A one-word explanation on why the eurozone cannot inflate its way out of trouble: Spain!

10/05/2012 by

So, Germany seems to have pushed the inflation-phobia monkey off its back. Its finance minister has condoned real wage rises for German industrial workers and the head of the Bundesbank has acknowledged a readiness to allow German inflation to outpace that of the rest of the eurozone. After fifteen years of violating the Maastricht agreement on the need to target the same rate of inflation (at around 2% – see here), Germany is now prepared to compensate the rest of the eurozone for the damage its deflationary strategy has caused.

This is, surely, a good thing, is it not? Yes and no. Yes, it shows that there is some hope that German policy makers will, at last, ‘get it’ that competitiveness is a relative (as opposed to an absolute) concept. And, No, allowing for above average inflation in Germany is too little and desperately too late to do anything about the Crisis we find ourselves in. Ironically, the head of the Bundesbank, Mr Weideman, has just published an article in the FT whose title gives the answer away: Monetary Policy is No Panacea for Europe. Indeed it is not. And the reason is… Spain. Or, to be more precise, Spain is an excellent case in point as to why a further easing of monetary policy, even if German wages are allowed to increase above inflationary expectations, will simply not do. Of why the rot has dug so deeply into the fabric of the eurozone that Eco101 macroeconomic remedies are neither here nor there.

Over the past two years, and following the Calamity that was 2008 in the global financial markets, Europe’s banks lost their capacity to reproduce themselves. Their zombification is nothing new. We have seen it before in Japan, as well as (to a lesser extent) in the US, in Britain etc. The difference in our eurozone case is that bank zombification came hand in hand with the steady erosion in the capacity of eurozone sovereigns to refinance their public debt. In effect, at least five countries (Greece, Ireland, Portugal, Spain and Italy) witnessed a triangular zombification involving a reliance of insolvent banks on insolvent states and a further reliance of the insolvent states on a Central Bank that lacks the tools to manage the insolvency of either the states or of the banks.

To put it simply, yes, Germany’s  ‘success’ at boosting its competitiveness by keeping its wage and price inflation well below the commonly agreed eurozone targets during the past 15 years has ensured that, when the Credit Crunch hit in 2008, the rest of the eurozone fell into a hole. However, this hole is now so deep that the rest of the eurozone cannot climb out by reversing the inflation dynamics within the eurozone. Now, we need something more drastic.

What is it that we need? The first thing that countries like Spain need is an urgent recapitalisation of its banks (see today’s FT article by Roubini and Greene) that does not increase Spanish public debt. This could be achieved very simply by having the various cajas taken over, and recapitalised, by the EFSF (with the EBA appointing new boards of directors). Just take the Spanish government out of the ‘banking game’. That way, the link that keeps reproducing the zombification-reinforcement mechanism linking banks and member-states ends immediately.

Why are the powers that be resisting this? Two reasons: First, as I have argued repeatedly, because the national elites are not ready to give up their extremely cosy relationship with the bankers. Secondly, because Spain’s insolvency (and Greece’s, Italy’s, etc.) is still seen by certain German policy makers as a golden opportunity to impose upon France (via the Periphery) their views on how things should be. You don’t need to take my word for this. Jens Weidemann said so in today’s FT piece (that I already quoted above):  “…relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act.”

So, here we have it: Spain is being screwed into the ground so as to, supposedly, impress upon it the ‘precarious state of its public finances’. What claptrap! Spain had a surplus in its budget in 2008 and has had a debt-to-GDP rate less than Germany’s. Behind Mr Weidmann’s subterfuge hides an unfathomable truth: Having gutted the rest of the eurozone for years, by squeezing German price and wage inflation below agreed limits, German policy makers are misrepresenting the cause of the Periphery’s woes. Rather than acknowledging the need to europeanise banking supervision, and a part of the eurozone’s public debt, they are offering trinkets in the form of an above average inflation rate. Why trinkets? Because, in view of the deflation that is coming to the deficit countries, having German inflation rise above average is as inevitable as it is useless.

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