Guest Post Written By Matthew Schoenfeld.
Matthew Schoenfeld joined Driehaus Capital Management in September 2014, where he focuses on risk arbitrage. Previously, he was a member of the Special Situations Group at
Will Europe fall down the deflationary rabbit hole and shatter global growth? That question has dominated mindshare in financial markets and it was the fulcrum of a much publicized debate between former U.S. Treasury Secretary Larry Summers and German Finance Minister Wolfgang Schaeuble at last week’s
First, it’s important to remember that Germany’s growth through austerity prescription was tested, and failed, less than a generation ago. In an effort to placate Germany’s voting public, 1992’s Maastricht Treaty (the European Union’s founding document) outlined stringent ‘convergence criteria’ for aspiring Eurozone members- namely, the criteria called for prospective members to slash fiscal deficits and refrain from currency devaluation prior to final evaluations in 1998. The experience of Germany’s two largest peers, France and Italy, during this period is illustrative.
At the outset of 1993, both needed to quickly trim fiscal deficits which roughly doubled the 3% of GDP permitted by Maastricht; they froze government spending (which contracted by 0.7% annually in Italy and grew by just 0.6% annually in France from 1994-1998), but this alone was not enough to close the gap. They looked to make up the difference by improving their terms of trade. Both succeeded- Italy’s current account shifted from a deficit of 2% of GDP in 1991 to a 2.8% surplus in 1997, while France’s moved from a 0.5% deficit to a 2.5% surplus over the same period- but they did so by denting domestic demand in an effort to make their goods relatively cheaper abroad. When combined with the freeze in government spending, anemic growth resulted; over the five-year period from 1993-1997, France’s annual GDP growth halved to 1.4% compared to 2.8% during the prior five-year period, while Italy’s annual growth stumbled to 1.4% from 2.4% during the prior period. Additionally, France drew menacingly close to deflation, with price growth shrinking to less than 0.5% in 1999.
An eerily similar dynamic is playing out today as Eurozone peers attempt to export their way to fiscal balance; Italy’s current account has moved from a 3.5% deficit in 2010 to a 1% surplus in 2013. Critically, this involves attempting to undercut or match Europe’s 800-pound export gorilla, Germany, on relative pricing- and because Germany has refused to budge on spurring domestic demand, its sub-1% price growth continues to set the competitive bar. The result is a no-growth currency zone once again on the precipice of deflation; over the same 2010-2013 period, Italy’s GDP contracted by more than 0.5% annually and consumer prices are now in decline.
The second important reality that Schaeuble, and Germany, apparently fails to grasp is the political capital and administrative continuity needed to implement their desired structural changes. The reforms needed are enormous in scale and scope- for instance, as much as a fifth of Italy’s economy is represented by the black market, while in France ‘economic dismissal,’ firing a worker to increase profits rather than trim losses, is a punishable offense- and would take years to properly see through. But Germany’s public demand for immediate belt-tightening increases leadership churn and unwittingly subverts the structural renewal they call for.
The efforts of France and Italy to comply with Maastricht are once again descriptive. Two of the most avid supporters of the integration plan were French President Francois Mitterrand and Italian Prime Minister Romano Prodi. Mitterrand actually fathered the Maastricht Treaty with then German Chancellor Helmut Kohl, while Prodi aggressively implemented budgetary measures from 1996-1998 to ensure Italy’s compliance with fiscal criteria. Both suffered politically. Prodi was unseated in 1998 when leftist members of his coalition withdrew support in opposition to his Euro-centered spending cuts. Mitterrand chose not to stand for reelection in 1995, but public approval of his Socialist Party was already in freefall and it is unlikely he would have been able to fend off opposition candidate Jacque Chirac, regardless.
More recently, efforts to appease Germany with quick budgetary fixes led to the 2013 ouster of technocratic Italian Prime Minister Mario Monti and have left French President Francois Hollande deeply unpopular. Hollande’s early attempts to walk the proverbial tightrope- keeping his Socialist base from defecting by eschewing spending cuts while placating Germany with tax hikes- proved toxic and stripped him of the political capital needed to successfully reverse course or implement durable reform. Everyone loses.
Schaeuble and Germany would do better to seek out Eurozone leaders and build trust behind the scenes instead of chiding them publicly for their fiscal sacrilege. This would preserve the political viability of prospective change agents and afford them the longevity needed to see through meaningful reform.
It would also avoid a very public calling of Germany’s bluff. After all, outside of jawboning, there is little that Germany can actually do to discipline defiant peers. The Eurozone mechanism for penalizing profligate members- the ‘Excessive Deficit Procedure’- has already proven toothless; Germany knows as much, as it avoided enforcement despite violating deficit criteria in 2002 and 2003.
Continued austerity ultimatums will not dissuade embattled politicians presiding over deteriorating economies. Rather, they will only further crystallize the fundamental truth that the German warden lacks control of the asylum. This is a truth that financial markets, which can more effectively mete out discipline, will continue to coalesce around if Germany fails to heed its past policy failures.
