Monday, 15 December 2014

Why Germany is right to "hold Europe ransom"

As I've stated in an earlier post, my recent trip to Germany has been full of positive experiences. Most importantly I gained insight into why Germany (i.e. its formal institutions) feels so strongly about the agenda for structural reforms and why it opposes any alternatives, particularly looser monetary policy and the idea that Germany should stimulate its economy to raise European aggregate demand.

A country that was once called the "Sick man of Europe", was the first to undergo painful reforms. Back in 2003 they started with preparation and implementation of the so-called Agenda 2010, which I covered on several occasions in the blog (see here or here). The Agenda carried a series of reforms, but the most notable and important ones were the labor market reforms (i.e. Hartz reforms), because of which Germany was able to cushion the blow of the 2008/09 crisis. Germany had the lowest increase in unemployment (virtually none) of all European countries during the crisis. 

The labor market reforms necessitated a joint approach from all sides, so the negotiations that started in 2003 included the federal government, businesses, unions, parliamentary representatives (i.e. all political parties) and even scientists. The centerpiece of the labor market reform was to curb the power of unions and craft guilds, making it easier for the young to enter the market, while contributing to the labor market flexibilization. The unemployment benefits were cut (a German can draw unemployment benefits only around half as long as an American), tax reliefs were introduced to those hiring, in addition to a whole set of marginal but important measures. The initial reaction was, as always, a shock. Unemployment increased as businesses started optimizing their labor intake (and hence firing more), coupled with dissatisfaction among the unions and guilds which in the end cost Chancellor Schroeder the elections. But the system was reformed. And it was precisely because of these reforms that Germany weathered the crisis much better than any other country in Europe. 

Leading by example: a balanced budget 

And once again Germany is leading the way in showing how to get out of the mess of unsustainable debt and sluggish growth. It is leading by example - next fiscal year Germany will have a balanced budget for the first time in decades. According to the debt projections, labor market trends and most importantly demographic trends (an ageing population), cutting debt is essential. An old population overburdened with debt is no promising future. Which is precisely why the number one priority of the government at this moment is to cut debt. How does one do that? "Easy", start by balancing your budget. The figures below show a strong statement of intent: Germany intends to have a budget surplus until the debt-to-GDP level is cut down to the Maastricht ratio of 60%. According to the existing projections, Germany will achieve this in 2018, so in only four years! Take note Eurozone periphery, this is what proper austerity looks like: 

Source: Federal Ministry of Finance
Source: Federal Ministry of Finance
Will this affect their GDP growth? Most surely. Growth will remain to be low at around 1 to 2% in the next few years, but just like in 2003, the system needs to be changed. And in this case the system needs a debt decrease. The opportunity cost of a temporary slowdown is low enough to justify the austerity approach applied by the Germans.

Criticism from the EU

However this zero deficit approach generates fierce criticism across the EU. Many have stated that Germany should continue to pile up debt to keep aggregate demand in Europe higher. They blame Germany on "holding Europe ransom" by forcing them into austerity without providing any relief. Germany should, according to the critics, provide more fiscal stimuli into Europe (indirectly of course) to help the rest recover as quickly as Germany did. However the German logic makes more sense. Germany is not in a recession (contraction) so it sees no point in applying the classical counter-cyclical solutions such as large spending hikes. Instead they opt for encouraging private investments instead of large public investments. This is best done with measures such as capital gains tax write-offs, lower corporate taxes, lower income taxes and other regulatory and non-regulatory (legal) measures aimed at helping businesses grow (see here a short guide for attracting foreign investments). Attracting private investments is the right approach, everything else in a state of unsustainable debt is wrong. FYI, private investments in Germany consist of 17% of its GDP, whereas public ones consists of only 1.8%. 

Germany has its own problems it needs to take care of. As mentioned, with an ageing population large public debt becomes a big problem. Not now, but in the near future. And Germany wants to address this issue immediately, not wait until it's too late. 

Furthermore the rest of Europe isn't far away from the German problem. They too are overburdened with debt, and Europe in general is ageing. Demanding large stimuli and further indebtedness is self-defeating, particularly in the long run, which isn't so far away. Even in the short run it won't cause the effect it is supposed to. Why? Because the private sector deleveraging in Europe as well. Two IMF economists show why this is a drag on growth particularly if all three major sectors of the economy (government, households and corporates) have high debt levels:

Source: VoxEU
The other reason is lack of lending. Banks are safe (according to the latest ECB stress test), but still unwilling to lend. And then we reach monetary policy. Critics of the ECB (and hence the Bundesbank) call for looser monetary policy, i.e. for a more expansionary approach. According to this argument it would be best to simultaneously apply both expansionary monetary policy and an expansionary fiscal policy to raise European aggregate demand. And then do the reforms, which everyone agrees are necessary. 

Where have I seen this approach fail most recently? Oh, that's right, Abenomics, the policy package of Japanese PM Shinzo Abe aimed at finally pulling Japan out of a 20-year-long stagnation. It's not so wise however to use the same policies that have failed consistently for 20 years and then hoping that suddenly they will make a difference. Even if applied simultaneously

Europe tries to do the same thing. Avoid a painful solution and provide persistent short-term stimuli, hoping that at one point they will make it. Economics doesn't work that way unfortunately. Not when there's so many structural unbalances as they are today in Europe (and Japan). Which is why, in my honest opinion, Germany holds the key to Europe's success. Leading by example in balancing their budget, while forcing structural reforms upon other nations is the only way to go for Europe. Everything else leaves them in a state of Japanese-style decades-long stagnation.


Addendum: One of the most commendable things about Germany's economic policies is the continued increase of investment in education. Despite the crisis and the (brief) recovery period, Germany increased spending on education from 3% to GDP before the crisis to almost 5% to GDP in 2014. This will be increasing even more, as the Germans have recognized where the foundations for long-run growth lie in (see here for greater detail). 
Source: Federal Ministry of Finance

Sunday, 7 December 2014

The German Social market economy

I've spent the entire last week in Germany, as a part of a delegation of Croatian economists and economic experts, organized by the Konrad Adenauer Stiftung (KAS). The idea was to visit the main economic and political institutions in Germany and open a dialogue on the problems facing Croatia, but primarily to learn about the experiences of the German solutions/responses to the crisis through the conceptual framework of their Social market economy (i.e. the German ordoliberalism). We have visited a series of institutions, starting with the Bundesbank and the ECB in Frankfurt, and ending with the Ministries of Finance, Economy and Energy, Labour and Social Affairs, and even the Office of the Chancellor, all in Berlin. In the middle we visited a series of other noteworthy institutions like BaFin (the regulator of financial services), the Council of Economic Experts, DIW institute, the banking association, a few members of parliament and so on. I plan to write a separate post on some of the main outtakes of the trip, with emphasis on how the Germans see their role in Eurozone, opposed to how the rest of Europe sees it. And rightly so. Before I descend into commenting the actual state of the German economy, I would like to extend a few thoughts on their "unique" idea of the so-called Social market economy. 

But first a little bit about the trip initiators and organizers, the Konrad Adenauer Stiftung. KAS is a political foundation (stiftung means foundation), associated with but independent of the German center-right party CDU which currently holds power in Germany. The idea of the Stiftung is to promote the ideas of freedom, liberty, peace and justice, democratic consolidation, and development, mainly through their civic education programs, but also to provide a basis for political action, all around the world. A similar institution to KAS is a foundation called Friedrich Ebert Stiftung (FES) aligned with the social democratic SPD. Both of these political foundations act as a sort of a shadow embassy outside of Germany, that connect their own parties (parties they're aligned with) with the opposition and in-office party of the country they reside in. In addition to this role, they both act to promote the civil society. KAS has offices in more than 120 countries worldwide, and thus serves a foreign policy role as well. For example they had an important role in the reconciliation and partnership between Germany and Israel, a relationship previously rebuilt by the Chancellor whose name the foundation carries - Konrad Adenauer. Rebuilding this relationship was crucial for Germany after WWII, and was the final step towards designing a new German society, one based on strong institutions, competition and democracy. Or in other words - ordoliberalism. 

Social Market Economy

So what is the Social market economy (in German: Soziale Marktwirtschaft)? According to the prevalent German interpretation it represents a type of market capitalism combined with policies promoting social insurance (protection for the poor, unemployed, health benefits, etc.). It is based on the idea that markets must be in the center, coordinating the economy (prices), while market participants must be constrained by strong and enforceable institutional rules. It is a system based on competition, order, and most of all on setting a clear institutional framework in which the market actors must participate.

Germans are proud of this model, introduced by the great Ludwig Erhard (pictured) back in 1949, who was then a Minister of the Economy, under Chancellor Konrad Adenauer. Erhard was the Economy minister for the entire duration of Adenauer's Chancellorship (14 years, from 1949 to 1963), and succeeded him as the next Chancellor from 1963 to 1966. He is widely lauded as the creator of the Social market economy, presented at the time as the compromising "Third way", something between the laissez faire Anglo-Saxon liberal capitalism (which was still, in the mind of the Germans, to blame for the Great Depression of the 1930s), and the communist central planning system (introduced during the Weimar Republic and fully applied during National Socialism). Germany needed something new at the time, an idea that transcends the fallen ideologies of the past. It needed, for the first time in its history, to apply a truly capitalist, market democracy.

That's why the model was so successful. From 1949, Germany, for the first time in its history, has introduced a democratic system with a market economy. The term most usually related to Erhard and this initial period of German democratic consolidation is the German economic miracle, which has in the 1960s and 1970s crated an economic powerhouse that Germany is today. It didn't start without problems however. In the begining, after the destruction of the Second World War, Germany was under occupation and under price controls and rationing. Housing was destroyed, industrial production as well, food production halved, inflation was an open threat yet again, and a lot of male population died in the war. The task seemed impossible, particularly due to the country being split in half and the animosity arising among its occupiers. But Erhard was stubborn enough to push through his reform despite the fact that many opposed it at the time. Even the allies weren't sure of his ideas. But he abolished the price controls and rationing of food, he limited monopoly power by introducing antitrust laws, reduced marginal tax rates (from 95% to 18% marginal rate), introduced a new currency reform to bring back price stability (and eventually turn the German Mark into the strongest currency in Europe). All the reforms came as an initial shocks, particularly the contraction of the money supply, but the stage was set for Germany to take flight. Literary overnight the country came to life. 

One might ask how is this economic model any different from the one applied in most of Europe today? A market economy with a welfare state - that's what Europe basically is. Some are more successful at it (Germany, Scandinavia, even the UK), while some are less (France, Italy, Spain) - relatively speaking. Who is to say the UK isn't based on the very same principles, even during the Thatcher era? A strong market-based economy, which has a notable social category. The difference here is not so much Germany vs rest of Europe, as it is Germany vs the United States. However the difference here is also in the margins. The US has something called cut-throat capitalism which fosters huge innovation and a keen trial and error process, while Germany (as well as the rest of Europe) has cuddly capitalism, which also innovates but to a lesser extent primarily due to a more lenient trial and error process. (These terms are used by Daron Acemoglu in a very interesting paper he co-authored with Robinson and Verdier, and which raised quite a discussion back when it's working paper version was published).  In Germany for example if you start a business and fail once, you don't dare repeating the same mistake again. In the US it is quite common to start over 4 or 5 times before finding the right recipe for success. After all Merkel recently expressed concern that there is no German Google or German Facebook. There is a reason why this is so, and why those kind of companies originate in the US, not in Europe. Which is not to say one system is better than the other. Both have their strengths, but both have weaknesses as well. The US exhibits higher levels of inequality because of this (even if we look at it historically), but due to its entrepreneurial spirit it has a much shorter time span for recovery and a much quicker response time than Europe. 

Overall, the German success is a unique story, but it's not a unique economic system. It is a market democracy with strong institutions. As easy as this sounds, for many countries there's still a long way to achieve it. 

Thursday, 27 November 2014

Two faces of modern entrepreneurship

The Atlantic had a very interesting recent text on the "Mysterious Death of Entrepreneurship in America" where they tell the tale two breads of entrepreneurs, one thriving and the other one hopelessly failing. At the same time when Silicon Valley entrepreneurs are soaring, the smartphone app market is booming, pages like Kickstarter are redefining the the very supply and demand for funding (providing a very interesting alternative to all sorts of traditional lending schemes), but on the other hand business dynamism overall is declining. Mom and Pop stores are dying out. BLS has the data: 

Brookings has produced a study describing the very same process of entrepreneurial decline, where the declining business dynamism is obvious across all sectors of the economy. As I've written before, the process of creative destruction in the US has halted in the past years. And why is this worrisome? Because of the effect on job creation. No longer are US SMEs the key driving force of new employment. 

This could be down to several reasons. One is surely the effect of the recession, even though the trends of declining business dynamism go all the way back to the 1990s (see further data here). Another could be the fact that the big companies are expanding more and more and are thus simply taking up more space in the corporate game, successfully running the small stores out of business. These big companies are usually not the source of major job creation (see the final graph), since they tend to expand abroad after reaching a certain size, where they focus much of their new job creation. This is why historically the domestic job growth in countries like the US has always originated from SMEs. Which is also why Americans like start-ups and small businesses. This is the famous US entrepreneurial spirit: 
"One paradox of globalization is that it's localized employment. Since big companies off-shore much of their job growth (or replace what's left of it with software or smart hardware), the future of work in the U.S. will come from work that absolutely has to be here, like health care, education, and food services. Start-ups can be special for many reasons—they can challenge lumbering incumbents, they can create new demand for stuff, they can introduce more ideas—but from a big-picture macroeconomic standpoint, they're also special because they're here, and when they expand they tend to expand here. It's easy to make fun of Silicon Valley these days. But at least its companies have a California address."
All in all, the declining trend of entrepreneurship is something to be worried about. It explains well why the US employment population ratio is still low, meaning that the US labor market hasn't really recovered (despite a low unemployment rate - I've mentioned this distinction several times on the blog). Furthermore all this could simply be pointing out to a new equilibrium for the US (Europe as well), where creative destruction has slowed down. The question is why? If it's a short-term consequence of the crisis, then a decade or so later we might see a reverse in trend. However, if it has slowed down due to structural instabilities and what Fukuyama refers to as political decay (I recommend his new book; read an excerpt from the book at Foreign Affairs), then the problem is extremely deep and it will take unprecedented effort to fix it. 

Tuesday, 11 November 2014

Graph of the week: A country divided

This weekend Germans celebrated the 25th anniversary of the fall of the Berlin Wall. A symbolic event that represented the end of an era (both the Cold War and communism in Eastern Europe were finally over); followed by a stream of euphoria and triumphalism from all sides. Looking back, 25 years later, some might say that the euphoria was misplaced: the world yet again resembles a Cold War status quo, where old foes are once again flexing their muscles in foreign territories. On the economic side, some Eastern European countries are arguably better off than before, while others remain in shambles of a failed transition. 

In Germany, at first sight the convergence wasn't as successful as initially hoped. 25 years later the western Germans are still living better than their eastern compatriots. GDP p/c in east Germany is still 2/3 of that in the west, unemployment is higher, its demographics is worse, and net migration is still positive from east to west, leaving many eastern rural areas scarcely populated. Looking at the images below, the eastern part of Germany suffers from the same 'illnesses' as all former communist countries (particularly those of a failed transition). This once again shows, more clearly than anything else, a natural experiment of history where one nation with the same history, culture and climate, divided by two different institutional system, generated two very different outcomes: one is prosperous and happy, the other (in relative terms) poor and miserable. 

Source: Washington Post
But let's not be too harsh. This divide in Germany isn't all that different than the north-south divide in Italy, Britain (where the south is better off), or the US. In socio-economic terms particularly. Every nation has within-country regional inequalities, where one part of the country is worse off (better off) than its most (least) successful region. In Germany the most successful region is probably Bavaria, so in comparison east Germany looks particularly bad. But that is no different than e.g. Lombardia vs Calabria in Italy, or South East and the Greater London area vs Yorkshire and North East in Britain. In each case the richest region is twice as rich as the poorest. In Germany however the divide carries an unavoidable cultural paradigm as well. 

For example consider the following two maps:

On the right side we have the share of foreigners in the total population, while on the other the relative success of the extremist NPD (Nazi) party. (I already discussed the electoral divisions along the Berlin Wall in the city, where the eastern part of the city voted highly in favor of the socialist party - not the social democratic SPD, but the successor of the former socialist party that ruled DDR - while the west of Berlin overwhelmingly supported Merkel's CDU). Anyway what is most interesting here is how the extremists (obviously highly opposing immigration) win in areas where there are very few foreigners to begin with! Perhaps in one way it makes sense - they fear that what they don't know. But I'll leave that discussion for another time. 

Saturday, 8 November 2014

In memoriam: Gordon Tullock

More than a decade after Mancur Olson, and almost two years after James Buchanan and Elinor Ostrom, another champion of public choice theory has passed away, at the modest age of 92. Gordon Tullock, together with James Buchanan (both pictured below), founded the public choice school of economics, or as they saw it "the theory of politics without romance". Their legacy still remains the single most influential theory that explains how politics interacts with economics, and how one cannot fully grasp all the economic phenomena and outcomes without understanding the logic of politics.

This is Tullock's (and Buchanan's) by far the biggest contribution to economics and even more so to political science. They taught us that politicians should be modeled and observed the same way market agents are modeled and observed; driven by self-interest and self-preservation. Before public choice theory governments were always modeled exogenously as a 'social planner' that unambiguously and without any negative effect corrects for market failures. It was basically the "deus ex machina" of the market system. Public choice theory and its numerous scholars to date exposed this as nonsense. Politicians and bureaucrats are people too, they too suffer from the same biases, lack of knowledge (informational asymmetry), and self-interest as do market agents. They get captured by well-organized interest groups, they focus on short-term goals aimed at securing re-election, they engage in corruption, and they seldom care of the public interest. This is why public choice theory necessitates the use of institutional and constitutional restraints on human behavior. The 'rules of the game' must be tilted in favor of the markets, not in favor of the expanding power of politicians and bureaucrats. The foundation of public choice theory was laid out in their most influential book, "The Calculus of Consent". I highly recommend it to all my readers. 
The founders of public choice theory: James Buchanan (left)
and Gordon Tullock (right)
Tullock was much more focused on the political aspect of the story. He studied the transaction costs of the political process just like Coase studied the transaction costs of firms. The biggest of such costs is rent-seeking, a term he didn't himself devise (Anne Krueger coined the phrase in 1974), but his 1967 paper "The welfare costs of tariffs, monopolies and theft" remains the single most influential paper on rent-seeking to date. Rent-seeking is a process of gaining private benefits through the political process (by lobbying or logrolling for example). It implies gaining protection for a certain privileged group, which in return promises political support, large campaign contributions, and even bribes. This protection varies from giving a monopoly status to a certain company, regulating market entry than hampers competition (such as introducing licences to specific occupations), imposing tariffs to import goods to protect the domestic industry, handing out subsidies to politically chosen "winners"; etc. Rent-seeking most precisely paints the picture of how politicians, when they follow their self-preservation incentives, create outcomes that reward special interests, very often at a huge cost to the 'public interest'. 

However Tullock also noticed that even though lobbying for political favors generates high returns to those who lobby, the actual lobbying expenditures are relatively low. This is called the Tullock paradox. The issue is why is there so little money in politics (here's a great paper on that topic btw), and why there isn't even more corruption than what we partially observe? One possible explanation is that voters simply don't like the sight of corruption, which makes politicians and lobbyists careful, and subject to restraints. The threat of punishment by the voters is very strong. My research focuses on finding the cut-off level of corruption (rent-extraction) - the optimal point - a politician needs to respect (balance) in order to maximize his/her stay in power. But this is just one of the possible explanations of the paradox, see this video for more. 

What is most interesting about Gordon Tullock is that he never got any degree in economics, and took only one economics class during his studies of law at the University of Chicago (he was also educated at Yale and Cornell, and received an honorary PhD from Chicago, but none of it in economics). Otherwise he was self-taught. And as a self-taught economist he was considered a close candidate for the Nobel prize in economics (together with Buchanan). That serves to tell you how brilliant of a scholar he really was. Rest in piece professor Tullock. 

His most important contributions are available in a 10 book series (The Selected Works of Gordon Tullock) published by the Liberty Fund:
  • volume 1 Virginia Political Economy
  • volume 2 The Calculus of Consent: Logical Foundations of Constitutional Democracy (with James M. Buchanan)
  • volume 3 The Organization of Inquiry
  • volume 4 The Economics of Politics
  • volume 5 The Rent-Seeking Society
  • volume 6 Bureaucracy
  • volume 7 The Economics and Politics of Wealth Redistribution
  • volume 8 The Social Dilemma: Of Autocracy, Revolution, Coup d’Etat, and War
  • volume 9 Law and Economics
  • volume 10 Economics without Frontiers