from Follow the Money

The Teutonic Monetary Policy Tradition

December 19, 2004

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My recent travels took me to old Europe -- and reminded me that the rest of the world is, in many ways, still unprepared for changes set to hit the world economy -- a world economy where the US trade deficit is shrinking, not growing, and the US is relying on world demand to support its growth -- not the other way around. There is doubt about the timing of such a change, but the direction is pretty darn clear.

This poses real challenges for Germany, in particular. Exports are an amazingly high share of its GDP, and exports to the US are something like 3-4% of German GDP. That is not China, which exports 14% of its GDP to the US, but it is high for Europe. Moreover, domestic demand growth has been particularly anemic inside Germany.

I am not one who believes that "structural reform" is the answer for all problems: some structural reforms make sense, some don’t. And I am a bit reluctant to call on suggest that other countries should emulate all US economic policy practices, which often seems to be the gist of most calls for structural reform. I can think of few worse ideas than trying to copy the US health care system: the US spends more than other industrial countries (as % of GDP), and gets less (life expectancy is lower). I am not one who axiomatically wants Europe to embrace US big box retailing, let alone all US labor market practies -- our real wage growth has not been all that impressive recently. I grew up in a "Wal-martized" Kansas, and lived for a time in Europe; shopping in Europe is a lot more fun than shopping in the local walmart.

But leave my personal preferences aside -- I am not convinced that the standard set of structural reforms to European labor markets -- reducing union bargaining leverage, making firing (and hiring) easier, scaling back the welfare state -- will increase European demand, at least in the short-run. Cutting real wages in Europe might make Europe’s existing export industries more competitive, but it won’t necessary lead European consumers to consume more. I am not sure any gain in investment would offset the potential drag on consumption created by a radical change in Europe. Some reforms may well be worthwhile to address European social problems -- reducing payroll taxes on new workers to spur hiring, for example, may be a good way to reduce youth unemployment. But the also may not spur european demand -- and what the world needs above all is for Europe to pick up for the US as a source of global demand.

So from a global rebalancing point of view, I suspect it is better to focus on structural reforms that would obviously tend to increase consumption -- expanded retail hours, for example. That would not require replacing small shops with big boxes; it only requires giving small shops the freedom to stay open longer. Making home equity loans and credit cards easier to get falls in that category as well: Europe could become a more American style consumer society without radically changing its social contract, or shifting the balance between labor and capital.

All these reforms would also tend to make demand more sensitive to interest rates -- which would be a good thing if Europe ever decided to loosen monetary policy. After all, cutting interest rates would make the euro less attractive, and tend to reduce its value.

I was frankly surprised by the resistance to the use of monetary policy inside contintental europe. The argument that monetary policy does not have any real impact anyway -- the classic Teutonic bundesbank argument -- is hard to square with the impact of loose money on the US economy recently. Do Europeans think loose money had nothing to do with the rapid recent expansion of US consumer demand? That rising housing prices have not encouraged more consumption? Real interest rates should not be negative. Ever been to the US? Inflation (CPI) this year looks to be more than 3% -- a lot more than the short-term interest rate!

Germany may be misreading the reasons why a strong D-mark led to a strong German economy in the post war period. The D-mark did not start out all that strong, at least not relative to the dollar -- it, like the yen, had a tendency to appreciate over time relative to the dollar, as Germany recovered from the war. During most of the post war period, the D-mark was also part of a system of fixed exchange rates -- whether globally, or inside Europe. Germany -- scarred by Weimer inflation -- kept monetary policy tight and inflation low. Since other countries were inflating more rapidly, and exchange rates were fixed, low inflation led the D-mark to depreciate in real terms -- and spurred Germany industry. The D-mark was strong in two senses: inflation was low, and their was constant pressure for the D-mark to be revalued upward. Partially, that reflected the productivity of the German post-war economy. But it also reflected the cumulative impact of inflating more slowly than others, and thus a tendency for the DM to depreciate in real terms over time as long as exchange rates stayed constant.

Alas, if Germany went into the Bretton Woods system with a currency that was undervalued -- it probably went into the Euro with a currency that was overvalued. There is no doubt that the former East Germany entered the euro at too high a parity: exchanging ost-marks for d-marks at one to one (meaning east germany went into the euro at the same parity as west germany) is the orignal sin of the post-reunification German economy.

German inflation has lagged European inflation since the introduction of the Euro, helping Germany competitiveness. Over time this will bring about the needed real exchange adjustment (just as over time, Chinese inflation will lead china’s currency to appreciate in real terms even if it keeps its current parity). But it strikes me that the traditional Teutonic preference for tight money and low inflation makes this process harder than it need to be. It is easier for Germany’s real exchange rate to improve if other countries inflate at 3% and Germany inflates at 1% than if the rest of the eurozone inflates at 2% and German prices stay constant ...

My bottom line: almost the opposite Joachim Fels of Morgan Stanley. He wants structural reform in europe, but rejects monetary and fiscal stimulus . I would end the constant US heckling about structural reform in Europe -- that is primarily a choice for Europe to make, and I am not sure US pressure has much impact anyway -- and demand monetary stimulus!

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