberal, but not the sort Walt seems to be referring to.)

But all of this ignores the real problem, which is that neither dogmatic realism nor dogmatic institutionalism helps us understand what's going on. Of course power and national interests are important, and of course the institution is important too. The maintenance of the institution itself is of national interest to member states. Neither is it a question of whether deeper integration will occur; it already has occurred. Never before had anything like the EFSF -- fiscal transfers from some EU states to others -- existed. Never before had the ECB intervened in bond auctions. The question now is whether this new integration becomes legally codified, or whether the cost of it becomes unbearable, and it is abandoned. Neither realism nor institutionalism helps us understand which is more likely.

So it's not just that Walt has the wrong answer, although he does, it's also that he's asking the wrong question.

*It's probably better to say that realists generally think of institutions as intervening variables, but not important independent variables. Like much else in realism this begs a question -- why would rational states waste time creating institutions if that's all the were -- but there it is.

A New EU Governance Structure?

The FT has abandoned it's "no cutting articles" policy, so I can link to their stuff again. And here's a piece about potential revisions to the EU economic government structure:

France and Germany are close to agreement on important elements of their plan for closer “economic government” in the eurozone, but they expect several weeks of negotiation with other European Union members to flesh out the details, according to high-level sources in Berlin.

The idea – termed a “pact for competitiveness” – amounts to a big concession by Angela Merkel, the German chancellor, to what was originally a French concept to beef up the policy co-ordination of the 17 eurozone members, rather than all 27 members of the EU.

However, Berlin government sources insist that the eventual proposal will have a strong emphasis on growth and competitiveness, as well as budget discipline, giving the plan a bias towards German policy content.

More details at the link. To me, this is how it looks these conversations are going:

Sarkozy: We need more policy coordination.

Merkel: Okay, then you all need to converge on our preferred policies.

Sarkozy: No no no. You don't understand.

Merkel: No, you don't understand. We've got the money. We've got the credibility. We've got outside options. We're not letting you all free ride. Take it or leave it.

Okay, okay, that's a bit of an exaggeration. But it seems clear that Germany is going to require a much stricter version of the Stability and Growth Pact before it agrees to any further integration. The article says that not only will public borrowing be restricted, but also higher retirement ages (sacrebleu!), harmonization of corporate tax rates (mon Dieu!), and other policies affecting competitiveness.

In other words, Germany is demanding the Germanification of Europe. We'll see whether those terms are acceptable.

PSA

Crooked Timber is hosting a symposium on Germany, its response to the EU debt crisis, and its role within the EU more broadly. The first three installments are in, with more to follow. I especially liked Mark Blyth's contribution, which I think gets the situation right. In a nutshell, he argues that Germany is doing what it's doing as a stalling tactic to give its banks time to prepare for an inevitable run.

Germany's Growing European Hegemony

Once you get past the silly Merkel/Sarkozy pop psychology (basically the first page), this article on the EU is pretty strong. Here's the conclusion:

With Germany ascendant and looking both inward and eastward, Britain staying out of the euro zone and France carrying less weight, the question of German leadership is now at the fore. Germany has traditionally avoided trying to lead Europe from the front; memories from World War II, though faded, have not yet gone away in the rest of the continent. Even now, anti-German feeling is rising among Greeks, Portuguese and Spaniards, who feel abandoned, even betrayed, by Berlin.

Still, Merkel is going to have to exercise more leadership if the euro is going to be saved, even if she still hides to some degree behind France. And active German leadership of the E.U. means a clearer understanding that politically difficult compromises are going to have to be made and that money will have to be spent and promised — all in the face of growing German discontent.

John Kornblum, the former American ambassador in Berlin and still a resident there, sees a model for Germany in the United States and the way it helped keep Europe together after the war, mediating disputes and finding compromises. “The Germans don’t see it yet,” he says. “But they will have to take on the role of the United States in Europe, and have the same kind of balancing role we had for such a long time.” At that point, Germany’s marriage with France won’t matter so much anymore.

Germany's Rising Tea Party Movement

The Euro crisis has been a common theme on this blog, and we've been pretty emphatic in placing Germany, not the PIIGS, at the center of controversy. Germany is the largest economy in the region. It controls the eurozone's monetary policy. And it will be the one to pay the largest share of bailouts in the periphery of the monetary union. If the Euro is to survive beyond the crisis, it will require a lot of leadership and sacrifice from Germany, not just the countries enacting austerity.

At times we've wondered if Germany was up for it. A recent Der Spiegel article indicates that growing numbers of Germans are not:

In a survey conducted in early December by the polling firm Infratest dimap, 57 percent of respondents agreed with the statement that Germany would have been better off keeping the mark than introducing the euro. Germans, it seems, are gripped once again by their historic fear of inflation: According to the Forschungsgruppe Wahlen polling institute, 82 percent of the population is worried about the stability of their currency.

Of course, the fact that 57% of Germans think they'd be better off having never joined the EMU is not the same as wanting to leave it now. But the movement is growing, and there is now a constitutional challenge opposing fiscal transfers from Germany to Greece:

In the spring, [Rolf Hochhuth] joined a group led by Berlin-based professor Markus Kerber that has filed a constitutional complaint against the billions in aid to Greece and the establishment of the European stabilization fund, which was set up in May 2010. Hochhuth wants the deutsche mark back. "I don't know if this is possible. I only know that Germany lived very well with the mark."

The article also argues that a Tea Party-style movement may be brewing:

"The return of the mark? I can imagine that we could see the rise of a German Tea Party focusing on precisely this issue," says Thomas Mayer, chief economist at Deutsche Bank, referring to the conservative American political movement. ...

Pollsters like Matthias Jung from Forschungsgruppe Wahlen say that they can imagine the formation of a protest movement coalescing around euro-related fears. "The government has to prove that the bailouts for Greece and Ireland serve our own needs in Germany," says Jung. "If the billions in aid are not convincingly justified, it will lead to a legitimation crisis." ...

On a Thursday evening in early December, boisterous beer-drinking visitors were loudly enjoying themselves at Christmas parties throughout Munich's famous Paulaner Bräuhaus beer hall. Meanwhile, in a separate conference room, Schäffler was giving a dry presentation to the Hayek Society on the sins that led to the euro crisis.

The name of the society is very fitting. Friedrich August von Hayek, who received the Nobel Prize in Economics in 1974, was of the opinion that currencies should be a product like any other. Just as companies sell radios, private banks could circulate their own money -- the idea being that the most stable currency would rule out in the end.

The euro, as the presenter and audience quickly agreed, is bad money. It should be abolished. Since the introduction of the European common currency, Schäffler has counted over 70 violations of the Stability Pact, which limits the annual budget deficits of euro-zone countries to 3 percent of GDP. He has also vehemently criticized the European Central Bank, which has been purchasing government bonds from cash-strapped countries, even though EU rules forbid it from buying debt directly from governments. "We buy everything except animal feed," said the FDP politician to general applause.

I guess retrenchment following crisis is not a U.S.-only sentiment. Nor is rediscovering Hayak. Also like the U.S., this puts Germany's government in a difficult position:

German Chancellor Angela Merkel of the conservative Christian Democratic Union (CDU) faces a dilemma as to how to deal with ordinary Germans' concerns about the euro. If she takes their fears seriously, she will have to assume a hard-line stance toward countries that are drowning in debt like Greece and Portugal. But if she plays the iron chancellor, she will have no choice but to break with the Europe-friendly traditions of former CDU chancellors like Konrad Adenauer and Helmut Kohl.

It's more complicated than that, because a retrenchment from the Euro will have drastic consequences for both German exporters and the German banking sector:

Henkel has a mission: He wants to divide the euro. All of the "olive countries" -- as Henkel dubs the Greeks, the Italians and the French -- should pay in southern euros in the future, he says. The north -- in other words, primarily Germany -- would pay with the northern euro.

Economists oppose the idea: German exports would become more expensive and German banks would lose billions in southern Europe.

In other words, the choice isn't between bailouts or no bailouts. It's bail out the PIIGS -- thus saving the Euro, and German banks and exporters -- or scrap the Euro as currently constituted, bail out the banks, and let the German exporters suffer. The former is current policy, and I expect that to continue unless a critical mass of German citizens forces the government to change course. I don't expect that to happen, just as I don't expect the Tea Party in the U.S. to have any lasting effect on policy, but it's within the range of possibilities.

I don't know anything about German constitutional law so I have no idea if the lawsuits have merit. I tend to doubt it. And I'm not sure how the German political climate will shift over the coming years. But I do know that further European political and economic integration -- which seemed inevitable only a few years ago -- is DOA for now, and maybe permanently.

Parsing Ireland, Germany, and the Euro

Here's how Tyler Cowen sees it:

My model here is simple. The Germans fear that if Ireland pulls the plug on the bailout deal, some of the other PBIIGS will meet immediate financial crises, and that spills over onto both German lending banks and Germany as the country holding the eurozone together. Ireland feels that if it pulls the plug on the bailout deal, the Germans don't lend enough support and a) they lose what's left of their banking system, and b) their next government bond auction goes very, very badly.

Here's the most recent news:

Despite rising pressure for new measures to draw a line under the debt crisis, Germany moved Monday to close off debate on an increase to a 750 billion euro bailout fund, or the more radical step of issuing common euro-zone bonds. ...

European diplomats say privately that there has been a debate in recent days on whether to increase the fund to make it clear that a big economy like Spain could be defended, if needed. But many believe that the public mood in Germany makes such a move politically impossible for Mrs. Merkel, unless it was presented as a last-ditch effort to save the euro itself.

“It is a last-resort mechanism,” said a European official who was not authorized to speak publicly. “We still have enough money for Portugal, if needed, and Spain is not drowning. There is also the question of whether this would send the right signal to the market. It might be misinterpreted as suggesting that there was more to come.”

Right now the domestic political equilibrium in Germany seems to be "We like regional integration but not being the PIIGS' sugardaddy. Greece was one thing, but Ireland, Portugal, Spain, and Italy are quite another. We can go back to the mark without too much problem. We'll have to bail out our banks, but that's cheaper than bailing out all of the PIIGS. If the PIIGS won't commit to austerity in order to make our banks whole, then we're not footing the bill. It's insane and immoral that we should be forced to pay for bad governance in the Euro's periphery." This is a reasonable and even right perspective.

The political equilibrium in Ireland seems to be "It is insane and immoral that we should be forced to pay off the bad bets of foreign bankers while they are made whole. Our government made a huge mistake in guaranteeing those foreign bets, thinking that a strong guarantee would never actually be called, but now it is being called and we're not paying. Any Irish government that wishes to pay will be removed from power immediately. We'd rather be Iceland than the alternative." This is also a reasonable and right perspective.

I have less information about attitudes in Portugal, Spain, and Italy, but if I were a citizen of one of those countries I'd be very hesitant to engage in austerity before it is clear what the outcome will be in other countries. If the Euro is going to break up or contract, why go through the pain? Just wait, then default and/or devalue.

Everybody in this equation -- Germany and the PIIGS -- have strong incentives to defect even if cooperation would yield a better outcome. And it's not even clear that it would. Those who gain the most from the Euro while contributing the least -- Belgium, Luxembourg, France, etc. -- are the ones pushing the hardest for cooperation.

I don't think it is very accurate to describe things this way (from the article):

Germany, once the driving force behind European integration, now has to placate public opinion, which is openly hostile to measures that could require Germany to pick up more of the tab for weaker economies.

This was always a concern, hence Maastricht. Now that it's clear that Maastricht is meaningless, German fears have been fully realized. As far as Germany is concerned, they've already donated billions of euros plus sacrificed the integrity of their central bank to peripheral economies that may or may not ever get their house in order. There is now discussion about moving to a fiscal union. Germany rightly recognizes that continued bailouts is a de facto fiscal union already. They don't want that. Why would they?

Germany isn't interested in sharing its credit rating either, and no wonder. Who in their right mind would co-sign for the PIIGS right now?

Mrs. Merkel has rejected a separate call from Luxembourg and Italy to create a common euro-zone bond. Such a move would not be permitted under the European Union’s governing treaty, she said. Creating the legal possibility to issue euro-zone bonds, German officials suggest, would require a substantial rewriting of the European Union treaty, something most countries would be unwilling to do because it could require referendums in several countries where it lacked enough support.

The question is now: how much is the Euro worth to Germany? How much is it worth to the PIIGS? Will Germany continue to add hundreds of billions of euros to the tab? Will the PIIGS enact and enforce the sort of austerity that Germany will need to see to keep the price down? Is there any way to ensure that this won't be a recurring feature of the monetary union?

Here's what will happen when one or several countries leave the union. Here's Barry Eichengreen going off. Here's a post asking IPE scholars to step up to the plate. Here's a very good discussion of the economics and politics of the situation, including a reference to Beth Simmons' book on the politics of adjustment during the interwar gold standard years, and this quote from Kindleberger:

[W]hether deflation and unemployment would saddle a major share of the load on the working class, as contrasted with the rentier. ... Keynes observed in 1922 that the choice between inflation and deflation comes down to the agonizing outcome of a struggle among interest groups.

I would note that during the interwar years not all of Europe were democracies; nevertheless, everyone left the gold standard eventually. The working classes have certainly gained bargaining power since then.

At this point, I think the IMF needs to prepare to lend currency to the PIIGS following a break-up of the Euro. That might not happen, but they need to be ready for it if it does, and those countries will need access to foreign exchange. The IMF needs to have a program of organized devaluation + writedowns ready in that case.

Many in the U.S. are quick to point out the lessons from Europe regarding debt. They should also note the lessons regarding currency. An inflexible currency leads to all kinds of other problems, including the ability to manage debt. This should be a warning to all those who want the U.S. to go back to a gold standard now, or to abolish the Fed in favor of a fixed monetary policy.

Short Answers To Easy Questions

Samuel Brittan muses:

Indeed, the insistence of the German government on impossibly severe fiscal policies makes one wonder if it really wants the euro to continue in its present form.

No, Germany does not want the euro to continue in its present form.

In Which I Don't Understand What Smart People Are Saying

I guess I'm an idiot, as I can't understand simple things. Paul Krugman says:

One clear result of the midterms is that we won’t have anything like a further round of stimulus. And this, in turn, means that the narrative all the Very Serious People will tell is that fiscal policy was tried, it failed, and that’s that.

To support this he presents two points of data, and only two. They are:

1. Germany's economic decline has been worse than the U.S.'s.

2. Germany's government spending has been higher than the U.S.'s.

From this, he concludes:

3. U.S. government should spend more in order to boost growth. (Or, alternatively, the U.S. didn't really try fiscal stimulus at all.)

As far as I can see, that conclusion is a non sequitur given the data he's presented. He updates the original post to say "Just to be clear, I’m not saying that the Germans were big Keynesians; the point is that neither of us were". Fine. But if there is a correlation between government spending and economic growth during this downturn, that correlation is very clearly negative given the data he's given us. How can we conclude from this that the election narrative that "fiscal policy was tried, it failed" is wrong? The data that he's given supports that very conclusion.

This is not a sophisticated analysis, and there are all kinds of relevant variables that aren't included. But Krugman doesn't say which of those might be mitigating factors. He doesn't qualify the data he presents. It's a really strange conclusion for him to reach. As I've noted before, Germany really messes with the standard Keynesian analysis. Tyler Cowen built off of that post here.

Brad DeLong writes about this post, but doesn't square the circle either. Like Krugman, DeLong is much smarter than me, so I guess I'm missing something obvious. I wish they'd point out what it is.

Also note that this crude analysis supports this recent study on the fiscal multiplier, since Germany has a fixed exchange rate with many of its trading partners, while the U.S. does not.

What am I missing?

Balancing Act

Just to piggy-back off of Dr. Oatley's post below. Geithner wants to cap current account surpluses or deficits at 4% of GDP. What effect would that have? Well, U.S. GDP is roughly $14tn. 4% of that is $560bn. In other words, a persistent 4% deficit in the current account is still quite large. Large enough that during most periods the U.S. was well within that boundary, though not during the mid-2000s. As the picture above shows, only in the last few years has the U.S.'s balance of payments been that sharply out of balance. (Note: that is nominal yearly data.)

What's interesting to me about the G20 kicking around these types of proposals are the distributional implications:

Representatives of the world’s largest economies, meeting in South Korea, reached tentative agreement early Saturday on the need to rein in trade imbalances, as part of an American-brokered compromise on calming exchange-rate tensions that have threatened to disrupt the uneven global recovery.

The Obama administration on Friday urged the other economic powers that make up the Group of 20 to agree to curb persistent surpluses and deficits that could contribute to the next financial crisis.

The proposal, which included a numerical limit, was backed by South Korea and quickly drew support from Britain, Canada and Australia. But it met with resistance from Germany and ambivalence from Japan, both major export countries. China, whose currency battle with the United States has threatened to derail the process of global economic cooperation, did not formally weigh in.

So after a marathon negotiating session that stretched into the predawn hours Saturday, the G-20 representatives agreed on the goal of “reducing excessive imbalances” — without a specified limit — and called on the International Monetary Fund to examine the causes of “persistently large imbalances.” The draft statement, to be ratified later Saturday, will also call on countries to “refrain from competitive devaluation” of their currencies, officials said. ...

Four countries have current-account surpluses exceeding 4 percent: Saudi Arabia (6.7 percent), Germany (6.1 percent), China (4.7 percent) and Russia (4.7 percent.) But under the American proposal, countries like Russia and Saudi Arabia that are “structurally large exporters of raw materials” would be exempt from the 4 percent limit, so the pressure would have fallen on China and Germany.

Two G-20 countries have current-account deficits larger than 4 percent: Turkey (5.2 percent) and South Africa (4.3 percent). The United States is next, at 3.2 percent.

A lot of stuff in here. First note that, once again, the expansion of the G7 to the G20 seems to have made it practically impossible to reach meaningful agreements with actionable language. How to reduce these imbalances? Umm... How much should they be reduced? No hard limit. What is the consequence of not reducing imbalances? None that I can see.

Of course the most important thing is who is reducing imbalances. As Dr. Oatley noted, it doesn't matter what countries like Turkey and South Africa do. Nor Russia or Saudi Arabia. It only matters what the U.S., China, and Germany do. The U.S. is under the proposed 4% limit, so is it any surprise that that is the level Geithner picked? It's the number that directly targets China and Germany, and to a lesser-extent Japan. The U.S. is trying to make China, Germany, and Japan pay for international macroeconomic adjustment. No wonder that those countries immediately rejected a firm requirement.

Meanwhile, Justin Fox notes that Keynes proposed something very similar during the Bretton Woods discussions:

Not impossible-to-enforce targets, but a system with incentives built in that would have made big trade imbalances unattractive to both sides. There’s that little matter of creating a new global currency and getting everybody to accept it, but this was at the tail end of World War II. If the U.S. had decreed that the International Clearing Union was a go, the International Clearing Union would have been a go. But at the time, the U.S. ran big trade surpluses and assumed it would do so forever. Its delegates at the Bretton Woods meetings were vehemently opposed. So the idea went nowhere.

Imagine that! Powerful governments decided not to pursue actions that went against their domestic interests. Who could have foreseen it?

The same dynamics are still at play even if some of the roles have reversed, so asking the IMF to investigate causes is a waste of time. China, Germany, and Japan have strong domestic political incentives to pursue policies that generate large current account surpluses. Their political survival depends on continued economic growth, and their economies are so structured that growth has to come largely from exports. The IMF will surely highlight the policies that lead to these outcomes, including exchange rate machinations, but it won't matter because they won't address the underlying political processes that generate the policies in the first place. Even if leaders wanted to bite the bullet and reverse these policies, their domestic constituents wouldn't allow it.

If the U.S. wants to address this issue, it's going to take much more than a vaguely-worded G20 communique. It will have to build a large constituency of other large economies. It will have to find a way to appease Germany and Japan while isolating China. It will have to massively boost domestic savings. And it will have to push a binding agreement through the IMF or WTO. That's a very tall order right now, and I don't see how they can pull it off. As the NYT article linked above notes:

Desmond Lachman, a former I.M.F. official now at the American Enterprise Institute in Washington, praised Mr. Geithner’s message. “It’s a constructive and imaginative proposal and it broadens the discussion away from an exclusive focus on currency to the wider set of policies needed to bring balance about,” he said. “But if you don’t have the Germans and the Chinese, this isn’t going to go very far.”

He added: “They want the U.S. to reduce its deficits, but they don’t want to reduce their surpluses.”

And vice versa.

Auschwitz, Germany, and 1968

I recently watched the excellent The Baader Meinhof Complex, about the wing of the sixty-eighters in Germany that eventually morphed into the Red Army Faction of domestic and international terrorists. I was originally turned onto the film by this Hitchens review of it. Like him, I highly recommend it, and it's available on Netflix Instant for those who subscribe.

Anyway, I didn't know much about the group before watching the film, and it sent me on one of those down-the-Wikipedia-wormhole jags that sucked up an evening. So I was pleased to find this excellent review in the recent n+1 by Yascha Mounk of Utopia or Auschwitz, a recent Columbia UP book by Hans Kundnani on the sixty-eight generation, its origins, its politics, and how it all went wrong. In a byte:

The violent fringes of the 1968 movement eventually even invoked the name of Auschwitz to justify lethal attacks on Jews. Identifying fascism with capitalism, capitalism with the Federal Republic, the Federal Republic with the US, the US with Israel, and Israel with all Jews, they soon came to think of Jews as the true fascists. This may sound like the tortured logic of your average antisemite, but the RAF started from an unusual premise: it was precisely the concern with the injustices their parents had perpetrated against Jews that led these young Germans to kill more Jews.

This was but one of several pathologies operating in German society at the time. But eventual statesmen like Gerhard Schröder and his foreign minister Joschka Fischer learned from them, and used them to further the rehabilitation of Germany as an important nation-state.

The government, along with other NATO countries, planned to use military force to protect Kosovar Albanians against Serbia. Fundamentalists within the [Green] party were outraged. On their view Germany’s history mandated pacifism. Fischer, by contrast, derived from his own understanding of German history an imperative to stop genocide by whatever means necessary.

“I didn’t just learn ‘Never again war,’” he told activists at a tense party conference, “I also learned, ‘Never again Auschwitz.’” In the end Fischer narrowly prevailed over the fundamentalists in his party. Under his leadership—and in the name of Auschwitz—German planes assisted in bombing Serbia. It was the first offensive mission of the German Army since World War II.

It's a fascinating review of what appears to be a fascinating book. I'm looking forward to reading it.

The New Germany, 20 Years On

Today is the 20th anniversary of German reunification. Der Spiegel has lots of coverage, including this interview with Condi Rice concerning America's attitude towards reunification and its negotiations with Moscow (as well as Paris and London and West Berlin), a discussion of whether sacrificing the deutsche mark was the price paid for reunification, and a photo gallery depicting the renovations in East Germany since 1990.

I don't think it's too much to say that the foundation of a new Germany is the most important event in Europe in the past 20 years. Everything that's come since then -- right up to the negotiations over eurozone bailouts -- stems from it. Amazing that the Chancellor, Angela Merkel, grew up in the East. It's worth reflecting on.