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Marshall Auerback

Marshall Auerback

Posted: December 6, 2010 12:16 PM

Like marriage, membership in the euro zone is supposed to be a lifetime commitment, "for better or for worse." But as we know, divorces do occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible and that one or more countries might revert to national currencies.

As far as the European Monetary Union goes, the prevailing thought has been that one of the weak periphery countries would be the first to call it a day. (In Ireland's situation, one could make a good case for it on the grounds of persistent spousal abuse.) It may not, however, work out that way: All of a sudden, the biggest euro-skeptics are not the perfidious English, but the Germans themselves. Take a look at these headlines (kindly drawn to my attention by James Aitken of Aitken Advisors, LLP): "Germany and the euro: We don't want no transfer union" on The Economist, "Jenkins: Where Are the Business Europhiles Now?" on WSJ.com, and even a book by Hans-Olaf Henkel, formerly of IBM (Germany) and hitherto one of Germany's great euro-enthusiasts (English translation), Return our Money.

So let's consider what happens if Germany decides to follow Herr Henkel's advice. On the plus side, given Germany's historic reputation for sound finances, the country will likely emerge with a strong Deutschmark. But this will likely come with a huge cost: Germany will probably save its banking system at the expense of destroying its export base. The newly reconfigured Deutschmark will soar against the euro and become the ultimate safe haven currency for speculators keen to find a true store of value. This will mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining countries) will fall dramatically. Even if the euro itself vaporizes, the Germans will simply pay back debt in the old currencies, likely at fractions of their previous value.

But Germany's external sector will be wiped out. The resultant appreciation of the new Deutschmark, along with the inevitable banking crisis in the periphery (which will exert significant deflationary domestic pressures in other countries and therefore reduce consumer demand) will engender a huge trade shock. Germany's growth will slow dramatically, as exports comprise such a large proportion of GDP.

Another interesting byproduct: By accounting identity, a fall in Germany's external surplus means a large increase in the budget deficit (unless the private sector begins to expand rapidly, which is doubtful under the scenario described above). So Germany will find itself experiencing much larger budget deficits.

Let's elaborate a bit further. My friend Randy Wray wrote a very interesting blog post last year entitled "Teaching the Fallacy of Composition: The Federal Budget Deficit," where he used the standard sectoral balance approach to show that:

At the aggregate level, the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income. But there is no reason why any one sector must spend an amount exactly equal to its income. One sector can run a surplus (spend less than its income) so long as another runs a deficit (spends more than its income).


And:

If we have a balanced foreign sector, there is no way for the private sector as a whole to save unless the government runs a deficit. Without a government deficit, there would be no private saving. Sure, one individual can spend less than her income, but another would have to spend more than his income.


So the spending-income relationships between the three sectors, which can be expressed in terms of the sectoral balance accounting framework, are binding on each individual sector.

This is important when we consider Germany's fiscal policies in the context of a situation in which its trade surplus quickly dissipates. Remember, this is not high Keynesianism, but simple double entry bookkeeping, developed some 6 centuries ago. Call it the tyranny of Accounting 101.

We know that if the government sector tries to run surpluses when there is an external deficit and the private domestic sector wants to save, you'll get much slower growth and much higher unemployment. The fiscal drag reduces spending power, which damages output and income growth and ultimately forces the private domestic sector to run down its wealth holdings. The only way to offset this damage is to have a greater external surplus (net exports) that adds spending to the local economy and supports income growth and the desire to save. That is the situation today in several Asian countries and Norway. If the private domestic sector saves and the nation enjoys an external deficit, the only way this can be sustainable is through continuous budget deficits. They should be ongoing and scaled to match the spending gap left by the other sectors.

In the current German situation, although the country runs a large current account surplus, it is insufficient to offset a high private sector predisposition to save (which means there is some deficit). But the current account surplus does allow for a smaller budget deficit than its so-called "profligate" Mediterranean neighbors, while still facilitating the private domestic sector's desire to save. As I have argued before, it is the "profligacy" of Germany's Mediterranean trading partners that has allowed it to rack up huge current account surpluses and therefore run smaller budget deficits than the PIIGS countries.

Germany will regain its fiscal freedom once divorce from the euro is complete. This itself is something the Germans should celebrate, providing their government takes advantage of it. Remember, once it returns to the Deutschmark, Germany becomes the issuer as opposed to the user of a currency, as is the case under the euro, and is fully sovereign in respect of its fiscal and monetary policy. Consequently, it can offset the external shock by running large government budget deficits, which will add new net financial assets to the system (adding to non-government savings) available to the private sector.

It will become almost impossible to run budget surpluses under this scenario, but this isn't bad for any country that issues debt in its own free-floating, non-convertible currency. As unpalatable as this conclusion might be for many, it is entirely consistent with national income accounting. As Bill Mitchell has pointed out on many occasions:

[T]he systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.


A budget deficit per se, then, will not cause any problems for Germany, as it will no longer have any external constraint after it restores the Deutschmark as its currency of choice. But Germany has historically embraced an export-based model at the expense of curbing domestic consumption.

So its policymakers face a choice: Will the country offset the decline in its current account surplus via a more aggressive fiscal policy by choice (i.e. proactively, in search of a full employment policy), or reactively, via growth in the automatic stabilizers? If the German economy slumps (as I expect it will), the deficits created by automatic stabilizers will rise as a matter of course. Germany can easily counter that if it chooses to do so.

It's never a laughing matter to see any economy slump. But anyone with a sense of irony will naturally be wondering whether the German government and its voters will get themselves in a frenzy about being so "profligate" as the inevitable trade shock develops. I suspect there will also be a touch of "schadenfreude" on the part of its recently divorced euro zone "ex-spouses." (How does one say "schadenfreude" in Greek or Spanish?) Personally, I've never seen the merits of eliminating government debt just so that the private sector is forced to go into greater deficit, and perhaps the Germans will eventually figure that out as well. In any case, one suspects that we are about to get a nice "teachable moment" for Frau Merkel if Germany does embrace the course of action now so enthusiastically endorsed by the likes of Herr Henkel.

But the country might well find truth in the adage, "Be careful what you wish for."

Cross-posted from New Deal 2.0.