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Richard KooEQUITY RESEARCH

German politicians and the eurocrisis

July 3, 2012

Last week, I had the opportunity to speak with a number of influential politicians,

academics, and senior government officials in Berlin. Talking with the politicians, all of

whom were members of parliament belonging to the ruling coalition, helped provide a

sense of what they believe in and also what they are worried about.

To begin with, my initial concerns proved unnecessary as they were surprisingly willing to

listen to the views of this Japan-based economist.

Unfortunately, we did not have as much time to talk as I would have likedthey were

understandably rushed since the Bundestag session responsible for making a final

decision on the European Stability Mechanism (ESM) was drawing to a close.

Germans believe structural reforms are essential for southern Europe

First of all, I was impressed by their firm beliefconviction might be the better termin the

need for structural reform in southern Europe.

There was a unanimously held belief that nothing will improve without extensive structural

reforms and that any aid provided in the absence of such reforms will do little more than

buy time.

One influential parliamentarian, for example, argued forcefully that Greece was not yet amodern nation-state and that it continued to operate under the ideas and systems of the

Byzantine and Ottoman empires. He felt this had to change before further aid could be

provided.

Greeces tax collection system was singled out for special criticism. The same politician

spoke of a Greek friend who tried to report to the local tax authorities that he had a pool at

his house but was told not to declare it since the paperwork was so troublesome.

Another individual remarked that many of Greeces democratic institutions are run on the

basis of personal and historical connections and that it was difficult to believe that elections

were decided on the basis of policy debate.

This comment prompted one person to note that Greece had been allowed into the euro

because it was the cradle of Western democracy, but todays Greece shared little with that

nation. He felt it had clearly been a mistake to let the country into the euro.

Another representative said that, regardless of what happens in the short term, Greece

should ultimately leave the eurozone, devalue its currency, and rebuild its economy to

restore competitiveness.

Some see progress in Greek wage and price adjustments

But one senior government official noted the possibility that both Greece and Ireland had

become significantly more competitive, citing sharp recent declines in Greek wages and

prices.

This officials view that things were moving largely in the right direction suggests that even

within the government there are conflicting opinions on Greece.

I said in my last report that the nations sharply contracting money supply meant it would

hardly be surprising if Greek wages and general prices were heading towards deflation. In

that sense, the competitiveness gap with Germany, where wages and general prices are

climbing, may be narrowing.

Richard Koo is chief economist at

Nomura Research Institute. This is hispersonal view.

Richard [email protected]

To receive this publication, pleasecontact your local Nomurarepresentative.

ee Appendix A-1 for importantisclosures. Analysts employed

y non US affiliates are notegistered or qualified asesearch analysts with FINRA inhe US.

Japanese version published on July2, 2012


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Conflicting views on approach to Spain and Portugal

Our views on the need for fiscal consolidation and structural reforms in Greece were largely in sync, as I do not think the country

is in a balance sheet recession. There was more room for disagreement on Spain and Portugal.

I argued that both countries are in balance sheet recessions and therefore require a special response in the form of fiscal

stimulus, whereas the Germans argued from start to finish that structural reforms were the only answer.

By structural reforms they were referring to the kinds of reforms that Germany itself had implemented from 2003 to 2005,

particularly pension reforms and other initiatives aimed at enhancing labor market flexibility. They emphasized repeatedly how

difficult those reforms had been for Germany.

Crisis necessary for structural reforms

These politicians were not even satisfied with the state of structural reforms in their own country, arguing that Germany still had

much work to do. But based on their experience of the difficulty of implementing these reforms, they believe firmly that this

represents a once-in-a-lifetime opportunity to pursue similar initiatives in southern Europe.

When Germany implemented its reforms around 2005, there was no time to waste because German businesses were moving

one factory after another to the low-wage countries of eastern Europe. Even so, they said there was tremendous political

opposition.

What they learned from this experience was that such reforms were possible only under crisis-like conditions. That experience

contributed to their view that the current economic crisis represented an excellent opportunity for fundamental reforms in

southern Europe.

Perfect opportunity?

In other words, Germanys own trying experiences around 2005 had convinced them that the unfolding crisis in southern Europe

represented a once-in-a-lifetime opportunity. Chancellor Angela Merkels tendency to talk about the need for structural reforms

whenever she has a chance is based on her own experience of the difficulty of implementing those reforms in Germany.

One member of parliament close to Ms. Merkel said the Chancellor is not opposed to fiscal stimulus itself but cannot accept

fiscal stimulus without structural reforms.

If one sees the crisis as an opportunity to force structural reform on southern Europe, the corollary is that the worse conditions

get, the greater the opportunity for reforms. In that sense, the Germans are unlikely to agree that deteriorating economic

conditions demand a change in policy direction.

I suspect Germany refuses to alter its stance despite the escalating euro crisis because of an unshaken belief that now is the

time for southern Europe to push ahead with the sorts of reforms that Germany implemented around 2005.

Southern European economies would have weakened much sooner if reform delays were to blameMy response was that while I was in total agreement on the need for structural reforms in these countries, the eurozones

current crisis was not caused by reform delays.

Economic conditions in southern Europe have deteriorated steadily over the past few years in spite of historically low interest

rates. Yet these countries previously enjoyed strong economies that responded in textbook fashion to low interest rates. I

argued that it was therefore unreasonable to blame the recent economic problems on delays in structural reforms.

If those delays were the true cause of the current economic malaise, southern European economies would have slumped long

ago, since the structural problems have existed for many years. But the economic weakness is only a recent phenomenon.

I added that a similar argumentthat structural reforms will cure all economic illshad been made in Japan a little over a

decade ago, but the reforms implemented by the Koizumi government did nothing for the economy.

I said that in Japan then, as in southern Europe today, structural reforms are indeed necessary. But the lack of reform is not why

these economies remain depressed in spite of zero interest rates. If the lack of reforms is not the cause of current crisis, theGerman push for reforms will not appear convincing for the people of the affected countries.

Balance sheet recession, not absence of reforms, responsible for southern Europes slump

If long-standing structural problems cannot explain why southern European economies suddenly stopped responding to

monetary accommodation, what can? I then talked about asset price bubbles and the balance sheet recessions that follow in

their wake.

While investors in the US, the UK, and Frankfurt now understand exactly what is meant by the term balance sheet recession,

awareness among politicians in Berlin remains spotty at best, and it took time to explain the concept.

I briefly discussed how asset prices plunge when an asset bubble bursts, leaving only the corresponding debt and prompting the

private sector to move en masse to minimize excessive debt. That leads to a destructive fallacy of composition and pushes the

economy into a deflationary spiral even though interest rates are at zero.


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This special kind of recession happens only once every several decades, but when it does the government needs to respond

with aggressive fiscal stimulus. Otherwise conditions will only get worseit is not a matter of the private sector toughing it out

until the economy turns around.

Eurozone suffers from both pneumonia and diabetes

While the Germans politely listened to my explanation of this new (for them) concept, they continued to insist the

competitiveness issue could not be resolved without structural reforms.

Ideally, I would have liked to explain the relationship between competitiveness and the money supply, as noted in my last report.

But I was speaking with people with limited time who were not necessarily trained in economics, and as a discussion of the

money supply would have required an understanding of the money multiplier, I gave the following example instead.

I said the eurozone was currently suffering from two diseasespneumonia and diabetesan analogy I drew on frequently in

Japan more than a decade ago.

Structural reforms are akin to a treatment for diabetes patients, who must eat carefully and exercise more to improve their long-

term physical condition.

A balance sheet recession, on the other hand, is more like pneumonia. If it is left untreated, the patients condition can

deteriorate rapidly. The patient can even die if proper treatment is not administered in the first three days.

These two illnesses sometimes occur simultaneously, which complicates matters because the treatments are in a sense

contradictory.

Diabetes sufferers must restrain their intake of food, while pneumonia patients can die without ample nourishment.

Eurozone should treat pneumonia first

When the two diseases occur together, the physician must give precedence to the pneumonia, which demands immediate

treatment. The diabetes can be left for later.

I added that regardless of what may be appropriate for Greece, where problems are due to previous governments fiscal

profligacy, insisting on austerity for Spain, Portugal, and Ireland is the wrong answer. It will only cause conditions to worsen.

This conclusion was utterly different from what my hosts had in mind, but I added two examples from Japan and the US: the

austerity policies implemented by the Hashimoto government in 1997 and Federal Reserve Chairman Ben Bernankes recent

warnings about the so-called fiscal cliff.

In the former case, the Hashimoto government chose to increase taxes and cut spending at a time when the private sector was

minimizing debt in spite of zero interest rates. The economy duly collapsed, sending the fiscal deficit from 22trn in 1996 to

38trn in 1999, an increase of 68%. It took Japan nearly a decade to bring the deficit back to its starting level.

In the latter case, the Fed chairman, who has demonstrated an understanding of the dangers of a balance sheet recession,

used the powerful metaphor of a cliff to warn Congress about the dangers of engaging in premature fiscal consolidation.

Finally, I noted that the Cameron government, which came to power in the UK on a platform of bold fiscal retrenchment, is now

seeking to change direction after watching the local economy behave in an entirely unexpected fashion.

Germans understand need to ease southern Europes pain

The German politiciansperhaps because they have been focusing exclusively on domestic and euro-related issues for the last

few monthslistened carefully to what I had to say about the situations in the US, Japan, and the UK.

I ultimately recommended that Germany support fiscal stimulus, not fiscal consolidation, in Spain, Portugal, and Ireland, which

face both balance sheet recessions and structural issues. Only after these patients recover from the first disease should they be

treated for the second.

The politicians seemed to understand what I was saying, with one remarking that sometimes a patient being treated for cancerneeds a shot of morphine.

In other words, if extreme pain prevents the patient from undergoing further treatment, the pain must be managed so that

treatment can continue.

German competitiveness gains not due solely to structural reforms

The problem here is German politicians view that the painful structural reforms carried out around 2005 were solely responsible

for the gains in German competitiveness and that it is inexcusable for southern European states that have not engaged in

similar reforms to come begging for help.

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Fig. 1: German balance of trade

Source: Deutsche Bundesbank

But as I noted in my previous report, much of Germanys newfound competitiveness can be explained by differences in money

supply growth with the rest of the eurozone. The domestic labor market reforms were also a major factor, but not the only one.

Evidence of this is offered by a breakdown of Germanys trade balance by region, which shows little change in the balance of

trade with North America or Asia from 2000 to 2008 while the trade surplus with other eurozone nations rose sharply (Exhibit 1).

If Germanys enhanced competitiveness were in fact the result of domestic structural reforms, the trade surplus should have

increased with respect to Asia and North America as well as the eurozone. But that did not happen.

Germans overestimate impact of their own structural reforms

I was unable to discuss this in my talks in Berlin because, as noted above, it involves the money multiplier and other issues

requiring a more-than-perfunctory knowledge of economics (although I did pass out copies of an essay discussing this point).

However, I sensed that German politicians overestimate the impact of the painful structural reforms carried out in the early years

of the 2000s. At the same time, they underestimate the impact of their balance sheet recession between 2000 to 2005.

After the IT bubble burst in 2000, Germany fell into a balance sheet recession and its money supply growth dropped sharply,

keeping prices and wages in check. The countries of southern Europe, meanwhile, were largely unscathed by the collapse of

the IT bubble, and their money supplies expanded in response to the ECBs low interest rates. Prices and wages rose

accordingly, putting them at a competitive disadvantage to Germany. The seriousness of the post-2000 German balance sheetrecession cannot be overemphasized. In response to the ECB bringing the policy rate down to a post-war low of 2.0% in 2003,

Spanish house prices shot up from 100 in 2000 to 207 by 2005, Irish prices shot up to 176, and Greek prices shot up to 166.

German house prices, on the other hand, fell to 92 by 2005.

In spite of such a large macroeconomic disparity between Germany and the rest of Europe, there is a broadly held belief within

Germany that the nations competitiveness gains are attributable entirely to structural reforms.

German labor market appears increasingly overheated

Several months ago the Bundesbank surprised the world by saying a rise in German wages would be acceptable, which stood

in sharp contrast to its legacy as an inflation fighter. The central bank may have recognized that to eliminate the competitive

disparities within the eurozone, a fall in southern European wages will have to be accompanied by a rise in German wages.

The German labor market has in fact become a sellers market, with companies fighting among themselves to attract talented

young engineers.

-4,000

-2,000

0

2,000

4,000

6,000

8,000

10,000

12,000

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

(mn, seasonally adjusted)

Eurozone

Asia

US

(yy)

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There has also been active immigration from southern Europe and Ireland, with inflows of job-seekers from countries like

Greece and Spain to Germany already exceeding 100,000.

The direction of money supply growth in Germany and southern Europe also reversed in 2008 when western housing bubbles

collapsed. The German money supply started expanding faster than that of the southern European countries. The ultra-low

interest rates introduced by the ECB in an attempt to help southern Europe were too lowfor the robust German economy, and

house prices there rose sharply for the first time in over a decade.

This implies that Germany is growing less competitive relative to southern Europe and that at some point the gap between the

two will close entirely.

Foreign capital inflows one reason for rising German property prices

While the phenomena described above all represent natural and necessary adjustments within the eurozone, there have also

been some potentially destabilizing developments.

One influential representative I spoke with said inflows of foreign capital were a major factor behind rising real estate prices in

Germany in general and Berlin in particular. He said Russia was the leading source of those funds, with wealthy Greeks ranking

second.

Russian fund inflows are attributable to that nations strong economy, which has been buoyed by rising oil prices. But the inflows

from Greece are driven by wealthy individuals buying up real estate in the much stronger German economy as a hedge against

an exit from the euro.

Their actions, meanwhile, are making it increasingly difficult for German politicians to approve a Greek bailout.

Most of the politicians were also aware that 10-year German government bond yields of less than 1.6%which are at leastpartly due to capital inflows from southern Europeare not healthy in an economy as strong as Germanys.

Politicians focus on southern European fiscal deficits but ignore increase in private savings

I also noticed that politicians were unaware that the private sectors of Spain, Portugal, and Ireland had become large net savers

in spite of near-zero interest rates.

They knew these countries were running large fiscal deficits and needed financial assistance from abroad, but were not aware

businesses and households in these countries were saving far more than they did just a few years ago at the peak of the bubble.

However, until it is understood (1) that the recession was caused by the private sectors unusual decision to deleverage in spite

of near-zero interest rates, and (2) that is also why fiscal deficits have increased as much as they have, it will be difficult for

policymakers to come to the conclusion that fiscal stimulus is the correct policy response.

In that sense, Ireland and the countries of southern Europe need to do more to publicize the fact that their economies now

exhibit the primary characteristic of a balance sheet recessiona substantial increase in private savings at a time of near-zerointerest rates.

Source of euro crisis: southern European savings flowing into German government bonds

Many also appeared somewhat surprised by my argument that the euro crisis was caused by a massive increase in Spanish

private savings and the investment of that savings in Germanrather than Spanishgovernment bonds.

I then discussed my proposal for preventing this kind of capital flight in the longer termfor an endgame, if you willa rule

prohibiting eurozone governments from selling debt to the citizens of other countries. Contrary to my expectations, only one

personan academic with close ties to the governmentrejected the proposal out of hand.

The politicians were at least willing to listen, which marks a change from a year ago, when the same proposal was rejected

pointblank. This made my job as presenter much easier, although that is not to say that everyone agreed with my analysis or my

proposal.

Policymakers likely to continue treating patient for diabetesTo sum up my impressions of Berlin, German politicians are starting to question the strongly held beliefs that have brought them

this far.

This marks a change from the situation just a year ago, when policymakers were still brimming with confidence. Some of them

even said last week that they needed to spend more time studying the experiences of Japan and other countries.

But at the same time they lack their American and British counterparts understanding of balance sheet recessions, and

rectifying this will take time. I therefore expect German policymakers will continue to focus on treating the patients diabetes

while largely ignoring his case of pneumonia.

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Appendix A-1

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