Why Germans are not ignorant

As GDP growth in Europe has turned sour again, the opponents of austerity are getting more worried, more vocal and more angry. It's understandable. I agree with them insofar as lack of demand is probably contributing a lot to European stagnation. If there was a way to swiftly implement structural reforms in Europe and at the same time give it a sizeable fiscal stimulus, I would be in for it.

I just have doubts whether some in the anti-austerity camp are able to imagine that the German government could ever think beyond economics. For Simon Wren-Lewis, failure to implement fiscal stimulus can only be the result of either "ignorance or greed". Paul Krugman happily echoes the remarks by diagnosing a "refusal to think clearly".

A moment's pause should be enough to see that Wolfgang Schäuble or Angela Merkel are neither very ignorant nor very greedy personalities. Most politicians and businesspeople, inside and outside of Germany, outperform them on both accounts. And so the diagnosis cannot be right. It does not advance the debate about solving Europe's problems, instead catering to an audience who has already made up its mind about the issue.

Economists in general have a tendency to ignore things outside of economic theory. Instead, upon seeing some behaviour not consistent with their favourite theory, they declare people stupid. It's okay to argue something does not make economic sense. But please make an effort first to see whether it does from another angle. Does the German government believe in the "confidence fairy", in expansionary austerity? My bet is that it is well aware of the thin evidence. Is Schäuble deeply satisfied to see Italians miserable? Give me a break. The game being played is different. It is called "Reformdruck".

"Reformdruck" (pressure to reform) is a concept I don't think exists in macroeconomic theory. It has a moral hazard flavour to it, but it is really not about that. The first premise is that many European countries badly need reforms to their political and economic system. This includes the much discussed flexibility in the labour market, but also raising retirement ages, cutting taxes and red tape for businesses, and enforcing tax collection while reducing the size of the shadow economy. The second premise is that reforms only happen when the situation is dire. Political systems are inertial and reforms happen only in bad times. All reforms carry costs and those tend to be avoided until even the most ardent defender of the status quo gives up his vested interests for the greater good. The conclusion is that for Europe to prosper, some countries will have to suffer economically. Only then can the national governments in Rome, Paris, Madrid and elsewhere implement the changes that lead Europe out of the valley.

This is well illustrated with the story "Mr Keuner and the flood tide" by poet Bertold Brecht:

Mr Keuner was walking through a valley when he suddenly noticed that his feet were walking through water. Then he realised that his valley was in reality an arm of the sea and that high tide was approaching. He immediately stood still in order to look around for a boat, and he remained standing as long as he hoped to see a boat. But when no boat came in sight, he abandoned this hope and hoped that the water would stop rising. Only when the water reached his chin did he abandon even this hope and begin to swim. He had realised that he himself was a boat.

In essence, Mrs Merkel does not want to send a boat to Italy because she hopes Italy will eventually begin to swim. Note how this is not a moral hazard story. Mr Keuner is not pretending to be helpless, being simply too lazy to swim. He is just being human, not mustering the courage to change his behaviour until it becomes inevitable to do so. In Merkel's view then, I think, Italians are not simply shirking and burning German money. But they will only be able to turn their country around when the economic situation is uncomfortable.

This argument is hard to grasp with macroeconomic theory. In our models, labour-market laws and all the structural issues of the economy are one thing, and deficiency of aggregate demand is another. To a New-Keynesian model, structural deficiencies in an economy are typically exogenous and in any case taken care of by the HP-filter. By contrast, a cyclical demand deficiency can and should be adressed by monetary or, at the zero lower bound, fiscal policy. No surprise then that, for the economist living in such a world, anyone demanding structural reforms without sustaining aggregate demand must be "ignorant".

There is, however, one real danger in the pursuit of the German policy stance. Mr Keuner did not see a boat. But what if he had seen his friend on a boat, only to be turned down by him? Germany is a large boat visible to everyone in the valley of the Eurozone. Imposing "Reformdruck" is already harming the friendship with its neighbours. The long term political cost of this might be greater than what most Germans on their comfortable boat imagine.