Merkel under pressure as calls grow for sea change in economic thinking

CORRECTING the economic imbalances underlying the eurozone’s debt crisis will demand years of austerity from the likes of Italy and Spain.

It could also require a sea change in German economic thinking to accept stronger domestic demand and higher inflation.

Beyond the urgent steps needed to keep the eurozone together, countries on the bloc’s periphery face a daunting task to increase domestic productivity and restore external competitiveness lost since the launch of the single currency by bringing their unit labour costs down closer to German levels.

Before exchange rates were fixed with the creation of the euro in 1999, countries could devalue versus the deutschemark.

Now, the same shift in inflation-adjusted exchange rates must be engineered by an “internal devaluation”, keeping down prices so a country’s goods and services can compete with those of other eurozone members.

Latvia did that, but at the cost of the sharpest recession on record anywhere. Its economy shrank 25% in two years. Ireland is also rapidly regaining competitiveness thanks to wage discipline.

“The problem isn’t Greece or Italy — it’s Germany,” said one European policy adviser. “Adjustment is going to be harder as long as Germany remains mercantilist. Germany needs to have its surplus disciplined.”

Germany rejects the tag of mercantilism, which regards exports as good and imports as bad, and says its world-beating engineering companies should be emulated not excoriated.

But the crisis has nullified the assumption made by the architects of the euro, finalised in the Dutch town of Maastricht in 1991, that national current account imbalances would not matter within monetary union.

“This theory has failed. It was a big collective mistake not to have a balanced current account criterion in the Maastricht Treaty,” a central banking official said.

“We see now that the current account balance is an element of sovereign credit worthiness.”

Heiner Flassbeck, head of the globalisation and development strategies division at the United Nations Conference on Trade and Development, said the only solution was to let wages rise in northern Europe to spur consumer spending and bring costs closer in line with those in the south.

So new ECB president Mario Draghi should explain that if the goal is average eurozone inflation of close to 2%, that is consistent with inflation in Germany of 2.5% to 3%, one leading academic economist said.

A safe-haven flight into a shrunken euro with Germany at its core would send its exchange rate soaring, decimating the country’s exporters. The recent experience of Switzerland, which had to print money to cap the surging franc, provides a salutary lesson.

“I don’t think they could stand the shock,” an international economist said.

“There would be huge deflation and the Bundesbank would have to do something really radical in response. So they might as well do it now.”

If Germany were to relent, it would not be without precedent. Under pressure from the US, Germany agreed to play the role of economic locomotive at the 1978 Bonn G7 summit.

Inflation duly spurted to more than 6% by 1981 and, some say, cost former chancellor Helmut Schmidt his job.

That history lesson will not be lost on Angela Merkel. But the stakes today are immeasurably higher, both for Germany and the world economy.