24 April 2013. Heiner Flassbeck knows it precisely, and he explained it to us in a public lecture he gave at the University of St.Gallen: the Eurozone is stuck in a currency crisis, and this crisis will result in the Eurozone breaking up in no later than five years. He can only see two possibilities. Either the southern countries leave the Eurozone and go back to their former currencies, which would then, of course, have to be strongly devalued, or the entire Eurozone will be plunged into a gigantic crisis. 

Flassbeck also knows why this will be the case: the euro will fail because German inflation has been too low ever since the introduction of the euro. In his view, Germany has not complied with the agreement that was linked to the introduction of the single currency: to let prices rise by an annual 2 per cent. This is why wage costs have increased much lesser in Germany than in the Eurozone’s southern countries, in particular, but also less than in France.

This has impaired the competitiveness of these countries. Since the traditional medium of devaluation was no longer available to them, this currency crisis was bound to occur. The financial and economic crisis of the last few years may have been the trigger, but not the cause of today’s currency crisis in the Eurozone.

Monetary makes devaluations impossible
This analysis is based on a fundamental conviction: the possibly not exclusive, but in any case dominating factor for price development is wages: in an economy unit labour costs and prices move almost in parallel. Monetary policy is not – or only marginally – responsible for price development.

Some points of this analysis are correct and not contested. One essential cause of the Eurozone crisis is indeed the differing development of unit labour costs and thus of the competitiveness of individual countries within the Eurozone. Traditionally, problems connected with such a crisis could be solved by devaluation, at least temporarily. Admittedly, in a monetary union this possibility is no option any longer.

Internal devaluation, i.e. reducing all wages and prices (or at least as many as possible), however, is much more painful than devaluation of one’s own currency. This is manifest in Greece and Spain today. There is indeed something explosive here, and if a controlled exit were possible, this would be an option for these countries that would have to be considered seriously.

Will we be surprised by retained inflation?
It is also correct to say that monetary policy alone is not capable of explaining all price developments. Since the Eurozone countries are jointly subject to the monetary policy of the European Central Bank (ECB), the average price development may be determined by ECB policy, but it is not responsible for the differences between the price developments of these countries. Moreover, the strong expansion of the (narrowly defined) money supply, consisting of cash and demand deposits, has not had an impact on price development so far.

To infer from this that monetary policy has no effect on price development at all, however, is at least rash. For one thing, we know from the past that a too expansive monetary policy boosts inflation. Swiss inflation in the early 1990s was not triggered by high wage increases, but essentially by the fact that the National Bank underestimated the impact of the introduction of the electronic bank clearing system SIC on the reserves held by banks. Thus, monetary policy in 1988 and 1989 was (unintentionally) very expansive, which resulted in strong price rises in the following years. Secondly, it is uncontested that hyperinflation is inconceivable without an enormous expansion of the money supply. And finally, we still do not know whether we will not be surprised by retained inflation after a while when the economic situation will have been improved.

Germany adhered to the inflation target
Blaming Germany is also problematic. For one thing, the ECB’s inflation target is not exactly 2 per cent; the rate of inflation should not be above, preferably below, but close to, 2 per cent. If we look at price development in Germany since the introduction of the monetary union, then (according to the data provided by the German Bundesbank) consumer prices have increased by an average of 1.6 per cent and producer prices by an average of 2.3 per cent per annum. Thus producer prices, which primarily reflect wage increases, have risen even more strongly than intended. If we take the Eurostat data, the average German inflation rate between 2001 and 2008, i.e. until the outbreak of the crisis, amounted to an annual 1.9 per cent, whereas in Greece and Spain the figures were 3.5 per cent and 3.1 per cent, respectively. According to these figures, it was obviously not Germany that failed to comply with the inflation target.

Flassbeck sees only one way of averting the expected disaster: wages, and thus prices, would have to increase strongly in Germany. He himself concedes, however, that this is not very realistic. Even if he himself believes that this could be politically imposed, it remains open how this should happen in a country in which wages are still very largely fixed by the social partners. Above and beyond this it must be taken into account that Germany, which only ten years ago was deemed to be the Sick Man of Europe, is highly unlikely to recklessly jeopardise the progress it made through the reforms of the second Schröder government, in particular.

Exit from the Eurozone – but how?
By way of an alternative, Flassbeck demands a controlled exit of the crisis countries from the Eurozone, yet he is stuck for an answer as to exactly how this should be brought about. Thus the conclusion is that one is able to agree with substantial parts of his analysis but has to contradict him in other areas, and that as far as the solution to the problem is concerned, there are still only two likely options: Either the internal devaluations, painful though they may be, will result in a situation whereby the unit labour costs in the various countries will converge, or someone will yet have a brilliant idea as to how a controlled exit from the Eurozone could be organised. Thus, the – rather sobering – conclusion from this lecture is that the crisis will continue for a considerable time to come and that we still have not found a simple solution.

Photo: Photocase / Text: © Gebhard Kirchgässner