A message from Germany: Not my problem

Paul Krugman complains (again) that Germany's tough line towards the South fails to appreciate how much its own relative economic success in recent years is the flip side of the Mediterranean countries' failure. By refusing to allow a higher eurozone inflation rate, Germany is effectively denying the South the chance to realign its relative costs in the same way Germany was able to do in the first years of the Eurozone. As Krugman shows in his post, Germany's success in holding down its labour costs was spectacularly successful precisely because the South did not manage to achieve zero real wage growth, and therefore provided a ready market for German products (not to mention an outlet for German financial surpluses). Resolving the crisis requires Germany to return the favour.

I'm always puzzled, looking at things from the perspective of the UK and Southern Europe, how it can be domestically politically impossible to persuade Germans to spend money. After all, the easiest solution to the crisis has always been that Germans dipped into some of their trade surplus to enjoy the South's warm beaches and hospitality, or maybe even buy a few second homes on the shores of the Mediterranean. It looks like a win-win solution. Yet, the hair-shirted Prussians prefer to stick it all under the mattress, and invite Southern Europeans to do the same, even if this does actually shrink the economy and put German savings at risk.

This can be seen as a cultural or ideological problem. In many ways, the discourse of belt-tightening on the European level has a quasi-religious quality. We need to suffer, and those who have least should suffer particularly, since being poor they probably deserve it. The poor, Weber would say, lack a beruf (calling), whilst the parsimonious rich are blessed and will be rewarded in the afterlife. The crisis becomes a morality play. Easy answers, like inflation or fiscal stimulus, must be wrong, because the crisis is a clear sign we have sinned and must atone.

I can't help thinking that it would be easier to convince Germans to adopt a more constructive attitude if Southern Europeans didn't enjoy such an enviously pleasant climate and physical environment. Whilst Germans have to endure long cold winters, the South basks in sunshine  - no wonder they don't work so hard. Of course, as has been well documented by now, the average Southern European worker has a much longer working week than the average German, and savings rates are also actually quite high in the South:

The truly profligate are the Anglo countries, with clearly lower savings rates than continental and Southern Europe.

The morality tale of Southern Europe's decline doesn't really fit with the facts, but my guess is that it is simply easier to digest for Germans than the harsh truth, which is that European Monetary Union was designed and is being governed in line with German interests. In other words, the moralistic tone of the Eurozone policy discourse is a cultural problem founded on a very real set of material advantages.

EMU was an extension of the process of market integration in Europe, removing one of the last remaining barriers to trade - national currencies. By creating a single currency, competitive devaluations became impossible. The usual beneficiaries of such devaluations - the weaker currency nations of Southern Europe - were prepared to sacrifice this competitive advantage in exchange for the inflationary anchor provided by Germany's dominance of the new currency union. What they didn't perhaps anticipate was quite how exposed they would become to Germany's extraordinary capacity to control price and wage rises, and how little help they would get from the ECB, which shaped monetary policy around the needs of slow-growing Germany, leaving the fast-growing periphery to inflate itself into an uncompetitive real exchange rate. And now, the only way back for the South is a brutal internal devaluation which, as well as closing off the labour market to anyone below the age of 35, will make debt servicing next to impossible.

Despite recent optimism about financial flows returning to Spain, this process of internal devaluation is far from complete, and there are incipient signs of deflation across the South, hence the ECB's increasingly desperate attempts to use monetary stimulus to get the economy moving. Still Germany protests that all of this has nothing to do with them, and refuses to play any part in raising internal demand in the Eurozone. But politics has an awkward habit of raising its ugly head in these situations. There will be elections in Spain within 2 years, and almost certainly in Italy and Greece even sooner. The problem will not go away, and Catalan nationalists and left populists in Spain, the Five Stars movement in Italy, Golden Dawn and Syriza in Greece, are all waiting in the wings. Barry Eichengreen established that you can't run a gold standard in a democracy. Is Europe trying to test this theory to destruction?

To Catch a Thief: What the Berlusconi sentence tells us about Italy

So finally, after 52 trials the communist judges that have infiltrated the Milanese courts and ultimately spread through the system all the way to the Cassazione (Italy's highest appeal court) have got their man. Berlusconi is convicted at the third and final level of judgement of a tax fraud committed some two decades ago and receives a prison sentence, although for a variety of reasons (age, an amnesty law, the possibility of 'alternative measures') he will not set foot in any jail.

The response from the convicted criminal himself was predictable enough: he has long argued that he is innocent of all charges and that his many trials are the result of left-wing judges trying to use the law to achieve a political end of eliminating the most popular politician in the country. What amazes many people outside Italy, and particularly in Northern Europe and the English-speaking countries, is that so many Italians still support him. After all, in some democracies the merest whiff of legal trouble or sexual scandal is enough to end a political career - British politician Chris Huhne was recently jailed and his political career terminated for evading a speeding ticket. Why do Italians seem so forgiving?

Let's try and get into the mind of the Berlusconi-supporting voter. First, there is the traditional deference with which many Italians view the rich and powerful - even Berlusconi's opponents refer to him as 'Il Cavaliere', after the honour of 'Cavaliere del Lavoro' (similar to our knighthood for services to industry) was bestowed on him by his friend Bettino Craxi back in the 1980s. Berlusconi plays to this role of the rich benefactor, giving supplicants gifts such as watches, jewels, apartments or simply money in the style of the traditional 'notables' of pre-democratic times. Of course, his TV channels are very helpful in cultivating this image.

But let's not assume that most of Berlusconi's support comes from these quarters. If there is one thing you can say about Italians, it is that they do not like to play the sucker. And in a country with such a Baroque administrative and legal culture as Italy, obeying the law and paying your taxes is fraught with danger. At best, you can end up out of pocket knowing that many others are cheating on their taxes. At worse, you can find yourself penalized for doing the right thing, since tax law is complicated and unpredictable, and very often tax levels are set on the assumption that citizens will indeed not report their full income. Not surprisingly, an estimated 13.5% of income is not declared to the tax authorities. More generally, Italy's legal system is exceptionally complex, with a much larger number of laws and regulations than other democracies, many of which are in flagrant contradiction with each other.

So when Berlusconi talks of the injustices he has faced at the hands of judges and the state administration, this chimes with the experiences of most if not all Italians. And those most likely to sympathize with him are to be found in the very large section of Italian society that owns property or their own business, or is self-employed. Sure, many Italians believe that the best way to deal with the problem would be if everyone paid their taxes and respected the law. Others take the view that that will never happen, and therefore the law should be applied in the most relaxed manner possible. When Berlusconi talks of 'liberty', he effectively means 'impunity'. Since the state and the law don't work properly, punishment is illegitimate, verging on totalitarian. This fits in nicely, of course, with Berlusconi's strident anti-communism.

In the end the saga of the justice system is representative of the broader problem of the development of the Italian state. The Piedmontese nation-builders of the late 19th century attempted to create a unified Italy on the basis of a French-style administration, in which local resistance to state power would be overcome by the imposition of a systematic, uniform set of laws to be implemented by a centralized bureaucracy. Unlike in France, the Italian state never quite succeeded in turning 'peasants into Italians'. The state remains, for many Italians, an unloved and even loathed presence, tolerated for providing tangible benefits such as jobs in the public sector, state pensions, and healthcare, but not respected. In large sectors of Italian society the state has failed to establish itself as a necessary framework for civic coexistence or an efficient and fair economic system.

For this reason, we can get rid of Berlusconi (perhaps), but it is much harder to overcome berlusconismo.

The Grasshopper and the Ant Revisited

Some interesting posts on debt from Antonio Fatas and Noah Smith which I'd recommend to anyone tempted to believe that debt is necessarily a bad thing (also Krugman here, here and here making similar points after David Stockman's rant). Noah Smith's post is headed by a picture of Aesop's fable of the Grasshopper and the Ant, a typical metaphor used by the debt phobic.

Just in case you want the short version, the story is basically that headline debt figures don't tell us that much about their consequences, and we have to consider two important variables: what the debt is actually spent on (Smith), and the ratio of assets to liabilities (Fatas). Put simply, getting into debt to finance consumption probably places a burden (in the form of lower than otherwise consumption) on future generations, but doing it to finance investment all else equal has the opposite effect.

Drawing on Smith's analysis, we can see that the remedy of debt reduction can end up being more damaging than the debt itself. The UK, for instance, has succeeded in cutting its government borrowing only by cutting government investment, which in the current climate means cutting investment in the economy generally (given the private sector's pro-cyclical reluctance to invest). This reduces the productive capacity of the economy in the future, reducing future consumption. In this case then, debt reduction, not debt itself, is what is placing a burden on future generations, since George Osborne is (rightly) preserving the current consumption of the growing elderly population, which constitutes the lion's share of social spending.

Fatas' point about balance sheets is another way of making the same point. Debt corresponds to assets; or as Krugman keeps pointing out, at the level of a whole economy debt is largely money we owe to ourselves. We can see that clearly enough by looking at Germany, whose headline gross debt number is actually pretty high, but whose net external investment position is comfortably in the black. Ignoring the assets that correspond to liabilities is like equating a student loan with credit card debt to pay for a holiday.

So the emphasis on debt is missing the point. It is investment that is important for future generations, not debt. And of course, by squeezing current consumption debt reduction in a recession squeezes current production, reducing the ability to pay off the debt without unnecessary pain. In the periphery countries of the eurozone, unemployment is driving the young - the future productive workers - to migrate, perhaps never to return, whilst the old - who are current consumers, but relatively unproductive - remain. In Aesop's terms, austerity kills the ants, leaving only the Grasshopper, sitting unhappily under a leaking roof. Why are we doing this to ourselves? Well that's for a future post.

The Euro Crisis as 'Cheese Touch'

My favourite scene in the first 'Diary of a Wimpy Kid' movie is the 'cheese touch'. A piece of mouldy cheese is left in the schoolyard, and the kids keep well away from it as it gets greener and slimier. Until, one day, someone touches it - and they are ostracised until they can pass it on to someone else who will get the same treatment. The cheese touch is passed around the school, creating horror and fear in everyone. It's kind of Camus' La Peste for pre-teens.

The euro crisis is starting to look a bit like the cheese touch. The banking crisis of 2007-8 created a financial blackhole, and at some point we are going to have to come to terms with the losses and start from scratch. But of course none of us want to take the losses ourselves. In the absence of some kind of sensible and credible agreement to spread the pain, each group/nation/individual has to try to protect themselves from taking a disproportionate share of the losses, and assume others will do the same. In short, we'll keep well away from whoever has the cheese touch. Today, it's theunfortunate small savers of Cyprus.

The answer has got to be that the burden of adjustment is shared. This is for moral, political and economic reasons. Morally, because, well, life isn't fair but it shouldn't be Mad Max. Politically, because unless we give up on democracy, the victims of adjustment will protest and remove representatives who impose unfair burdens. And economically, because the weakest groups politically tend to be the weakest groups economically, and they simply can't take the losses - witness the brutal yet futile welfare reforms in the UK.

Who decides how to share the pain of adjustment? In Wimpy Kid, the responsible adult - the school janitor - is also disgusted by the mouldy cheese and sweeps around it. The EU is probably our demotivated janitor. And in Wimpy Kid, the cheese touch's journey around the school ends when it lands on Dieter Muller, a German exchange student. Baffled by zey cheese touch, Dieter takes it with him back to Dusseldorf. My guess is that ultimately the euro crisis will end the same way.

The Italian Election: Why it's Actually Good News

So, with all the usual commonplace reactions to the Italian election: 'chaos', 'ungovernable', and so on - it's time for a contrarian view. In a number of ways this is a great outcome.

First, Berlusconi will be happy with the result for sure, because it gives him huge bargaining power - no majority in the Senate is feasible without him. But let's remember that his coalition won only 29% of the vote, down from 47% in 2008, and his party, the PDL, won 21%, down from 37%. So the worst expression of Italian corruption and conservatism took a battering in the polls. Italians are not as forgiving as we feared.

Second, the two parties that represented continuity in sticking to the absurd commitment to austerity - the PD and Monti's Scelta Civica - both performed way below expectations. Monti's result is hard to read as anything but a rejection of European technocracy and its perverse insistence on pain and sacrifice as the way to recovery. Greece and Spain have largely caved, Italy, the biggest and most important Southern economy, and probably the most self-confident despite its problems, has said 'basta'. This has got to be good for Europe - better we accept this now, then have to wait for Golden Dawn to win in Greece.

Third, Italy's venal and reactionary political class is obviously a huge problem, and the amazing performance of Beppe Grillo's Five Stars Movement - at 25% the most voted individual party - shows that many Italians, and especially the young, have had enough of their politicians. Again. Of course, Berlusconi himself emerged out of the ruins of the last exercise in eliticide, back in the early 1990s. He then proceeded to piece together a new regime of rent-seeking and policy paralysis which is responsible for Italy's long-term decline. Grillo may have no policies, but as a protest vote you can't get much better than that. If nothing else, Grillo sends a clear signal to the crooks that a large number of Italians have had enough of the stealing and incompetence.

Now, this does not mean I'm optimistic. But if we add this result to the steady shift in the debate towards the inescapable conclusion that austerity is a disaster (even Olivier Blanchard thinks so now), then perhaps Europe will edge towards some more sensible approach to preserving the euro. Will this solve all our problems? No. But if Merkel wants the euro to survive, she'll have to start listening to Southern European voters as well as her own.

New paper! The Trouble with Economic Reform in Southern Europe

The Trouble with Economic Reform:

Understanding the Debt Crisis in Spain and Italy

Jonathan Hopkin

Introduction

The ‘great recession’ of the late 2000s began as the collapse of the ‘Anglo-Saxon’ model of highly leveraged capitalism, but the countries that have suffered most have been the Southern European democracies, often referred to as the ‘PIGS’[i]. The transformation of what started as a banking crisis into a sovereign debt crisis has ended up engulfing countries who, for the most part, were not particularly associated with the financial excesses of the boom years, and has allowed debate to move away from reform of the financial system in the Anglo-Saxon countries to the sustainability of government spending in Europe, and particularly Southern Europe, and the future of the euro currency.

To read the full paper, click here.