Germany is right to ask for austerity

by Edmund Phelps

Financial Times
July 19, 2012

Many commentators think the crisis in Europe is caused by the euro and that the fix is to give aid to the insolvent to avert large defaults. Neither is true.

In the typical narrative, Germany gained its competitiveness via a euro cheapened by a poor periphery. But that overlooks how Germany preserved its competitiveness when former chancellor Gerhard Schröder forged an agreement with the unions for wage restraint in return for jobs. It also overlooks how Italy and France could have preserved their competitiveness by doing the same thing. Germany simply showed better vision and leadership.

The difficulties of many European countries derive from their corporatism: state projects serving cronies and vast social protection programmes, both run by elites. These surged in the 1970s and 1980s. The prospect of a lifetime of such benefits – sweet contracts, soft loans, early pensions and the rest – created something new: social wealth.

In the next stage, a number of states began to run sizeable fiscal deficits – Italy as early as the mid-1980s and France in the early 1990s. So it was a relief that the Basel I agreement, which went into effect in 1990, lowered to zero banks’ capital requirement on sovereign debt – no matter how risky. Then, leaving aside mounting entitlements, public debt levels as a proportion of gross domestic product took off – peaking at 65 per cent in France and 120 per cent in Italy in 1997. As increases in benefits outpaced increases in taxes, households saved some of the gains in disposable income. So households saw their private wealth rising alongside the social wealth.

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