How Germany Benefited From The Euro

Includes: ADRU, ERO, EU
by: Antonio Fatas

Since the launch of the euro, there has always been a question about the benefits that Germany could enjoy of sharing a currency with other countries. While for the other countries (the "periphery") the benefits in terms of credibility and stability of a strong currency were obvious, for Germany the benefits were simply the additional trade integration that the euro would produce. Some believed that this benefit was too small to compensate for the potential risk of being part of a club with riskier countries. The current crisis has provided arguments for those who believed that Germany should have never been part of the euro.


In his most recent article Paul Krugman argues that the current German model needed the euro to work. Germany had tried to keep labor costs under control in the past but without success. The launch of the euro locked the exchange rate and sent capital flows to the periphery producing inflation in those countries. Even if German inflation was still positive (so no painful disinflation), there was an inflation gap with others, one that allowed Germany to be more competitive as the periphery became less competitive.

Quoting from Krugman's article:


The corollary of this argument is that Germany benefited from the euro in a way that was not expected at the time when it was launched: by allowing an increase in competitiveness relative to the other euro members.

I agree with this argument but I think that there is part of the story that is missing. Not all other members of the euro area had high inflation. Let's compare Germany to France.



So in the comparison between France and Germany the story above does not seem to work; adjustment did not come from inflation in other countries but by the relative control of wages in Germany (relative, of course, to changes in labor productivity and all of this relative to French wages). But here is where I think the euro could still have played a role: when Germany had its own currency, it was very difficult to engineer a "competitive devaluation". Reductions in wages or prices could easily be compensated by a stronger currency (the German Mark). This might run contrary to our intuition that competitive devaluations are easier with flexible exchange rates. For a country very committed to keeping inflation low and a strong currency, it is difficult to deliver a competitive devaluation through monetary policy. But once the exchange rate is fixed, a combination of control on labor costs and the inflation that was generated in some of the periphery countries finally allowed Germany to produce a reduction in unit labor costs and growth via expansion of exports. And that is how Germany benefited from the euro.