Lamenting that intellectual inertia is responsible for slow progress in economics, Servaas Storm sets out to teach a lesson to everyone who may still be foolish enough to believe that relative labor costs matter for international competitiveness and that diverging unit labor cost trends – specifically persistent wage moderation in Europe’s largest economy, Germany – may have played a rather critical role in sinking Europe’s monetary union. It is a dangerous myth, Storm proclaims, that labor costs drive competitiveness. He suggests that the eurozone crisis originated from a different set of causes altogether; German wages are little more than trivia.

I fear that Servaas Storm will further add to existing confusions about both German wages and the widely misdiagnosed and never-ending eurozone crisis more generally. His blog of January 8, 2016 titled “German wage moderation and the eurozone crisis: a critical analysis” (see here) is hardly a masterpiece in analytical coherence. I will focus on some key issues.

Storm appears to be making three big points. First, German wage moderation is a mere fiction. If Germany’s competitiveness improved at all under the euro, that was the result of nothing else but its engineering ingenuity: “It was German engineering ingenuity, not nominal wage restraint or the Hartz ‘reforms’, which reduced its unit labor costs. Any talk of Germany deliberately undercutting its Eurozone neighbors is therefore beside the point.” Second, Storm essentially agrees with the “consensus narrative” recently proposed by a group of CEPR-associated researchers (see here) which sees the origin of the eurozone crisis in rampant capital flows causing massive intra-eurozone current account imbalances. German wage moderation does not feature at all in the consensus narrative, a conspicuous neglect that prompted Peter Bofinger’s recent critical response (see here; and also here). Storm’s attack therefore reserves some special venom for Bofinger (amongst various other proponents of the wage moderation hypothesis, including this author). Third, the eurozone’s real underlying problem, according to Storm, is that the euro has “not led to a convergence of member countries’ production, employment, and trade structures, but rather to a centrifugal process of structural divergence in production.” Somehow – but other than through wage moderation! – Germany got even stronger in high value-added, higher-tech manufacturing under the euro, while the eurozone South remained stuck with low value-added, lower-tech manufacturing.

In the course of presenting these three points (or hypotheses) Storm not only thoroughly misrepresents the “wage moderation hypothesis,” he also fails to shed any new light on the supposed role of capital flows, while ending up with the rather disheartening proposition that the euro is essentially nonviable until the eurozone’s production structures converge to the German standard.

Regarding the first point, the idea that German wage moderation may be fiction rather than fact, I am simply baffled. The wage moderation hypothesis (at least as I have presented it; see here, here, and here, for instance), starts from the following facts (data courtesy of Eurostat and the OECD). First, Germany’s unit labor cost trend stayed persistently below the common stability norm as set by the ECB; reneging on the golden rule of currency union. Second, German wage inflation was the clear outlier in the downward direction. Third, German productivity growth barely met the euro area average.

Looking at these stark facts I concluded that “the decline in unit labor cost growth was not due to any acceleration in productivity growth, but caused by a marked decline in wage inflation. In other words, not German engineering ingenuity, but wage restraint gave German exporters an extra boost” (Bibow 2012, p. 14). Based on his own calculations that supposedly measure compensation and productivity per  hour worked, Storm reached the opposite conclusion (see quotation above).[1] Investment in Germany, both private and public, has been rather sluggish under the euro. But, by some magic, Germany supposedly still managed to pull off some covert productivity miracle. Also, all along employees in Germany were quite aware that their pay “raises” were not getting them anywhere under the euro. But, according to Storm’s calculations, they may have all just been suffering from some kind of money illusion.

Let me also add some historical context here. By the late 1980s, huge imbalances had built up inside Europe under the “hard EMS.” German unification and the ERM crises of 1992–3 then swiftly rebalanced Europe, and internal balance was broadly maintained until the late 1990s as inflation rates fully converged to the (historical) German (and new ECB) standard. In the late 1990s/early 2000s Germany had a small current account deficit, France and Italy small surpluses, and catching-up Spain a still manageable deficit. Things then ran seriously out of kilter under the euro. Why? A German myth (widely propagated by both official and mainstream voices) says that Germany had to “restore” its competitiveness, which at least acknowledges that something peculiar happened in Germany that was of some wider significance. Storm denies that whatever happened in Germany had anything to do with wages but was purely the result of German engineering ingenuity. Storm has failed to convince me that the facts shown in Figures 1-3 may be fictitious. Figure 4 also begs the question why German engineering ingenuity only fired up inside the eurozone until 2009 – when Germany got lucky to find a new outlet for its exploding engineering ingenuity in the rest of the world; just as its austerity ingenuity was suffocating its eurozone partners.

Storm has also failed to convince me on his second point, the recently proposed “consensus view” that capital flows provided the sole and ultimate cause of Eurozone imbalances while German wage moderation, assuming it happened at all, played no separate role but was at best only a consequence. As a heterodox monetary economist, as a scholar of Keynes and Minsky, I would probably be the last person to deny that credit and capital flows can cause a lot of havoc indeed. I am well aware of the explosion of gross capital flows inside the eurozone (and beyond) in the 1990s and especially under the euro. In the 1990s, once the dust of the currency market upheavals of the early years had settled, capital flows were driving the “interest rate convergence process”; in anticipation of the single monetary policy that the euro was promising to eurozone member countries. Providing largely homogenous if not uniform financial conditions throughout the eurozone was an important promise of the common market and common currency; as a level playing field and monetary unifier. In fact, the implied (one-off) adjustment in (relative) interest rates and asset prices was far advanced if not largely complete by the time of the euro’s launch. It is important to appreciate what then happened under the euro, in the period leading up to the crisis, and after.

Storm appears to suggest that – somehow – Germany was the predominant “push factor” behind capital flows inside the eurozone and that German banks in particular created a lot of credit in the eurozone periphery. I see no basis in the facts and little logic behind this view. Instead I propose as one important issue for consideration here that protracted stagnation in Germany (the eurozone’s biggest economy) helped hold down interest rates across the eurozone – given that the eurozone now had a common monetary policy as set by the ECB. It matters towards what level financial conditions across the currency union are converging. Another (related) important issue is whether the common monetary policy stance (as set by the ECB with a view to “average” economic conditions across the currency union) together with converging financial conditions (thanks to vibrant gross capital flows) is equally suitable across the currency union. A “one-size-fits-none” monetary policy becomes a source and amplifier of economic divergence (a kind of endogenous asymmetric shock) if economic conditions in eurozone member countries are not actually aligned.

The wage moderation hypothesis states that wage moderation in Germany undermined private consumption, which, in turn, also undermined private investment in Germany. It states that German wage moderation was an independent (exogenous) and crucial causal factor behind emerging divergences and the corresponding buildup of imbalances. Wage moderation started in Germany around 1996. It is neither any surprise nor does it contradict the wage moderation hypothesis that wage inflation in, say, Spain accelerated (well above the ECB’s 2 percent stability norm) in the bubble phase of the 2000s. Wage-price inflation differentials become self-reinforcing – until crisis strikes.

Was it mainly German banks’ mortgage lending in Spain that fired up the country’s housing bubble then? I doubt that very much. That part of the job was mainly done locally. Spanish banks do not need German saving or deposits to create credit. But German export surpluses presuppose spending elsewhere – as the source of German income, saving, and deposits. And that’s of course not in conflict with German banks piling into Spanish (and Greek, etc.) sovereign debt at the same time. Nor is it in conflict with German banks piling into private eurozone debt securities, including securitized Spanish mortgages, and/or lavishly lending to Spanish banks in interbank markets. French, Dutch, and Belgian banks (and, of course, the City of London) did a lot of that too. Just as European banks, including the large Spanish ones, were also keenly expanding globally. What distinguishes German banks is that they had little attractive domestic business to go around – due to domestic demand stagnation as caused by wage moderation. They ended up featuring prominently in Germany’s soaring net capital outflows.

The explosive growth of gross capital flows inside Europe itself says nothing about whether German wage moderation was an independent cause behind the emergence of grave intra-area imbalances in competitiveness and trade (and hence large net capital flows). In general, those who deny any role for German wage moderation appear to be the same kind of spirits who also believe that a country that ends up running 8 percent of GDP current account surpluses merely (and somewhat magically) “restored” its competitiveness. I cannot help but detect in this peculiarly skewed perspective certain ideological presuppositions that consider low/lower/falling wages as an inherently and inevitably good kind of thing, always and everywhere. Mainstream economists simply cannot fathom that wage moderation can possibly be a problem anywhere, at any time, and under any conditions. And not all of these economists are working for investment banks that may pay them to uphold this rotten ideology.

Let me add then that Storm also grossly misrepresents the wage moderation hypothesis by suggesting that it would solely emphasize the “expenditure-switching effect” of divergences in competitiveness at the expense of the “income effect.” Nothing could be further off the mark. Of course the income effect will typically dominate trade balances by far (especially if competitiveness is driven by wage differentials rather than swift exchange rate changes). To repeat once more what we already stated above: stagnant wage incomes in Germany were behind stagnant domestic demand, which, in turn, was also holding back German imports (with rising import-content of German exports becoming the key driver of German import growth under the euro). I focused on the domestic repercussions of this self-reinforcing and destabilizing process above. Externally, the vital issue is that divergences in competitiveness positions are cumulative, with trade imbalances getting bigger over time, with flows changing stocks (balance sheets), and with debt legacies (balance sheet troubles) failing to evaporate quietly, even if it were possible to restore competitiveness positions (and get rid of the flows) overnight. None of this is in any conflict with the wage moderation hypothesis but actually an important part of it – unless the role of wage moderation gets misconstrued.

Turning then to Storm’s third point, Germany’s relative strength in high value-added, higher-tech manufacturing, it appears to me that Storm may be confusing disparities in levels of productivity at a point in time (say, 1999) with changes in relative productivity (and wages and unit labor costs) over a certain period of time (say, since 1999). To repeat, the eurozone started out from a position of broad internal balance in 1999. When intra-regional imbalances built up in the 1980s, there was little controversy about the role of inflation differentials. By contrast, today Mr. Storm wishes to explain the imbalances that have built up since 1999 under the euro solely in terms of German engineering ingenuity, which apparently experienced a kind of sudden outburst under the euro. For some reason I just fail to see Germany’s supposed euro productivity miracle in the data (see figure 2 above).

Of course, Germany’s relative strength in 1999 was very much of the kind Mr. Storm suggests. And Germany may have further strengthened its position through the establishment of supply chains in Eastern and Central Europe (ahead of other eurozone member countries). Furthermore, German exports were uniquely well positioned to benefit from the rise of China and other emerging market economies. Their insatiable hunger for German capital goods was just what Germany needed, especially after 2009. But these factors essentially amount to a positive terms-of-trade shock. They would imply that German wages should have grown more strongly than in less favored eurozone member states – not less strongly. In other words, these arguments only underscore that German wage moderation was a massively destabilizing force. They strengthen rather than undermine the wage moderation hypothesis.

Yet I have no doubt that only few minds would be open enough to even consider the counterfactual of relatively stronger German wage growth under the euro. From the perspective of the wage moderation hypothesis, the eurozone would have experienced both stronger and more balanced domestic demand-led growth (see here). Most importantly, the eurozone would have been spared the buildup of internal imbalances the legacies of which are still threatening the survival of the euro today. So let me close with the most absurd suggestion featured in Mr. Storm’s “critical analysis”: the idea that the wage moderation hypothesis justifies the official wage deflation strategy imposed on euro crisis countries since 2009. Quite the opposite: the wage moderation hypothesis would strongly favor internal rebalancing through faster wage growth in Germany. Today, Germany’s partners have converged to the trajectory as set by the ECB’s stability norm. It is Germany that, while no longer diverging further, refuses to converge to that norm, thereby forcing everyone else into deflationary rebalancing (see figure 1). One consequence is that the ECB is missing its objective by a large margin.

Yet, the fact that the eurozone authorities opt for the most precarious and most damaging rebalancing strategy is nothing but an act of pure folly. The official folly is certainly no excuse for either denying the validity of the wage moderation hypothesis; nor the relevance of trends in relative unit labor costs in determining international competitiveness, especially inside a currency union. Mr. Storm appears to suggest that wages don’t matter much anymore and that the only way to rebalance the eurozone is to replicate Germany’s production structures across the currency union. Good luck with that.

One may note, however, that functioning currency unions such as the United States can survive perfectly well with regionally heterogeneous production structures. Sustaining the eurozone currency union without a transfer union (beyond the EU budget) presupposes the avoidance of divergences in competitiveness positions and related buildup of imbalances that led to the euro crisis. (I dubbed this “Germany’s euro trilemma”: namely that Germany “cannot have all three: perpetual export surpluses, a no transfer/no bailout monetary union, and a ’clean’ independent central bank.”) Needless to say, the unresolved euro crisis itself has made sustaining the currency union all the more difficult. Old heterogeneities have worsened in the process, new divisions have opened up. Attempts to explain this outcome without reference to wage moderation in Germany do not represent any progress in economics though. Underbidding one’s currency union partners is the most foolish thing one can possibly do—particularly as the euro was meant to be the coronation of the joint effort of generations of postwar Europeans to prevent ever repeating the folly of the 1930s. Largely thanks to German disingenuity, the euro experiment has failed dismally.

[1] This essay was written when I had a couple of hours to kill on my return flight from Europe last week. In the meantime, Bofinger had responded to Storm’s “critical analysis” (making partly similar arguments as put forward here; see http://ineteconomics.org/ideas-papers/blog/friendly-fire), prompting a reply from the latter (see http://ineteconomics.org/ideas-papers/blog/response-to-peter-bofinger) which sheds a little more light on the dubious figure 1 in Storm’s original piece.