The long shadow of the fall of the wall

Daniel Gros 17 June 2010

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Economists call a happy monetary union an ‘optimum currency area’. The Eurozone is clearly no longer a happy family, but as Tolstoy observed some time ago, unhappy families are unhappy in their own ways.

The Eurozone is not really suffering the kind of ‘asymmetric’ shock that economists used to take as the biggest problem for a monetary union. The crisis of 2010 seems rather to be the result of a large global shock which affects different Eurozone member countries differently because some are not prepared for rough times.

This essay shows that some of the trends which now are widely assumed to be the result of EMU are in reality the natural consequence of the confluence of two unique events: German unification and the global credit boom of the 2003-2007.

Keeping this perspective in mind is critical to avoiding the mistake of old generals. The new policy framework for the euro should not be designed to “win the last war”; it should not be designed assuming that the first decade represents the norm.

From German unification to boom in the European periphery

The sequence of events that led to the present crisis looks, in retrospect, quite simple if one goes back twenty years ago. Unification produced a domestic demand boom in Germany, but a recession in most of the rest of Europe.

When the unification boom ended in Germany in 1995, the tables turned and Germany’ became for a decade the weakest economy of Europe – ‘the sick man of Europe’ (Figure 1) – while the others enjoyed export-led growth (1995-2000, Figure 2) and later a domestic demand boom fuelled by low interest rates and easy availability of credit (from about 2000 onwards). All the while, Germany’s slow income and wage growth allowed it to regain competitiveness.

This background is important because today it is taken for granted that Germany has low relative unit labour costs and a huge current account surplus. However, this was not the case for much of the decade preceding monetary union.

The great asymmetry in the European business cycle started in late 1989 with the fall of the wall. Within one year Germany was unified and a U-turn in economic policy arrived. While (West) Germany had achieved a balanced budget in 1988, the year preceding unification, the unified Germany was now burdened by the huge expenditure necessary to rebuild the dilapidated infrastructure and housing in the former GDR, leading in a couple of years to a fiscal deficit reaching 4 % of GDP (not counting very large off budget expenditures). Moreover, East German wages were quickly brought close to the West German level, leading to huge increase in new Länders’ purchasing power, and an attendant consumption boom.

This extraordinary demand impulse led to inflationary pressures (despite a sizeable current account deficit). The Bundesbank reacted in a predictable manner – it increased interest rates. Other central banks in Europe could not follow suit because their countries had no unification boom and, in the case of Italy, had to keep interest rates low to keep a lid on the interest payments their treasuries had to make on their huge public debt.

The indirect consequence of the fall of wall was thus not only a boom in Germany, but also serious problems in the European Monetary System. Britain and Sweden quit, and the fluctuations bands were widened enormously. IT also led to an over valuation of the deutschmark which contributed to the weakness of the German economy between 1995 and 2005. Indeed when the euro arrived, most observers predicted that Germany would have a rough time ahead because it entered with excessively high relative labour costs.

Mirror image growth patterns

German growth was the mirror of that of most other Continental nations was for almost twenty years (Figure 1). Between 1990 and 1995 Germany had exceptionally strong domestic demand, but a weak export performance. Just the opposite of what most of the rest of Europe was experiencing. They suffered from high interest rates but got competitive exchange rates.

After 1995 the tables turned and the traditional pattern returned whereby domestic demand became weak (and remained persistently so for over a decade) in Germany, but domestic demand (both in terms of consumption and construction) took off in the rest of Europe, especially in those countries which enjoyed a sharp fall in interest rates as they prepared for the euro. These countries – often lumped together under the acronym PIGS, or more respectfully, GIPS (Greece, Ireland, Portugal, and Spain) – were regarded as the star performers of the Eurozone until 2007.

The impact of the low euro interest rates – sometimes negative real interest rates in the GIPS – was magnified by the new-century worldwide credit boom. Asset prices soared (especially of housing Figure 3) thus increasing greatly the availability of credit even to weaker borrowers (subprime housing in the US and Spain, and subprime governments in Europe). Without this global credit boom, the imbalances that developed after the euro’s launch would likely have remained much smaller.

This asymmetric business cycle over the last twenty years can be seen for example in the current account of Germany relative to that of the Southern EU members. Figure 2 shows that for much of the 1990s Germany was running a deficit and the GIPS a (small) surplus. This changed only around the time the euro’s creation. However, until about 2003/4 the resulting divergence was not much different from values seen just before unification. The German surplus and the Southern deficits reached unprecedented values only when the credit boom really started.

The importance of the credit boom in pushing house prices and thus domestic demand in a differentiated way can be seen by looking at the evolution of house prices. The chart below shows the ratio between house prices and rents, which in principle (like the price/earnings ratio for stock prices) should be stationary and thus presents a good indicator of potential bubbles. This ratio went down in Germany, but started to increase in Southern Europe already before EMU started, i.e. once the ERM crisis of 1995 had been overcome.

Concluding remarks

This short summary of the broad economic trends which conditioned the euro’s debut suggest a simple question: “Given the starting position, was the euro destined to fail?” The answer seems to be ‘no’.

The key disruptive element was the global financial crisis which ended the preceding global credit boom – none of which was the euro’s fault. If this boom had ended with a whimper rather than a bang, the construction booms in Ireland and Spain might have unwound themselves slowly. Accompanied by a strengthening of domestic demand in Germany which leads gradually to higher wages in Germany as the German labour market nears full employment (recall that when full employment was reached in 1995 wages increased considerably), the world is likely to have looked very different.

The required adjustment in Ireland and Spain might thus have been much more gradual, without an accompanying systemic crisis.

The Greek case, however, is entirely different. Greek governments ran profligate fiscal policies for years, hiding the debt where possible. This was a story that was doomed to end badly with or without the global crisis. Overspending and data manipulation almost never ends well.

Figure 1. GIPS and German growth, 1990 to 2009

Figure 2. Long-term current account swings

Figure 3. Asset bubbles in the GIPS.

Note: Index divided by the average 1990-1999

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Topics:  EU institutions

Tags:  governance, Eurozone crisis, Eurozone rescue

Director of the Centre for European Policy Studies, Brussels

Events

CEPR Policy Research