Monday, March 10, 2003

Germany: All Bets Are Off

Stephen Roach lambasts the bureaucrats at the ECB for their inability to respond in kind to the magnitude of the problem which faces them. But as he says when deflationary pressures arise in the eurozones biggest economy, then all bets may be of. That is, the one size fits all policy may need to be adapted to give priority to Germany's special needs: as anyone who has read my last two posts will already know, I wholeheartedly agree. However I don't think anyone is likely to be willing to listen. There's too much political cudos at stake, and the inflation 'sinners' would complain like hell.

But there’s an added wrinkle to Europe’s conundrum. Germany, its largest economy, is probably already in recession. Unfortunately, Germany has entered this recession with only a 1% inflation rate, implying that it wouldn’t take much of a contraction to tip fully one-third of the Euroland economy into deflation. Yet there doesn’t seem to be much leeway in the rigid EMU policy framework to give Germany special treatment. That’s precisely the problem. For a nation whose current structural dilemma goes back to the uneconomic terms of German reunification in 1990 — a one-for-one exchange rate between the high-productivity West and the low-productivity East — some policy flexibility is essential. Yet focused on backward looking gauges of pan-European inflation that were still flashing an estimated 2.3% y-o-y increase in February 2003, the ECB’s latest incremental move suggests that it remains wedded to its formulistic approach of targeting price stability in the 0 to 2% zone.

Therein could lie Europe’s biggest pitfall. From the start, the European Monetary Union has been framed around the “one size fits all” credo. In other words, what’s good for Europe is presumed to be good for Germany. This approach may work fine under most circumstances. But when deflationary pressures emerge in the largest economy in the region, all bets could be off. At such extremes, Germany’s dominant share in the Euroland economy may well require precisely the special treatment that the ECB refuses to offer. To do otherwise may well risk a contagion of German deflation quickly to the rest of the region. Consequently, in an effort to set policies for the region as a whole, the ECB may be neglecting not only the biggest link in the chain, but also the weakest. To be sure, the outcome is hardly known with precision. But the risks of a German-led deflation in Europe are now rising. In my view, incrementalism under those circumstances may well be a recipe for disaster.
Source: Morgan Stanley Global Economic Forum

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