Germany faces an awful choice. It has done everything by the book. It's citizens work hard, accept modest wage increases, and avoid excessive debt. It's government likewise limits its borrowing. It is highly competitive and is a world-class exporter. But now everything is going pear-shaped and they can see no way out. One by one Eurozone governments are going bust, requiring bailouts or threatening to default. Germany has tried to solve the problem by agreeing to lend money to these countries provided that they implement austerity measures and 'structural reform'. But this approach has not worked. Wherever implemented it has aggravated the debt problem. Now that Spain has succumbed and required a (disguised) bailout, Italy is next, and then the game will be up, as its huge debts will take Germany down with it. Everyone is clamouring for Germany to put all its financial and economic might behind the entire Eurozone. But that would mean placing German citizen's hard one savings at risk - something that they are understandably reluctant to do. Yet if they don't help and countries default, the resulting financial contagion could destroy the Euro and the EU. Germany is deeply committed to the EU and is desperate to prevent this happening. It certainly does not want to be blamed for destroying the EU.
Looked at this way, which is the perspective of most Germans, there seems to be no way out. But there is. What is required is for Germany to understand what the real problem is. When they do the solution will be obvious.
There has been much discussion about the need for fiscal and banking union to solve the problem. In short it is argued that a monetary union such as the Eurozone can only work if the Eurozone developed a structure similar to the USA. I would argue that this is not only unrealistic, at least within a time scale needed to prevent collapse of the Eurozone, it would NOT solve the key problem which underlies the current crisis. Conversely, addressing this problem will both resolve the crisis and provide the time needed to move towards full integration.
Another way of describing credit creation is that banks create money and equal amounts of debt. The money accumulates in the net exporter countries while the importers retain the debt. Such a system cannot continue for ever. Eventually the debts will become too great. And this has come to pass.
So what is to be done? The core of the problem is that a system which relies exclusively on commercial bank lending is vulnerable to financial collapse. As soon as growth stall and and confidence drops people stop borrowing and start saving and paying down their debts. This cause a drop in the money supply and demand and asset prices (which back up much of the debt). This leads to a recession which leads to further drops in confidence and reductions in spending and asset prices. A downward spiral continues until there is complete collapse. Even if those with the money step in to stand behind the debts of the indebted the problem is not solved. The entire system becomes insolvent.
It is critical to understand that what is happening is contraction of the money supply. Bank-created loans are paid paid off the money is eliminated. Economic activity, which depends on money, is thereby reduced. The only way to break this downward spiral is to introduce counter this contraction by introducing net financial assets into the economy through increases in government spending and/or decreases in taxes. In other words government must spend more into the economy than they extract through taxes - the essence of deficit spending. This must be supported by the ECB either through provision of debt free money to government's, or through them purchasing government bonds.
This will restore demand and thus growth and reduce unemployment. Most importantly, it will finally allow the aggregate private sector to save and pay off its huge debts. Everyone will be better off and the Euro would be saved.
Looked at this way, which is the perspective of most Germans, there seems to be no way out. But there is. What is required is for Germany to understand what the real problem is. When they do the solution will be obvious.
There has been much discussion about the need for fiscal and banking union to solve the problem. In short it is argued that a monetary union such as the Eurozone can only work if the Eurozone developed a structure similar to the USA. I would argue that this is not only unrealistic, at least within a time scale needed to prevent collapse of the Eurozone, it would NOT solve the key problem which underlies the current crisis. Conversely, addressing this problem will both resolve the crisis and provide the time needed to move towards full integration.
So what is this problem? Essentially, it is that the Eurozone is becoming insolvent, if it is not so already. This process is accelerating and has reached the stage that it is irreversible unless there is massive intervention by the ECB to inject net financial assets into the banking system through support of deficit spending, something which is blocked by Eurozone rules.
The problem arose because of a serious flaw in the design of the Eurozone. Its critical feature is that it is forbidden for the ECB to act in a way that enables increases in the money supply through deficit spending. As a result the only mechanism by which the money supply can grow is through credit creation by commercial banks. This was OK during the boom years because banks created money (too) freely, supported by (and resulting in) asset price inflation in several Eurozone countries. As noted in previous posts, the problem with growth fuelled by commercial bank lending is that it is accompanied by ever-increasing debt since all new money is matched by an equal amount of associated debt. Under this system economic growth across the Eurozone REQUIRES increasing private sector debt
The rules meant that, even with economic growth, it is impossible for the Eurozone as a whole to accumulate net financial assets. Some within the Eurozone can accumulate net assets but only if others become more indebted. Individual and businesses can accumulate profits but only if others borrow more to provide the source of these profits. Similarly countries that are net exporters within the Eurozone can stay in the black, but only at the expense of the net importer countries.
Another way of describing credit creation is that banks create money and equal amounts of debt. The money accumulates in the net exporter countries while the importers retain the debt. Such a system cannot continue for ever. Eventually the debts will become too great. And this has come to pass.
So what is to be done? The core of the problem is that a system which relies exclusively on commercial bank lending is vulnerable to financial collapse. As soon as growth stall and and confidence drops people stop borrowing and start saving and paying down their debts. This cause a drop in the money supply and demand and asset prices (which back up much of the debt). This leads to a recession which leads to further drops in confidence and reductions in spending and asset prices. A downward spiral continues until there is complete collapse. Even if those with the money step in to stand behind the debts of the indebted the problem is not solved. The entire system becomes insolvent.
It is critical to understand that what is happening is contraction of the money supply. Bank-created loans are paid paid off the money is eliminated. Economic activity, which depends on money, is thereby reduced. The only way to break this downward spiral is to introduce counter this contraction by introducing net financial assets into the economy through increases in government spending and/or decreases in taxes. In other words government must spend more into the economy than they extract through taxes - the essence of deficit spending. This must be supported by the ECB either through provision of debt free money to government's, or through them purchasing government bonds.
This will restore demand and thus growth and reduce unemployment. Most importantly, it will finally allow the aggregate private sector to save and pay off its huge debts. Everyone will be better off and the Euro would be saved.
Germany will see the drawback of this approach as being two fold. First the risk of inflation if money creation is excessive. Second, the moral hazard of providing both profligate governments with 'free money'. Regarding inflation I would argue that the risk is minimal and it would not be difficult to reduce any inflation by simply reversing the policy and tightening monetary policy. Regarding moral hazard I would argue that the approach that should be used is for the ECB to provide debt free money to Eurozone countries on a per capita basis. That would mean that everyone benefits to the same extent.
Importantly this will enable Germans to keep their hard earned savings while preserving the EU.
I believe that Germans (and other Eurozone citizens) would embrace this solution if it was offered to them. The tragedy is that it is not even being offered to them. ECB-supported deficit spending is not even on the agenda. That reflects the dreadful state of macroeconomic theory, for which academic economist are largely to blame.
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