A just-so German story
NOMURA recently published an interesting research note by Richard Koo on Germany, its balance-sheet recession in the early 2000s, and the effects it had on Europe. According to some, he “nailed it”. Actually, he only partly nailed it; in some aspects his work contradicts his own analysis.His story in short: Germany suffered from a balance-sheet recession after the dotcom bubble burst in early 2000. The ECB fought back with low interest rates, which hardly worked for Germany because of the balance-sheet recession, but created bubbles in the periphery and thereby export demand for German products. Had Germany used fiscal stimulus instead, bridging the balance-sheet recession, ECB policy could have been tighter—to the benefit of countries like Ireland and Spain. That the periphery is uncompetitive is therefore not their fault or the result of “poor policy choices”, but the result of loose ECB policy.This story is wrong on three accounts. First, Germany’s recession was not primarily a product of the dotcom bubble. Second, the soaring export demand for German products from the rest of the euro area is a myth. And finally, the uncompetitiveness of the periphery is of course the results of poor policy choices—something that actually follows from Mr Koo’s own analysis.Germany’s recession in the early 2000s was not your garden variety balance-sheet recession. One of its main causes was that public banks were increasingly exposed to competition as state guarantees were lifted and European financial markets further integrated. Easy financing conditions for German banks, firms and households were coming to an end.Some may still want to call that an (atypical) balance-sheet recession, but there were “structural” problems, too: rigid labour markets, Germany’s overvaluation within the euro and deindustrialisation pressures in the world’s most industrialised country. All of those factors influenced the low growth of money and credit in Germany. A balance-sheet recession is therefore only part of the answer, and the dotcom bubble an even smaller part.Be that as it may, the ECB was trapped: absent a German fiscal stimulus it had to set interest rates at a level that was too high for Germany but dangerously low for the periphery. Did that lead to soaring export demand for German products from other parts of the euro area?The soaring export demand story fits perfectly with many explanations of the euro crisis, but it is wrong. Of course, the determination of what counts as “soaring” is difficult. A natural measure is Germany’s market share of within-euro-area trade, keeping the composition of the euro area constant. If Mr Koo and others are correct, we would expect Germany’s export market share to rise strongly. At the same time, we would expect Germany’s imports as a share of total euro-area trade to remain roughly constant.As the chart at right clearly shows, it was the other way around. Germany’s export market share does increase slightly, but was only marginally higher in 2006 than in 1995, when Germany had a current-account deficit, not a surplus. The soaring export demand from Europe for German products is one of those often-heard truisms about the euro crisis that is actually false.What did change massively, however, were Germany’s imports from the euro area as measured by market share. The collapse in German import share is a sign of a weakening domestic economy. The German current-account surplus vis-à-vis the rest of the euro area was therefore accompanied by import contraction, not unusually high export growth. Wherever the German savings recycling took place, it was not in the euro zone.The most important of Mr Koo’s arguments is, of course, about the role that fiscal policy could have played in Germany during the early 2000s. The basic theory of why fiscal policy has an important stabilisation role in a monetary union focuses on domestic demand management: since monetary policy cannot be tailored to national economies, fiscal policy needs to keep aggregate demand on track, in both directions.Mr Koo’s argument extends to other consequences of monetary union. If some countries do not stabilise their economies domestically, and the central bank has to pick up the slack, booming regions will be further stimulated—and contracting regions further hurt. This extra stimulation or contraction via monetary policy amplifies boom-bust cycles. The next victim of such a boom (and bust?), ironically, may be Germany.Mr Koo's argument sounds convincing, and I agree that Germany could have softened its recession to a larger extent with fiscal stimulus. Whether a realistic fiscal stimulus would have changed ECB monetary policy by much is less clear: structural factors in Germany would have kept unemployment high enough to result in low inflationary pressures. The periphery might have gained little.The periphery could have gained massively, however, by taking the concept of a balance-sheet recession to heart itself. After all, the opposite of a balance-sheet recession is (obviously) a credit-fueled asset boom. And if a balance-sheet recession requires the government to step in with fiscal stimulus, the opposite naturally requires the government to step in to contain an overheating economy—especially in a monetary union! In addition to a highly restrictive fiscal policy with massive surpluses, macroprudential tools in banking and real estate are further policy options.Mr Koo’s apologetic remarks about the periphery’s policy choices completely ignore that his very own concept of putting balance sheets at the heart of the business cycle goes both ways—just like the modern critique of austerity, may I add. If the periphery’s ignorance of the fact that both insights have a flipside is not a “poor policy choice”, I don’t know what is.The concept of a balance-sheet boom/recession is an important one for Europe. Fiscal policy not only needs to manage domestic demand because monetary policy is unavailable. It also needs to counteract booms and recessions domestically because the use of monetary policy may have harmful effects in other regions. If you compare these lessons to Germany’s focus on debt levels and austerity, it is clear that it has not learned any of them.