What Should Europe Do?

A quick note before the rest of the day bears down on me.  Kantoos Economics offers another take on the appropriate European policy response.  He rejects the standard line of thinking:

One proposed solution is for Germany to employ fiscal stimulus at home, to increase domestic inflation and increase investment and spending. Simon Wren-Lewis goes as far as to argue that this is what a truly but hypothetical European government would do. I disagree: a European government would employ stimulus in the periphery, not Germany.

Broadly, I agree with this, although I think we view it through a different lens.  If Europe had a true fiscal authority, it would automatically redistribute resources via transfer payments and taxes from wealthly regions to less wealthy regions – thus creating demand in the periphery as it adjusts.  And also, such a system would allow for a mechanism to boost overall growth as well via deficit spending.

Absent a direct transfer, the next option is an indirect transfer – stimulating Germany in the hopes that greater domestic demand will stimulate exports from the periphery. Assuming that Germany has no interest in pursuing either strategy, Kantoos puts the ball in the ECB’s court:

We live in a Keynesian world here in Europe, where downward wage adjustments are very hard. Add to this high debt levels, and it is clear that the internal devaluation process, in the midst of a deleveraging process by households, banks and firms, together with austerity will doom these countries to deflationary recessions….What the ECB should do is to toughen lending standards in Germany, raise collateral requirements, down payments etc., and do the reverse in Spain. This should limit investment and consumption in Germany, and encourage it in Spain. It should mimic a differentiated monetary policy, and try to come as close as possible to the respective natural interest rates.

I think this approach suffers from a number of challenges.  First, if capital is relatively mobile, it would be difficult to prevent a loan in Spain from making its way to Germany, so I am not sure the ECB can produce a differential monetary policy.  Second, it is not clear that easing lending conditions in the periphery would encourage additional spending.  I don’t think it will be all that easy to reverse the process of private sector deleveraging in the periphery simply by easing lending conditions.

More to the point, policy to date has been to match private sector deleveraging with public sector deleveraging – the austerity program.  What the ECB could do in this situation is to alleviate the need for public sector deleveraging by acting to bring down interest rates on government debt in the periphery.  And not with haphazard, start and stop programs the ECB activates only when their back is up against the wall.  But instead, to make it clear they are a lender of last resort for Eurozone nations.

Also, I can’t imagine that slowing the German economy, and by extension, the overall Eurozone economy, by enacting tighter credit conditions is in anyone’s economic interest.  I am skeptical that this demand will suddenly appear in Spain.  And this, I think, is fundamentally the error in Kantoos’ argument – he seems to see this as a zero sum gain.  If we reduce demand in Germany, we can make it appear in Spain, thereby reducing the risk of overheating and bubbles in Germany.  There are too many internal frictions to prevent such a smooth transfer of demand.  Instead, acting to slow growth in Germany will only aggravate the drag in the periphery, thus generating more of the hysterisis effects decribed by Kantoos.

Finally, Kantoos directed his post at Paul Krugman, not me.  But I think that Krugman would see his concerns about high inflation in Germany and might refer Kantoos back to this post.

This post originally appeared at Tim Duy’s Fed Watch and is posted with permission.

7 Responses to "What Should Europe Do?"

  1. DiranM   May 2, 2012 at 5:00 am

    The best solution would be for the Eurozone to drop dead, return to national currencies and rename the EU back to "European Community" giving up on a supra-national state!!!

    Fire all the Eurocrats and send Bozo-Barroso and Humpy Rumpy back to pasture.

  2. Marco Tizzi   May 2, 2012 at 6:55 am

    The only easy solution is Germany out Euro.
    The rest are more or less in the same (bad) situation either for private debts like Netherlands or public debts like Italy or both like Spain.
    So a Euro without Germany can devaluate can change the ECB can solve all the problems.

    And I think Germans would be quite happy to get out of Eurozone.

  3. EzioP   May 8, 2012 at 10:27 am

    An alternative could be to push Germany out of the EU and euro and let it to get back to the mark. The other 26 EU countries will continue with both EU 26 and euro. The euro will be inflate and by that the 26 countries will benefit of possible expansion, while Germany with the mark evaluation will reduce export and increase import. This way will balance the two currencies and the two economic areas. The EU 26 will of course continue with the austerity program but tie to it the expanding one. With this approach the weak countries will reduce the impact for retuning their debt and the expansion perspectives of the EU 26 will be a warranty for the other countries.

  4. R. Coutinho   May 9, 2012 at 8:46 am

    In 2000 B.C. the Babylonians knew that they had to periodically have debt jubilees. In the Torah, the ancient Israelites also had debt jubilees. This is because growth follows an S curve while debt rises either exponentially or linearly (it never slows down). The current situation is what happens when debt can no longer be serviced (due to it having finally reached the point where the slower growth curve can no longer sustain even the interest payments).

    More debt will not solve the problem. Inflation will not solve the problem (it will only delay it). The debts must be written down or cancelled. Then we start the cycle all over again.

  5. Dr. Hergen Heinemann   May 11, 2012 at 6:23 am

    There is no question what Europe should do. There is no Europe; there are only 27 nations in the EU. Anglo-Saxons tend to blend this out..So, why should Germany limitless tolerate redistribution of wealth to the periphery while the periphery do what they want and not the needful restructuring of unsustainable structures.

  6. kareb45   May 30, 2013 at 2:56 am

    Europe should do what ever it takes to be a better country. Lets just be a law abiding citizen and let the government work on it.