A few days ago Peter Bofinger, one of Germany’s “wise men,” published an astonishing post titled “German wage moderation and the Eurozone crisis” that appeared on VoxEU.org (see here) and Social Europe (see here). The post was astonishing in more than one way. First of all, it seems astonishing that, in late 2015, and not 10 years earlier or so, a wise man from Germany should feel the need to draw attention to the role of German wage moderation in the eurozone crisis. Persistent German wage moderation under the euro is an undeniable fact. How can there be any controversy about it some 20 years after it started?

No less astonishing was the particular occasion that triggered Bofinger’s post. Bofinger responds to a recently published CEPR Policy Insight titled “Rebooting the Eurozone: Step I – agreeing a crisis narrative.” This is an essay by a group of CEPR-related economists attempting to establish what they see as a “crisis narrative” that may be more in accordance with the basic facts about the eurozone crisis (rather than being based on myth or political convenience). In particular, these economists reject the official narrative that is still popular today among some key eurozone authorities, especially Germany’s finance ministry: namely, the “sovereign debt crisis” myth. Their alternative crisis narrative highlights large intra-eurozone capital flows and imbalances and the “sudden stop” event that featured their eventual implosion. Bofinger generally agrees with the proposed alternative crisis narrative but makes the point that something rather important is missing in it: the alternative CEPR crisis narrative pays zero attention to the role of German wage moderation and is therefore “incomplete.” It is indeed astonishing that one of the supposedly leading European economic policy think tanks proposes a crisis narrative, and one supposedly based on the basic facts, but misses the most basic fact of all: that German wages stopped rising under the euro.

Peter Bofinger seems to have been baffled about this too. He provides a very compelling analysis of the far-reaching economic consequences of German wage moderation inside Europe’s currency union since the late 1990s. He starts from the proposition that “for the ideal functioning of the EZ, unit labour costs of each member state should increase in line with the inflation target of the ECB,” and then moves on to show that, instead, German unit labor costs stayed essentially flat for the ten years preceding the eurozone crisis. According to Bofinger, this persistent deviation from the ECB’s price stability norm caused the very imbalances inside the eurozone that, according to the crisis narrative proposed by the CEPR economists, were at the heart of the eurozone crisis.

According to Bofinger, German wage moderation operated through the following channels. First, German inflation stayed persistently below the ECB’s target rate and the eurozone average. Inflation differentials turned the single nominal interest rate set by the ECB into an amplifier of divergences: relatively tight financial conditions in Germany held back domestic demand while relatively easier financial conditions in member states with above-average inflation boosted domestic demand in these countries. Second, wage moderation directly depressed employees’ incomes and domestic demand in Germany, which also held back German imports accordingly. Third, German wage moderation improved Germany’s price competitiveness and exports over time. Finally, wage moderation caused a shift in Germany’s income distribution, boosting profits and corporate saving at the expense of employees.

Bofinger references a number of supposedly respectable mainstream sources that have provided some pieces of empirical evidence supporting his analysis. He concludes that “an EZ Crisis narrative that does not account for the effects of the German wage moderation is incomplete. Germany is by far the largest EZ economy and it is a very open economy with strong trade links to all other EZ member states. It would be difficult to explain why such a strong internal devaluation, which is regarded as a key determinant of Germany’s success story in the 2000s (Dustmann et al. 2014), did not have significant repercussions for the rest of the EZ.” Very difficult indeed!

Congratulations. There is very little to critique about Bofinger’s post. Germany and Europe can be glad to have him on the German board of ‘wise men’. Personally, I am no longer bothered by the fact that my own contributions on this issue are widely ignored in mainstream circles, that is, by economists that one reads about in the mainstream media. As a matter of principle mainstream economists don’t need to cite anyone who is not a member of the mainstream circle anyway. This mutual admiration society is convenient, since it saves the mainstream a lot of embarrassment. Mainstream economist can discover the truth with a 20-year delay and not be accused of plagiarism or anything of the sort.

For the record, even prior to the euro’s launch I highlighted the role of the Dutch wage under-bidding strategy within the ERM in the 1980s and 90s. While the actual paper only appeared in 2001, I started presenting the analysis in it at conferences in 1998. In 2005 at the latest I started highlighting the dangers of soaring intra-eurozone imbalances that were the consequences of the German wage under-bidding strategy under the euro. (See here, here, and here, and this one).

Heiner Flassbeck, whom I got to know in 2006, first at a conference in Lugano in early 2006 organized by Andrea Terzi and myself and then during my first stint at UNCTAD’s Globalization and Development Strategies Division in the summer of 2006, provided the same kind of analysis and arguments even much earlier. Indeed, in an article back in 1993 (in a book called Währungsunion oder Währungschaos, Gabler, edited by Peter Bofinger) he clearly identified the wage problem as being crucial for the functioning of the currency union. In 1997 (here the original in German) he already described the emerging gap in unit labor costs as a looming danger for the Monetary Union, which was created only in 1999. In 2005 he provided (with Friederike Spiecker) an article that had all the arguments of Peter Bofingers response (in German here). A similar article was published by both authors in English in 2011 (here). His contribution to the 2006 conference in Lugano was called “Wage Divergences in Euroland – Explosive in the making” (a reference can be found here), where the disaster was foreseen with all its analytical elements.

Meanwhile, at least two well-known Anglo-Saxon mainstream economists with a “Keynesian” leaning, Paul Krugman (see here and here) and Simon Wren-Lewis (see here), have directed their readers’ attention to what is politely called “German wage moderation” and its role in the context of the eurozone crisis. They may or may not have believed they were saying something novel. I don’t think Bofinger believes that he has said anything novel regarding German wage moderation himself. To repeat, the astonishing thing is that he had to say it at all. In any case, it is good and important that he made “his” point – since it will be read by many people, and perhaps not all of them will close their minds to the arguments he makes. Unfortunately, this would be both the “official” and the standard mainstream response to any suggestion that there may be something wrong about German wages. The mainstream simply cannot fathom that wages may be too low. In their world wages can only be too high.

As to the CEPR piece, there is much in it that I can basically agree with – at least when “completed” by that crucial missing point highlighted by Bofinger in his response. So the really big puzzle that still remains is how these mainstream economists were capable of ignoring the role of German wage moderation in the first place. I will just make three brief comments here.

First, it appears to be a typical case of mainstream economists’ general lack of understanding of the macroeconomic role of wages and labor markets. There are some brief hints in the CEPR piece on factors that may drive up wages and costs and thereby harm competitiveness. But there is indeed complete silence on what happened in Germany. Truly remarkable! Read again Bofinger’s summarizing paragraph and ask yourself how it is possible that mainstream economists – quite routinely in fact – excel in missing the forest for the trees!

Second, in a piece like this the following kind of routine mainstream remarks will not be missing: “the rigidity of factor and product markets made the process of restoring competitiveness slow and painful in terms of lost output.” Of course, here we go again, the never-ending “structural rigidities” story that, for instance, also guides the troika in imposing “structural reforms” in euro crisis countries, etc. Mainstream economists love to live in their fantasy world of perfectly flexible prices (rather: price levels!) and firmly believe that anything short of that ideal must surely be a problem. To mainstream economists it appears that slashing wages cannot but boost employment and lead troubled eurozone countries out of crisis. Well, try doing that when there are no neighbors around to beggar – and you are likely to end up in deflation instead. Perhaps Mr. Draghi will then simply export eurozone deflation through euro depreciation, you might think. But the point remains that wage deflation can at best boost exports – but comes at the risk of lastingly undermining domestic demand. That was actually Germany’s own experience as the “sick man of the euro” prior to the crisis.

Third, the CEPR piece seems to view capital flows as the one and only driving force behind all troubles, and in this context features some curiously muddled remarks about current account imbalances as saving-investment imbalances. In terms of national income accounting the two are of course equivalent. The trouble starts, however, when mainstream economists mistake those ex post accounting identities as representing causal factors. And things get really bad when they see saving as the source of capital flows that cause investment somewhere else. For that is nothing but terrific nonsense based on what I dubbed the “loanable funds fallacy” a long time ago (see here and here; and, of course, Keynes spotted that fallacy a very long time ago indeed). To this day mainstream economists remain firmly attached to flawed loanable funds theory, the source of endless intellectual confusions.

There is no doubt that capital flows played a prominent role in the eurozone crisis. But to some important extent those capital flows were essentially passive facilitators rather than driving forces during the buildup phase of imbalances. Most of the “bubbly” lending in the later eurozone crisis countries was initially undertaken by local banks. The distinguishing feature of the monetary union was the ease with which these banks could take recourse to euro interbank and bond markets to fund the expansion of their lending business – given the absence of exchange rate risk and deep integration of euro money markets as fostered by the ECB in particular. The key thing here is the initial provision of finance that allows production and spending to go ahead in the first place. Banks can create the needed money “out of thin air” – and they may choose to do a lot of it if they trust that the wholesale refinancing will be no problem and will leave them with a nice profit. The excess spending in current account deficit countries (say, Spain) is necessary for the income and saving in current account surplus countries (say, Germany) to arise in the first place. And before any of that can happen at all, someone has to provide the wiling spender with the money that is needed to initiate the spending. Capital flows do feature in all this but they are not necessarily the ultimate driver of things. The crisis narrative presented by Bofinger suggests that relatively easier financial conditions in euro crisis countries (to-be) enticed lending, spending, and bubbles while German banks were happy to recycle Germany’s notorious export surpluses – given that their domestic lending business was flat anyway, and precisely because of the damage that German wage moderation was doing to German domestic demand.