Symmetric adjustment: domestic demand, exchange rates and price levels

by George Hatjoullis

Economic news in the UK in the 1960s was dominated by ‘balance of payments’ crises and ‘devaluation of the pound’. The burden of adjustment was always placed on the deficit nation. Running a surplus was always deemed virtuous. To the naive schoolboy (me) studying economics this all seemed a little odd. Adjustment in the deficit country meant either suppressing domestic spending and/or depreciating the currency. However, depreciating the currency is always symmetric. This is the elegance of freely floating exchange rates. It forces all to adjust.

The suppression of domestic demand however is not symmetric. Germany ran a consistent trade surplus throughout this period. In part this was born of competitiveness which the UK could at least partly adjust for through the exchange rate. However, the surplus was not simply a competitiveness issue. Germany also ran a very tight fiscal policy. The effect was to keep domestic spending below what it might have been and thus contributed to the trade surplus. The UK was forced to accommodate Germany’s overtight fiscal policy and pursue a tighter fiscal policy than it might otherwise have needed to run. Does all this sound familiar?

The eurozone is looking like a repeat of the 1960s. Germany is running a very tight fiscal policy. Its uncompetitive partners are being forced to run even tighter policies than they might have done to keep demand balanced within the eurozone. However, there is the added factor that symmetric exchange rate adjustment is no longer possible. In a freely floating exchange rate system relative fiscal policy would still be set by Germany. However, the corollary of weak southern european currencies would be strong northern european currencies. The relative price level adjustment would be symmetric. Not so in the eurozone.

Germany has no interest in seeing relative price levels adjust through German inflation. Nor do Holland or Finland for that matter. This is forcing the entire burden of relative price level adjustment (to compensate for relative productivity levels) on the low productivity member states. When combined with asymmetric relative fiscal policy adjustment, this has placed an excruciatingly painful burden of adjustment on the weaker economies.

This is why Hans-Werner Sinn could argue ( that the ECB was wrong to cut interest rates at the last policy meeting. His view is that policy adjustment should always be asymmetric and Germany should never have to deviate from its tight-fiscal-policy-and-price-stability-within-Germany stance. The only option for Germany’s eurozone partners is adopt the same internal policy positions. Given the starting point this is a very painful ask.

The ECB is actually set up to run a symmetric monetary policy and spread the burden of adjustment more evenly. The target inflation rate (almost 2%…let us call it 1.9%) recognises that relative price level adjustments require higher than average inflation in some states. When even this target is not going to be met the ECB naturally acts through easier monetary conditions. Germany and its authoritative voices respond unfavourably because they believe Germany should not have to bear any burden of adjustment through higher inflation. They would have the ECB raise rates now!

Why anyone wants to be part of this eurozone is a mystery.