The case against sudden austerity

A currency union with Germany was supposed to work like this. The peripheral euro countries would earn enough and produce enough useful goods that Germany would buy competitively as to create no significant trade deficit. 

 

In short Germany needs to accept a decline in its trade surplus with the PIGS, and the PIGS need to adopt german style fiscal management and a big reduction in their public sectors.

 

The reasons are explained below:

 

Lots of sturm und drang lately in the eurozone. Germany has decried the profligacy of its southern peers, especially Greece. Athens, meanwhile, feels resentful about what it perceives as Berlin’s bullying. Amid a rash of strikes in Greece, Spain and Portugal, emotions are running high. Yes, Greece and the other big-spending Club Med countries must tighten their belts. They also need to increase their competitiveness. But to insist, as Berlin has done, that austerity is the only way out for these countries is both unrealistic and untrue. Germany must play a role too.
Greece, Italy, Spain and Portugal, for example, run large current account deficits. Last year, these deficits summed to about €102bn, about half of which was due to trade within the eurozone. Germany, meanwhile, has a large current account surplus – last year it reached about €80bn – about half of which is also due to trade with its eurozone partners. For the past ten years, this relationship worked to everyone’s favour. Germany enjoyed export-led growth. Club Med countries provided much of the demand for those exports. But this symmetry is as true of the bust today as it was of the boom then.

Imagine, for a moment, that the Club Med countries somehow manage to deflate their way to recovery and shrink their budget deficits to Maastricht-prescribed levels. To do that would entail a massive reduction in spending equivalent to €120bn, or about 6 per cent of German output. One consequence of this contraction would be a huge slump in demand, including for imports.

Germany would not be able to substitute with increased exports to other countries. The economy, which is already stalled and only currently propped up by exports, would go into reverse. Berlin would then face some tough choices. One of them, as Lombard Street economist Brian Reading suggests, would be to sustain a substantial rise in its budget deficit to compensate for lost demand elsewhere. If only out of self interest, German opposition to a Greek bail-out plan is therefore likely to soften.