Why Germany needs higher inflation
by Ian Solliec
The challenges facing the euro area are complex and daunting. It urgently needs to bring inflation back on a normal path, a route that would be in Germany’s enlightened self-interest. If Germany cannot agree to reflate its economy, the only reasonable alternative is to leave the single currency bloc.
At root, the euro area’s problems are not primarily fiscal in nature. They reflect instead a balance of payments crisis, arising from dramatic divergences in competitiveness between the core and the periphery in the early years of the euro.
So the answer lies in restoring the competitiveness of periphery countries to avoid them becoming further mired in the vicious cycles of low growth and budget deficits leading to depression and unrest.
The official German position is that structural reforms are the way forward to regain competitiveness. However, expected increases in productivity are uncertain, and at best will happen in the long run. In the short run, the only way to boost competitiveness within the currency union is via internal devaluation, with nominal wage reductions.
This policy has clearly shown its limits. The example of wage moderation successfully implemented by Germany in the 2000s is irrelevant, since higher inflation in the periphery allowed Germany to gain competitiveness simply by suppressing wage growth. It never had to tackle deflation.
Since, in a currency union, competitiveness can be adjusted only by acting on inflation differentials, Germany’s ultra-low inflation is a fundamental problem. Above-average inflation in Germany is the only answer. Appeals for solidarity have shown their limits. Yet once the possibility of a euro area break-up is considered, the case for promoting German reflation becomes stronger.
Germany’s economy suffers from potentially risky imbalances, which would worse in the case of break-up. The current account surplus, at 7% of GDP, is the most evident sign of this disequilibrium.
If Germany had its own currency, it would be a lot higher as a result of Germany’s relatively low production costs.
If the euro were to split between stronger and weaker members, German exporters would suffer a considerable revaluation, with highly negative consequences for the German economy. Compared with this, the benign effects of moderately higher German inflation would be a boon.
Currently, with so much excess capital to invest abroad, Germany is bound to make costly mistakes. With its ageing infrastructure, Germany has no shortage of investment opportunities at home.
Rather than suffer the adjustment of a euro break-up, German industry should welcome a steady real appreciation brought about by moderately higher inflation, which would give it plenty of time to adapt to a stronger currency.
With their own currencies much-devalued, on the other hand, the Italian, French, and Spanish economies – in the event of a breakup – would roar back to life. Inflation would, it is true, erode the real value of Germany’s roughly €1tn of net claims on Europe and the rest of the world.
However, gradual erosion would be much preferable to the dramatic loss that would follow a break-up, caused by the ensuing hole in the balance sheet of the Bundesbank that would cost German taxpayers dearly.
So the choice for Germany is to decide between releasing some of the pressure that has built up in the system, or risk a catastrophic upheaval. This is a matter of selfinterest as much as of solidarity.
Certainly, inflation may be difficult to rekindle. And French and Italian reforms are badly needed. Yet as long as Germany obstructs the European Central Bank’s actions to inject more liquidity into the financial system, inflation has no chance of returning to the path set down by the ECB’s mandate, and structural reforms will never bear fruit.
Indeed, a clear nod of approval from German authorities could be enough to shift inflation expectations in the right direction. Ideally, Germany would take more forceful fiscal action, launching infrastructure projects at home and responding to Jean-Claude Juncker’s appeal for European countries to join his investment programme.
The time has come for Germany to make up its mind and act, quickly and decisively. Unfortunately, history provides no great assurance that this will actually be the case.
■ Ian Solliec previously worked for BNP Paribas, corporate and investment banking department, focusing on quantitative research. Back