Germans Need to Accept Higher Inflation

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The future of the European Union is likely to hinge on whether Germany can be convinced to accept high rates of domestic inflation.

That’s because the only way to generate a rebalancing of competitiveness within the euro zone is either for peripheral Europe to become more competitive by deflating its costs of production, which is to say mostly labor, relative to Germany. Or for Germany to become less competitive relative to the rest of Europe by seeing its own wages and other production costs rise.

Simple really.

This is the same restructuring that’s starting to happen in the world’s other major single-currency regime, the dollar-yuan bloc. By depreciating the dollar, the Federal Reserve is trying to generate a bit more inflation at home and a lot more in China. Ultimately, either China won’t be able to take the inflationary pain and will have to revalue the yuan relative to the dollar, or inflation will erode its competitive advantage.

The euro zone doesn’t allow for revaluation, so changes in relative rates of inflation are the only road to rebalancing.

But that’s not quite the whole story. Inflation erodes the value of savings held in cash. If you consider cash the equivalent of instant maturity zero-coupon government bonds, inflation represents a “haircut”, in the parlance, or a loss to bondholders.

But why should some bondholders be forced to take all the pain while the rest are being rescued? After all, higher rates of inflation in Germany would punish German holders of cash and holders of German sovereign debt. But in low inflation (albeit no longer deflation) countries like Ireland, Greece and Portugal, bondholders would be given a free ride.

Not fair, right?

Certainly this would be a tough sell to German savers, who, since at least the mid-1920s, have been allergic to even the mention of inflation, never mind accepting a rate in, say, the high single digits for at the very least a few years.

Holders of Greek, Irish and Portuguese sovereign debt would also have to take losses, and possibly substantial ones.

Writing for Project Syndicate, Simon Johnson, an MIT professor and former chief economist at the IMF, and the LSE’s Peter Boone, estimated that private holders of Greek and Irish sovereign debt would have to take losses in the order of 80% to 90%. That’s what’s required merely to push either country’s debt load below the 80% maximum threshold. Debt loads above this level, particularly when a majority of creditors are foreign, tend not to be sustainable.

Nor would that necessarily be the end of it. Italy and Belgium have massive government debts. And countries like Spain and France would see their state burdens rise if they were required to bail out banks crippled by writedowns to Greek, Irish and Portuguese debt.

Indeed, there’s an inevitability to all these bond losses, be it inflationary losses on cash or outright default on debt.

As John Hussman, of Hussman Funds, put it:

“The proper way to deal with a major debt crisis–indeed, the only way nations have ever successfully dealt with major debt crises–is through debt-equity swaps, restructuring and writedowns.”

This is true of mortgages, bank debt, and sovereign debt. Creditors, who have hitherto been protected, will have to suffer before this crisis is resolved. And creditors include people holding cash and other “risk free” savings like those that Germans have long favored.

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    • [...] Sicht des Wall Street Journal hängt die Zukunft der Europäischen Union primär davon ab, ob Deutschland eine höhere [...]

    • Wages in Germany are set by the employers themselves or by so-called tariff partners (agreements between employers' associations and trade unions). The government has no say whatsoever in this process.

      So when you're saying Germany should raise inflation by raising wages, it's like you're talking to a white wall, because there is no measure to achieve this on a collective level.

    • A shame the way Portugal is always being glued to Greece and now to Ireland, while none of the problems of the last 2 reflect in Portugal, which even as economical growth right now, above Spain or Italy. In 2008 Portuguese deficit was 3%, now it's 9% (belowe UK for instance). Stop glueing Portugal to this mess, only because it's a small and southern country. The worst thing is that these kind of press tends to be self fulfilling prophecy, once you start repeating that Portugal is a problem, Portugal will become a problem.

    • No she doesn't, idiot.
      Peripheral countries, including their bondholders, having had a free ride on based on german rates, need to deflate their bubbled up GDPs and subsequent indebtedness and get their house in order, simples!

      Chris, London W6

    • [...] Mattich at the Wall Street Journal noted:   “That’s because the only way to generate a rebalancing of competitiveness within the euro [...]

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