Olli's follies and the Pros and Cons of TAFTA

The recent letter of EU commissioner Olli Rehn to EU finance ministers which, against overwhelming empirical evidence that austerity has failed (see graphs below), continues to support the economic equivalence of the Ptolemaic theory, just leaves me speechless in the face of so much arrogance and Besserwisserei (there is really no adequate english translation for this word, pedantery only comes close).

      Austerity and Changes in Debt-to-GDP ratios in the Eurozone 

Source: Paul de Grauwe; data source: Financial Times and datastream

    Austerity and Economic Growth in the Eurozone 

Source: Paul de Grauwe 

Since a number of other observers have already competently commented on this issue, please allow me to refer you to selected comments by Paul Krugman: "Euro Delusions", Karl Whelan, economics professor and former economist at the Federal Reserve: "Is Debate about Fiscal Multipliers unhelpful ?", Paul de Grauwe, professor of International Economics at the London School of Economics: "Panic-Driven Austerity in the Eurozone and its Implications", and an independent economic blogger in Brussels: "Die Kosten des Sparwahns."

I will instead comment upon another issue, proposed at the last EU summit: a trans-atlantic free trade agreement (TAFTA). This idea is not new. Already in 1995, European officials put forward a proposal for the creation of a US-EU free trade agreement, provoking me to write a paper about it while I spent a sabbatical at Harvard's Kennedy School of Government. The paper is rather wonkish, but might contain a few useful insights ---> see some extracts below:

EXTRACTS of a 1995 paper on the Pros and Cons of TAFTA
prepared for Harvard University, John F. Kennedy School of Government

(copyright held by the author of this blog)

Net Trade Gains from TAFTA

International trade theory is concerned with the efficiency of global resource allocation and the maximization of global welfare. The theory holds that global welfare rises if the formation of a free trade area (FTA) results in greater opportunities for specialization and trade. Conversely, global welfare suffers a decline if the FTA diverts trade from more to less efficient producers. Hence, according to traditional trade theory a free trade area improves global welfare if and only if its trade-creating effects outweigh its trade-diverting effects.1 In the next sections I will examine whether this might be the case with the creation of TAFTA.

Trade Creation2

According to Lawrence (1995) trade creation will be largest among FTA member countries with high initial levels of protection suppressing their trade.3 With the exception of agricultural trade, this is clearly not the case in the US or in Europe. Tariffs are already very low so that further tariff reductions under TAFTA are unlikely to result in large additional trade flows. However, TAFTA is likely to strengthen the competitive pressure on ‘outsiders’ to either join the group or create another free trade area (either complementary to or competing with TAFTA), thus spreading the process of liberalization and trade creation among other nations (domino effect).4

It is further argued that the mere increase in market size leads to economies of scale and scope and enhances the opportunities for specialization and trade. This effect is said to be strongest among countries that produce similar goods.5 On this point, the statistical evidence in favor of TAFTA is most convincing. With a common US-European market of 750 million people, a common GDP of $15 trillion,6 and an expected enlargement of the European Union to include Central and Eastern Europe in the not too distant future, the trade creation potential from TAFTA is enormous.

Recent experience also suggests that intra-industry trade and foreign direct investments (FDI) flourish particularly well among countries at similar stages of development. Borne out by statistical evidence of trade and investment flows among OECD countries during the past decade,7 TAFTA is likely to strengthen the already existing intra-industry trade and FDI-creating effects. Furthermore, the spill-overs from innovations induced by FDI will benefit TAFTA members as well as external producers, and is likely to create additional trade inside and outside of the free trade zone. 

Trade Diversion

One of the most salient arguments advanced in opposition of FTAs centers around the allocative efficiency implications of trade diversion from more to less efficient producers. This argument refers to the effects of discriminatory rules of origin or other barriers against producers outside of the FTA region. Even if trade creation is enhanced inside the FTA, trade diversion will occur, and global welfare will be impaired, if more efficient producers outside the free trade zone are prevented from competing with ‘inside’ producers. Bhagwati puts it bluntly: “[FTAs] are two-faced, bringing free trade to members, but amounting to implied protection against non-members.”8

This argument would indeed weigh heavily if TAFTA led to trade diversion as a result of discriminatory trade practices or other negative effects on outside producers9. Hence, to avoid any reduction in global welfare care should be taken to prevent and/or offset the potential trade-diversionary impact of TAFTA by lowering external tariffs as well as internal ones, by maintaining a non-discriminatory rules and regulations, and by keeping the group open for membership to all interested countries.10

A related view holds that even if the FTA is not discriminatory against outsiders it impedes efforts toward free global trade by diverting scarce resources away from multilateral trading initiatives and by providing an attractive alternative instead.11 The evidence from a recent WTO report suggests, however, that FTAs promote liberalization trends and thereby reinforce the global trading system. Rather than alternatives to free global trade, FTAs seem to be complements and stepping stones toward it.12

Yet, some economists warn that the global effects of TAFTA, especially when combined with APEC, may be extremely harmful to the multilateral trading system. TAFTA and APEC together cover 80% of world trade and encompass the most significant players and issues, leaving little room and scope for negotiation under the WTO umbrella.13 In view of the mounting international opposition to the formation of a ‘rich-country club’, it is advisable to avoid this exclusive image of TAFTA and keep it open to other regional and non-regional members, both rich and poor.14

Institutional Aspects of TAFTA15

While traditional trade theory focuses on the creation of trade flows and the minimization of trade diversion to optimize the global welfare impact of an FTA, non-traditional trade analysis takes a broader view of global welfare. It takes into account the effects of ‘deeper integration’ measures and addresses economic governance issues that affect the sovereignty of the nation state.16 In my view, a thorough assessment of the net gains from TAFTA also requires the weighing of the expected costs and benefits from the institutional changes under discussion.

Costs

If TAFTA remains limited to a cooperative trade and investment agreement with an à la carte menu of policy measures, the costs in terms of sovereignty loss will be minimal to zero. Since the US, however, envisions a number of ‘deeper integration’ measures such as the standardization of product tests and the harmonization of regulatory policies, there will be some adaptation costs to conform with common standards as well as some loss in independence in policy making. I expect that most of the costs from deregulation will be borne by European countries due to their much higher level of regulations and the extent of industrial policies applied in the region. 

Benefits

The potential trade- and investment benefits from institutional changes envisioned under TAFTA are sizeable. Regulatory harmonization and the mutual recognition of each other’s product standards and certification procedures will facilitate market access and reduce production and distribution costs. Further, the security of market access and the guarantee of FDI property rights will diminish investor uncertainty and is bound to stimulate two-way trade and investment flows as well as job creation on both sides of the Atlantic. Moreover, the benefits from institutional harmonization accrue to both internal and external producers.

Other Considerations

US public opinion on TAFTA seems to be divided. Its enthusiastic reception by multinational corporations comes as no surprise. Unexpectedly, however, TAFTA also enjoys strong support among labor unions and the democratic minority in Congress who view the agreement as their “last chance” to introduce Europe’s labor and welfare standards in the US.18 Given the maturity of the economies involved there is little concern about US workers’ pay being “undercut by the pitiful wages in poor countries.”19

Employer groups, on the other hand, are apprehensive about TAFTA’s expected upward pressure on US labor and welfare costs, and the potentially damaging effect on US competitiveness.20 Other groups argue that, as an exclusive rich-country club, TAFTA will be internationally divisive and result in the extension of Europe’s protective ‘tariff walls’ to the US.21

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1/Compare Lawrence (1995): “Regionalism, Multilateralism and Deeper Integration”, pp. 21-25.
2/Consistent with the new General Agreement on Trade in Services (GATS), foreign direct investments and other factor and non-factor service trade is included under the broad heading ‘trade’.
3/Ibid., p. 25.
4/Baldwin (1993: “A Domino Theory of Regionalism”) points out the “domino effect” of the proliferation of FTAs (cited in Lawrence,1995, p. 39).
5/Lawrence (1995), p. 26.
6/See the Economist of May 27, 1995: “In need of fastening”.
7/Recent trading patterns among OECD countries reflect growing intra-industry trade flows. Parallel to this trend, two-way FDI flows among OECD countries have tripled from 1982-92, growing several times faster than global trade and output (see Brooks-Senftleben, 1993: “Private Capital Flows .......: Overview of Recent Trends and Some Thoughts on Sustainability and Future Prospects”, Ibero-America Institute for Economic Research, Discussion Paper No. 62, p. 9).
8/Compare the arguments advanced by Bhagwati in the Financial Times of May 31, 1995: “Personal View - the High Cost of Free Trade Areas”.
9/Compare Lawrence (1995), pp. 26-27. He points out that outsiders may be hurt by a decline in their terms of trade due to lower demand for their imports from FTA members. However, Lawrence also argues that the negative terms of trade effect could be offset by income- and import-stimulating economies of scale effects inside the FTA.
10/A recent WTO report suggests that the trade-diverting impact of existing FTAs has been minimal to non-existent even though discriminatory rules of origin are widely applied (see the summary of key WTO findings in the Financial Times of July 12, 1995: “FT Exporter”).
11/Compare the comments by Mr. Ruggiero, head of the WTO, in the Financial Times of April 28, 1995: “Priorities in World Trade.”
12/Compare the Financial Times of July 12, 1995: “FT Exporter”.
13/The economists referred to are Anne Krueger and Jagdish Bhagwati (compare the Financial Times, of April 28, 1995: “Priorities in World Trade”.
14/Yi (1994) argues that FTAs that are open to outsiders will eventually lead to full multilateral free trade (see Yi, Sang-Seung: “Stable Structures of Trading Blocs and Welfare”, mimeo, Dartmouth College, cited in Lawrence, 1995, p. 42).
15/Compare Lawrence (1995) for an introduction to non-traditional trade analysis based on institutional effects.
16/For example subsidies or other industrial or trade policy measures (compare Lawrence, 1995, pp. 28-34.
17/TAFTA was first proposed by Mr. Kinkel, Foreign Minister of Germany. The European trade commission strongly favors the initiative (compare the Financial Times of April 20, 1995, and the Economist of May 27, 1995).
18/See the International Herald Tribune of June 8, 1995: “Europe’s Search for Security......”
19/Quoted from the Wall Street Journal of June 5, 1995: “US Backs More Liberal Trade Effort with Europe.....”
20/Compare the EIU Crossborder Monitor of June 21, 1995: “More Market Access: Trade Partners Wary of Bold Initiatives Globally.”
21/Ibid. and Financial Times, April 28, 1995: “Priorities in World Trade”.

And what about Germany's 'synthetic' competitive devaluation strategy ?

This weekend’s Group of 20 meeting of finance ministers and central bankers in Moscow focused on the prevailing market fears of currency wars and a 1930’s style death spiral of competitive currency devaluations. Following the aggressive push for easier monetary policy by Japan’s new prime minister Shinzo Abe and the resulting slump in the Yen, the Group of Seven felt the need to sooth markets already before the G-20 meeting with the following statement:  

“We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates.” 
(G-7 statement of February 12, 2013) 

Oh really ? While Jens Weidmann, president of Germany’s central bank, vehemently refutes the intention to devalue the euro (“the exchange rate of the euro is broadly in line with fundamentals” .....“you cannot really say that the euro is seriously overvalued”), at the same time he supports Merkel's synthetic competitive devaluation strategy in Europe, i.e. economic austerity policies that synthetically replicate a currency devaluation by changing the value of economic variables, with similar effects on the price of tradables (exports and imports) and export performance. 

Let me expain what I mean by 'synthetic' competitive devaluation:

Just as financial instruments can synthetically replicate risk exposures and generate similar returns as other financial instruments without the need for real assets [1], economic policies can be designed in such a way as to attain the same effect as a competitive currency devaluation without the need to change nominal currency values. For example, a combination of higher value added taxes (VAT) on consumer goods and a cut in payroll taxes or a payroll tax subsidy lowers unit labor costs and lowers export prices as export goods are exempt from VAT. This fiscal devaluation approach has recently been advocated by Harvard economist Gita Gopinath and colleagues as a response to the loss of competitiveness in the eurozone (see Gopinath et al., 2011: "Fiscal Devaluations") and is now being planned in France to revive the country's competitive edge. Keeping nominal exchange rates unchanged, the recommended combination of policies acts as an effective export subsidy and thus leads to the same outcomes as a nominal currency devaluation, namely an increase in exports. 

Germany's Merkel government has pioneered this synthetic currency devaluation approach already in 2007, combining an increase in VAT from 16% to 19% with a cut in employers' social security contributions from 6.5% to 4.2%. The fact that employees did not benefit from a similar cut in social security contributions clearly shows that it was meant to be a payroll tax subsidy for employers designed to lower unit labor costs, the standard measure of competitiveness [2], and thus increase exports. 

The fiscal devaluation in Germany was implemented in addition to the policy measures of Agenda 2010 which lowered nominal wages and non-wage labor costs and put pressure on general wage levels through various labor market liberalization and flexibilization measures. Using Germany's Agenda 2010 as a blueprint, the labor reforms imposed on Greece and other highly indebted countries in the Southern European periphery by Germany's Merkel government and the troika of IMF, EU commission and ECB encompass a number of measures designed (to lower unit labor costs [2] and increase competitiveness:

• the lowering of nominal wages and social security contributions;
• the reduction of unemployment payments;
• the shortening of the eligibility period for unemployment payments;
• the downward adjustment of public pensions;
• the reduction or elimination of labor market regulations, facilitating 'hire and fire'.

The combination of Agenda 2010 and fiscal devaluation policies were so successful that Germany went from a trade deficit in the early 1990s (as a result of the economic boom following reunification with the former DDR) to the global export championship in nearly every year since 2000.

Germany's synthetic competitive devaluation approach, of course, also resulted in huge trade imbalances within the eurozone, injecting centrifugal forces so strong that they risk destroying the European monetary union. This risk is not yet banished but growing as long as Germany insists on generating trade surpluses within the eurozone.

Applying the same synthetic competitive devaluation policies in the entire eurozone will not solve matters, but simply transport the problem onto the global stage, increasing the risk of international protectionism and an implosion of international trade. 

I therefore welcome the final communique of the G-20 meeting in Moscow which reads in paragraph 5:

"We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open."

Let's all hope that these words do not fall on deaf ears in Germany and the rest of Europe.

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    [1] For example, as the availability of mortgages to construct the highly lucrative mortgage-backed CDOs was limited, Wall Street quants simply designed synthetic CDOs using CDS to reflect the risk exposures of mortgages, thus creating an unlimitless universe of CDOs....the perfect weapon of financial mass destruction.   

    [2] Unit labor cost = average cost of labor per unit of output.

CameroMerkel's austerity cum competitiveness-Agenda 2020 for the EU

"...Austerity measures are straining growth....We need growth, we need green growth, we need growth that is inclusive, that is job-creating, and that is gender-inclusive....
We need greater solidarity between and amongst generations."

(cited from Christine Lagarde's speech in Davos, January 23, 2013)

Following Christine Lagarde's extraordinary speech in Davos.....as I was starting to dream of policymakers who, having learned from their mistakes, would immediately stop all austerity measures in the eurozone and implement policies supportive of inclusive growth, I was jerked back into the sad reality of Europe: while  enlightened people talk about inclusive growth and solidarity, our European nincompoop politicians keep playing the same old and tired tunes of austerity and competitiveness.

The EU budget deal of February 8 is an utter disaster, complete with the usual pork for the farmer’s lobby and other special interests, rebates for the oh-so-poor Brits and Danes, and a heavy dose of public service bashing by Britain’s Cameron (he demanded ! a €1 bln reduction in EU civil servants’salaries and pensions). The budget also includes the most non-sensical, pro-cyclical expenditure cuts on research, energy and transportation projects. Apart from €6 bln previewed for the fight against youth unemployment, there are NO funds allocated specifically to counter the disastrous economic and social effects of austerity measures in the Southern European periphery. Shameful ! What is the purpose of a European Union if not to help Europeans in a grave economic crisis ? 

Far from proposing to fund counter-cyclical economic recovery measures, the new European dream team of David Starve the Beast Cameron and Angela the Schwabian housewife Merkel forged an unholy alliance to push through the first ever real-term cut in the EU budget and a seven-year agreement on actual spending which is normally set year-by-year. The final agreement previews a 7-year budget of €960 billion [1] and actual spending allocations of €908 billion, down from the €994 billion spent in the current budget cycle. The difference between the budget plan and actual spending allocations results in a deficit of €52 billion already at the planning stage which clearly contradicts the intent of the recently enacted fiscal pact. (see  Bloomberg: “Europe Leaders Bow to Cameron Demand to Deepen Spending Cuts” and Lost in Europe: “Kein Zukunftsbudget”).

The European Parliament should put this budget deal where it belongs: into the garbage bin.

In addition to successfully pushing through an EU austerity budget, CameroMerkel discreetly directed EU president Van Rompuy to launch their competitiveness agenda, the so-called reform contract which would commit countries to competitiveness reforms along the lines of Germany's Agenda 2010. Central to this competitiveness agenda is the lowering of unit labor costs via nominal cuts in wages and non-wage benefits as well as labor market reforms that would facilitate the firing of workers and the individual determination of wages, thus putting additional downward pressure on wage levels.

European unions have already registered their protest in a press release by IndustriAll European Trade Union, an association of 197 national unions, arguing that the planned reforms are an attack against tariff autonomy and that the EU has no mandate for the determination of national wages. Resistance is also forming among Europe's social movements which are planning europe-wide action days for the EU summit in March.

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[1]  The proposed EU budget amounts to roughly 1% of EU-GDP and is dwarfed by public spending at the national level which averages 50% of GDP. 

We need inclusive growth... and greater solidarity [IMF Managing Director Christine Lagarde]

As noted in my last post on Germany's and Britain's competitiveness dogma, there were also some positive developments in Davos. It was none other than the Managing Director of the much-maligned IMF who brought some reason and humanity back into the economic debate: Diplomatically but firmly, Christine Lagarde noted that while some structural competitiveness reforms and fiscal deficit reduction may be necessary, austerity measures are straining growth and should be moderated. Again and again, she stressed the need to focus on growth - not just any growth, but green growth, job-creating growth, and inclusive growth:  

     “Inclusive growth is one of the top priorities of policymakers. The top risk is severe income disparaty. Excessive inequality is corrosive to growth and it is corrosive to society. We, nor policymakers, have not paid enough attention to inequality ! All of us, including at the IMF, thanks to research that was conducted recently, have a better understanding that a more equal distribution of income allows for more economic stability, more sustained economic growth, and healthier societies with stronger bonds of cohesion of trust. This research is confirmed by empirical findings.”

       ..... "Gender inclusion is critically important and, frankly, too often neglected by policymakers. By raising the employment rates of women, we can attain higher rates of growth and employment. When women do better, economies do better."

       ...."We need greater solidarity between and amongst generations.....We need growth, we need green growth, we need growth that is inclusive, that is job-creating, and that is gender-inclusive."

Lagarde even quoted FDR: "The test of our progress is not whether we add more to the abundance of those who have much, but whether we provide enough to those who have little."

---> see the video of Christine Lagarde's Davos speech of Jan 23, 2013 here 

What a couragious speech at a meeting of the fabulously rich global business and investment community and the highest echelon of government officials catering to this global money elite. It is one thing to consciously stay away from this 'happening of the rich and famous', but quite another to have the audacity to tell them in no uncertain terms that  they need to change and show some solidarity with others. 

Whether Christine Lagards's speech was just a genius stroke of PR or whether the IMF Managing Director  and her economists really mean it remains to be seen. Fact is:  her arguments were very well received by her colleagues Angel Gurria, General Secretary of the OECD, and Trevor Manuel, South Africa's Minister of Finance and Member of the G-20. Ms. Merkel, on the other hand, was not amused.

The German (and British) competitiveness dogma (part III)

For those who still do not fully grasp what all the fuss about competitiveness is all about, Germany’s chancellor Merkel and British premier Cameron made it abundantly clear in Davos: It’s about lowering labor costs, liberalizing labor markets (i.e. reducing workers’ protections), and cutting social spending. Merkel even admitted that the implementation of such ‘structural reforms’ against popular opposition will only be successful under pressure (see Frankfurter Allgemeine of January 25, 2013: "Merkel: Wir brauchen Druck für mehr Wettbewerbsfähigkeit.") In Milton Friedman’s words: “Only a crisis – actual or perceived – produces real change” (Capitalism and Freedom) --->see my post on “The role of crises for Troika shock therapy” and the highly recommended documentary "The Shock Doctrine".

So, as pre-exercized in Southern Europe, a crisis is conjured up to justify far-reaching labor market reforms and other structural competitiveness measures in the rest of the eurozone as the price for Britain’s stay in the European Union (the following passages are cited from David Cameron's speech at Bloomberg in London):

“There is a crisis of European competitiveness as other nations in the world soar ahead…Europe’s share of world output is projected to fall by almost a third in the next two decades. This is the competitiveness challenge and much of our weakness in meeting it is, frankly, self-inflicted….[through] complex rules which restrict our labor markets"…and “excessive regulation”...“As chancellor Merkel has said, “if Europe today accounts for about 7% of the world’s population and produces 25% of its GDP, it is currently financing 50% of global social spending. And then it’s obvious that it will have to work very very hard to maintain its prosperity and its way of life.”…..More of the same will not see the EU keeping pace with the new economic powerhouses of the world…More of the same will just produce more of the same: less competitiveness, less growth, fewer jobs….That is why we need fundamental, far-reaching change.”

Apart from the fact that this kind of rhetoric sounds eerily familiar to the arguments that promoted financial market liberalization before the Great Financial Crisis, Cameron seems to view the favorable economic development of emerging nations as a zero-sum game leading to a “global race of nations”… “for the wealth and for the jobs of the future": "Europe is being outcompetet, out-investet, out-innovated and it is time we made the European Union an engine for growth, not a source of cost for business"...."You ought to deal with your debts, you ought to cut business taxes, you ought to tackle the bloat in welfare...." (see Cameron's speech in Davos, lecturing EU policymakers). "Now, back in the UK, we've been doing all of this."

Oh, really, Mr. Cameron ? And what are the results ? Let's have a reality check:  In Q4/2012, "UK GDP fell by a shocking 0,3%, which means that the UK is back in recession,".... unemployment is rising, the trade balance is deep in the red ..."and productivity seems to have collapsed". The explanation for the dismal economic performance is that the UK is following the wrong policy mix: "trying to aggressively tighten fiscal policy at the same time as persistently pressurizing UK banks to raise large amounts of capital is just the wrong thing to do." (Jim O'Neill, Chairman of Goldman Sachs Global Asset Management)

To sum up: the UK's economy is far from being the shining light in Europe - it rarely (if ever) has been. Why should Europe's policymakers follow an economic model which obviously is not working ?  

Yet, to the ears of Europe’s competitiveness queen Angela Merkel, Cameron’s words sound like music. She immediately endorsed his demands that Europe improve its competitiveness and proposed a second pact (in addition to the fiscal pact) for EU member states, committing themselves to structural competitiveness reforms where needed. See an excellent assessment of Merkel's new plan here: Merkel's Agenda des Schreckens.

With friends like that, Europeans don’t need any enemies !

Fortunately, there were also very positive developments at Davos.  Please check my next post for a report on those.

The German competitiveness dogma (part II)

I have explored some of the consequences of Germany's obsession with competitiveness in my posts The German competitiveness dogma, part I and The Blueprint of Labor Reforms in Greece: Germany's Agenda 2010. 

More evidence is appearing on the particularly damaging effects of the 'structural' competitiveness reforms closest to the heart of the Merkel government, namely the reduction of unit labor costs by way of nominal wage cuts and the liberalization of labor markets, which, in a recessionary environment caused by draconian austerity, results mainly in firings. Not surprisingly, the 2012 edition of the Employment and Social Development review of the EU commission finds that the Southern eurozone countries that had to implement these competitiveness measures in return for European financial 'assistance' seem "trapped in a downward spiral of falling output, fast rising unemployment and eroding disposable incomes." Since 2007 "the unemployment rate gap between the North and the South has widened from 0% in 2007 to 7.5% in 2011".

Evans-Pritchard correctly diagnoses a "demand shock as the real culprit" of these developments and concludes that the evidence "subverts the central claim of Europe's austerity mandarins that labour reform will somehow, magically, deliver recovery..." He already sees half of Europe in a great depression, "less acute than it was for the same bloc of states in the early 1930s but more protracted and ultimately deeper." He goes on to criticize the ECBs monetary policy as still too tight for most countries in the eurozone, implying that a looser ECB monetary policy would help lower the external value of eurozone export goods and thus lead to more exports and growth. This is the nominal devaluation approach toward higher competitiveness.

In this post, I'd like to focus on the German competitiveness approach via internal, real devaluation by way of wage reductions and labor market reforms. There are three main reasons why Germany will not support a nominal devaluation of the euro: First, because high-quality German export goods are not very price-sensitive (as recently admitted by Olga Wilde, Speaker of the German Industry Association). Second, because a nominal devaluation would awaken the inflation zombie by way of higher import prices. Third, because it would devalue the substantial amounts of euro-denominated savings deposits and other financial assets held by Germans. And so, the preferred German approach toward higher competitiveness rests on the internal, real devaluation of export prices mainly through labor cost reductions via cuts in nominal wages and non-wage labor costs (social security contributions) as well as general downward pressure on wages through the liberalization of the labor market.     

Underlying the German competitiveness doctrine are several faulty assumptions:  first, that the nominal cost of labor is the only determinant of export prices and export demand which is non-sense and without any scientific foundation [1]. Second, that nations compete against each other like big corporations. Paul Krugman, international trade expert and Nobel prize winner in economics, pointed out already in 1994 that this view is flatly wrong (see "Competitiveness: A Dangerous Obsession"): "The economic woes of countries cannot be attributed to 'losing' on world markets".... "The result of this obsession with competitiveness "is misallocated resources, trade frictions and bad domestic economic policies."

Looking at economic developments in Germany, it is abundantly clear that Krugman's claims are fully borne out by the evidence, as shown in my post on the Agenda 2010: the massive reallocation of resources away from Germany's internal market resulted in a dramactic worsening of living standards for the German population, with broadbased declines in real wages, the creation of a low-wage sector, and the widespread use of precarious employment contracts depressing general wage levels in Germany. Furthermore, Germany's bad domestic economic policies led to trade imbalances vis-à-vis other eurozone members and trade frictions with its non-European trading partners: the effective internal devaluation of German tradables resulted in mounting trade surpluses and is largely responsible for the huge economic imbalances that are at the root of the euro crisis. Currently, Germany's chronic trade surpluses causes trade frictions with the United States where Germany's competitiveness drive is viewed as a "free rider strategy, which relies on exploiting global demand rather than generating it at home," thus creating trade imbalances that are disrupting the global trade structure" (see The Telegraph: "Germany displaces China as US Treasury's currency villain"). 

At this point, it is important to recall that the Great Depression of the 1930s was caused by competitive currency devaluations as each country attempted to generate growth through exports. This provoked a vicious circle of retaliatory trade protections which eventually led to a complete collapse of international trade. The strategy to generate exports in a declining market through competitive devaluations became known as "beggar-thy-neighbor" policies as exports could only be generated at the expense of other countries.

Are we moving down the same destructive path ?  I believe, we may:

- On January 4, 2013, Bloomberg reported that "the world's developed nations are stepping up efforts to weaken their currencies"....While Japan's newly elected Prime Minister Shinzo Abe called for aggressive central bank action to boost growth and inflation, Switzerland has successfully blocked the appreciation of the Suisse franc, and the US Federal Reserve is continuing quantitative easing (monetary expansion through the purchase of Treasury bonds).

- On January 16, Bloomberg reported that eurozone chief Jean-Claude Juncker's complained of "a dangerously high euro": Russia warned that "the world is on the brink of a fresh currency war".

- Germany's Merkel government continues to impose nominal wage reductions in the Southern eurozone periphery, and structural labor market reforms designed to depress general wage levels and thus enhance competitiveness. This is nothing else but a competitive internal currency devaluation with similar export price and demand effects as a competitive nominal currency devaluation.

The competitiveness doctrine obsessively imposed in the eurozone and elsewhere will depress global demand and growth if every country follows it !

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[1] Unit labor costs, i.e. nominal labor costs per unit of output which is the standard measure of competitiveness, can also be reduced by an increase in output (the ratio's denominator). While holding labor costs (the numerator) constant, output can be increased through productivity enhancements which in turn can be achieved by investing in human resources (education, work training) and the tools they work with (investment in research and development). Such investments would have the added benefit to increase aggregate demand, employment, and economic growth !

The German competitiveness dogma (part I)

With the rising probability of another election victory for Merkel and her 'christian' democratic party, the PR machines are revving up for a post-election Agenda 2020. The protagonists in this PR-farce (Schmierentheater) are the usual culprits who, before the Great Financial Crisis, supported the competitiveness Agenda 2010 and promoted the deregulation and liberalization of Germany's financial sector: Joerg Asmussen, member of the ECB-Board and former state secretary in the finance ministry who arranged billion-€uro taxpayer bailouts for several German zombie banks, predicts a return of the 'sick man of europe' status for Germany if the country cannot fix its current "weaknesses" (see "Merkel Economy Shows Neglect Amid Concern Sick Man to Return", Bloomberg Jan 9, 2013).

It may come as a surprise that the strongest economy of the eurozone - an island of prosperity - may have weaknesses, given that the country boasts record employment levels, record export sales and tax receipts, a budget close to surplus and negative market interest rates on its federal bonds (meaning investors are paying for the honor of providing credit to Germany and the German people). But according to some economists, Germany's industrial production growth is too slow, labor costs are too high, productivity is not keeping pace with wage deals, the labor force is aging and shrinking, and "then there's the skills issue" (Joerg Asmussen [1]: "the workers of tomorrow aren't getting the education they need to compete globally"  and - god forbid - the country has lost its top-five spot in the competitiveness index of the World Economic Forum (see the Bloomberg article mentioned above) .

Oh boy ! The world export champion and whip-cracker for competitiveness in the eurozone is loosing its competitiveness ? The world is coming to an end !

Not mentioned is a small but decisive detail: between 2000 and 2010 the German work force hasn't benefited from any wage increases but instead suffered real wage losses, witnessed the spreading of precarious employment contracts formerly unknown in Germany, and cut-throat downward wage competition leading to hourly wages of €1 in some cases. While Germany's Agenda 2010 policies thus achieved a real devaluation of unit labor costs, these beggar-thy-neighbor policies created the huge trade imbalances which are at the root of the euro crisis:

The correct economic policy response to redress these imbalances would be to promote wage increases in Germany instead of economically non-sensical austerity measures in the euro zone's periphery. Yet, Germany's genius economists plan to worsen the imbalances by artificially manufacturing a non-existing economic crisis in Germany as an excuse for a second round of Agenda policies (see my blog "the role of crises for....shock therapy" and some reactions to the planned Agenda 2020 here and here). 

Can't say we didn't warn you about what will happen after a reelection of the Merkel government. If you don't like it, do something to prevent this outcome NOW !

“I do not feel obliged to believe that the same god who has endowed us with sense, reason, and intellect has intended us to forgo their use.” 

(Galileo Galilei)

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[1] Obviously, there is nothing wrong with the skills set of the German work force or they wouldn't be able to sell such excellently made export goods sought after by the entire planet. But what about your skills issues, Mr. Asmussen? Got an overdose of neo-liberal ideology and business economics ? Where were your superior skills when you recommended the financial deregulation and liberalization policies that cost German taxpayers hundreds of billion €uros ? It's time you paid for this, Mr. Asmussen !