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Germany is in recession and on the verge of deflation. It can be argued that this state is connected with the introduction of the common European currency.

The public in 12 out of 15 EU states gave credence to the politicians who promised that the introduction of the euro would contribute to higher economic growth, lower unemployment and that it would bring monetary stability to all European countries. As former German finance minister Theo Waigel noted in 1997, "Increasing economic growth and decreasing unemployment is very important for Germany today. More than four million unemployed Germans ... are not an anonymous mass. ... Therefore we struggle for the creation of economic and monetary union, which guarantees more economic success, more investments, and thus better protective mechanism against unemployment."[1] Today Germany has four and a half million jobless people and the poor economic growth turned into a slump.

German recession is often connected to the phenomenon of deflation. Although the average rate of inflation in the eurozone is 2 per cent, it differs among its individual countries. Fast-growing Ireland has higher inflation than prior to the euro, and the stagnating Germany is on the verge of deflation (see Chart 8). Such divergent effects are caused by the economic diversity of the European monetary union.

Chart 8: Inflation in the Eurozone

Source: Eurostat

A country that gives up its own currency for the euro loses the exchange rate as a natural tool balancing the flows of money between the domestic economy and other countries, so that the amount of money in the economy becomes an uncontrollable quantity. Any increase in exports or investment inflow translates into an increase in the amount of money in the economy, and each decrease in exports or outflow of capital within a currency area leads to a lower volume of currency. When the volume of money is growing, prices tend to reflect it flexibly by moving upwards, which has been the case of the Irish inflation. When the monetary stock decreases, the lower aggregate demand is often reflected by a decrease in production due to the downward inelasticity of certain prices, which has been the case of the German recession.

Such as each tide in a sea, increasing the level on one side, is accompanied by an ebb decreasing the level on another side of the sea, similarly each flow of capital from one to another part of the eurozone increases the level of prices in one part and decreases the level of prices in another part of the eurozone.

When the German export lobby pushed for the launch of the euro a few years ago, it hoped that the coverage of weaker economies of Southern Europe would contribute to the depreciation of the single currency, with a weaker euro boosting German exports. But today the German economy is paying the price of the euro introduction. If the stagnating German economy could use the mark today, the mark would have depreciated and would have helped to bring Germany back to the growth track. The relatively fast economic growth of Spain, Greece or Ireland hinders the depreciation of the euro, which would be so beneficial for the German economy today.

Such divergent effects are caused by the economic diversity of the European monetary union, in full accordance with the theory of optimal currency areas. Excessive inflation or unemployment is a standard side effect of any monetary integration of heterogeneous economies.

After the reunification of Germany, some one million people have moved from the East to the West. Germany was homogeneous enough to enable such a huge shift of the labour force. Now when whole Germany is in recession no million-men shift takes place. So if the labour mobility in Europe is insufficient, then one can claim that it was a mistake to unify European currencies.

Of course, that no currency area is optimal. Then fiscal transfers can offset the insufficient labour mobility. If the shifts of the labour force are not to cope with a recession in some regions then fiscal transfers can work in lieu of the insufficient labour mobility. In other words, a common currency can work also within an area which is not an optimum currency area provided that there is a political will to allow fiscal transfers. Such a will usually exists in national states but is hardly supposed to be in supranational entities. Unlike the nation states the EU has not the economic-policy instrument, the fiscal policy, at its disposal. The European union has a common currency, but lacks the common fiscal policy.

When European politicians admitted that there would be such a crises some day, they did not expect that rich Germany would be affected first. The problem is that Germany can hardly expect that countries with lower GDP per head would help Germany with fiscal transfers. It was assumed that poor countries might be affected first. If it is difficult to advocate supranational transfers from the rich to the poor countries, how difficult would be to advocate transfers from the poor to the rich countries of the eurozone?

In addition of that, not only that Germany cannot expect transfers from the other members of the eurozone, but it will even systematically send money to others which will even deepen the problem. Instead of transfers coming to Germany to offset the private capital outflows, the fiscal transfers leave Germany together with the escaping private capital.

Fiscal ebbs due to a fiscal fine. The European Growth and Stability Pact requires that a country with a fiscal deficit higher than 3 % of GDP paid fines to the common budget. If Germany had to pay the sanctions for non complying the European fiscal rules this would have not only negative budgetary but also negative monetary consequences for Germany: Another outflow of money from the country would only deepen the deflation crises. The European monetary union found itself in a trap: It must enforce rules because otherwise some countries could behave as free-riders while the others would pay for the irresponsibility of their neighbours through higher interest rates and through higher inflation rates. Now it seems that the Irish or the Finns pay the inflation tax into the German budget. Recently the Germans and the French outvoted the sanctions in the European Council so it seems that the Growth and Stability Pact, arranged to secure at least elementary fiscal discipline, is dead.

Germany is net contributor to the structural funds. There is a systemic outflow of money from Germany anyway. Even without paying fines, each year about 0,6 % of GDP goes from Germany to poorer European countries through the European budget, as Germany is a net contributor to it. As there is the single currency, the German money stock shrinks every year anyway. Germany pays about 7 billion euros through the EU especially to the Irish, Greeks, Portuguese and Spaniards.

Money transfers upon the ECB by-laws. Monetary integration had another unintended fiscal consequence. National central banks send receipts derived from the government bonds to the European Central Bank. Formerly these interest payments had gone to national budgets in the form of the central banks’ profits. Today this money is redistributed in the European System of Central Banks and Germany loses billions of euros each year.

From the three above reasons it is clear that Germany systematically pays (a logic that the rich should pay to the poor) instead of receiving European fiscal transfers (a logic that countries in recession should receive help). Paradoxically Germany supports those European countries which are in boom. It seems to be out of a discussion that this might reverse.

If Germany had its own Mark, it would depreciate in reaction to German recession, both against the dollar and against the other European currencies. Cheaper Mark would encourage German exports and foreign investments. Such a depreciation would help Germany to cope with the recession. This is not possible today, as Germany has its own currency any more. On top of that Germany systematically subsidises these countries. The result is that money in circulation shrinks, which adds to the deflation and recession.

There are several possible solutions of German problems.

1. First, what would help Germany is such a change in the monetary policy of the European Central Bank that would result in higher average inflation, which is now at 2 per cent. This could be achieved only at the cost of even higher inflation in those countries that have high inflation now, such as Ireland. The low inflation target of 2 per cent means that some regions can easily fall into deflation accompanied with recession, which is the case of Germany now. In general, we can say that the more the economic development varies in different regions of a currency area, the higher the average inflation rate must be in order to prevent the single currency from causing deflation or recession in some of the regions.

As a result, we often hear about the need to ease the inflation goal of the European Central Bank. If this happens, under pressure from Germany, the hallowed independence of the European Central Bank will die sooner than anybody would have expected.

2. Second solution would be cutting fiscal transfers from Germany to other European states. The European rules do not allow cutting transfers unilaterally. However recently Germany together with Netherlands and other net contributors to the EU budget voted in the European Parliament for a record low contribution for the fiscal year 2004 set under 1 % of GDP (the ceiling is 1,27 % of GDP) and sent a letter to the European Commission with a proposal to cut even the ceiling for the years beginning 2007.

3. Third, Germans can do nothing and wait for a natural recovery. Economy is a dynamic organism that receives impulses unexpectedly. In this respect, that is just a question of time when the economic situation in the eurozone changes.

4. Forth solution would be interference at another place. If for example Germany successfully reformed its fiscal system or labour laws, this could be an impulse for higher economic growth, which would attract foreign capital (or at least keep the domestic at home), German economy could recover in spite of the binding single currency.

An extreme solution would be a separation of the currency, i.e. to abjure the euro and to return the German Mark. A separation of a currency is quite a common phenomenon in the history. National governments usually decide to establish a separate currency when they do not want to pay the inflation tax in favour of other nation (which was the main reason for separating Czechoslovak currency from the Austrian currency after the World War I), or when they believe that a supranational currency is harmful for the national economy (which was the main reason for dividing Czecho-Slovak monetary union in 1993). But predominantly, a separation of a currency is performed if the overall separation of a nation from a supranational state takes place. When an entity overtakes powers in fiscal and tax policies it usually overtakes also monetary policy, i.e. establishes its own currency. As long as Germany is in favour of deepening European political integration it is unlikely that a political demand for a separate currency emerges.

Petr Mach

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