German Adjustment, by Paul Krugman, in NY Times: It has become clear that one of the main forces behind the insistence on austerity as the answer to Europe’s problems is the belief among many German opinion leaders that their own experience in the last decade shows the way. Here’s Josef Joffe:
Why [should France emulate] the former German chancellor? Because he dared tell his own electorate what neither Mr Hollande nor Nicolas Sarkozy would have uttered even on the rack. Nine years ago, Mr Schröder warned his country: reduce social benefits, loosen up labour markets and accept individual responsibility – or else. Then he carried through with his “Agenda 2010”. And lo, Germany went from zero to 3 per cent growth in the two years before the crash – and back to 3 per cent thereafter.
So, how useful a role model is German adjustment in the 2000s?
It certainly did happen:
But how did it happen? I As I pointed out a couple of days ago, Germany got out of its turn-of-the-millennium doldrums by moving into a huge trade surplus, which is not possible for everyone now. Even that, however, isn’t the whole story.
That trade surplus was possible because Germany had a large fall in its costs and prices relative to other euro countries. Here’s the German real exchange rate using unit labor costs relative to the same measure for the euro zone as a whole, using OECD data (note to serious wonks: I know that’s not a perfect procedure, but I don’t have time to do it right — and I’m sure that the basics won’t change):
What’s really striking from the current perspective, however, is that Germany was able to achieve this “internal devaluation” without anything resembling actual deflation:
How was that possible? The answer is that there was relatively high inflation in the European periphery thanks to those big capital flows from the core to the periphery.
Or to put it differently: Germany believes that its successful adjustment was the result of its own virtue, but in reality it was successful in large part because of an inflationary boom in the rest of Europe.
And here’s the thing: the Germans are now demanding that the European periphery replicate its achievement (and actually surpass it, because the required adjustment is much bigger) without providing a comparably favorable environment — they’re demanding that Spain and others do what they never did, which is deflate their way to competitiveness.
This is a road to disaster.