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Niall Ferguson Is 90% Correct: Europe's Problems Cannot Be Solved by Deflation on the Periphery

Niall Ferguson says something very true and important:

Ludwig Erhard Prize Acceptance Speech: The crisis of the eurozone did not happen because the southern states failed to enact German-style labour market reforms. The crisis was a transatlantic banking crisis from which the German banks were in no way exempt. Labour market reforms would also have done almost nothing to address the underlying institutional problems that are to blame for diverging competitiveness within the eurozone.

Now Europe is in a desperate mess that simply cannot be solved by deflation on the periphery…. Unemployment rates are terrifyingly high. This is a toxic mix and one that is politically unsustainable.

What can be done? First, banking union needs to go ahead because the crisis in the sector cannot be solved solely with sovereign backstops. That means a single supervisory mechanism, a European resolution authority and deposit insurance scheme. Secondly, some fiscal integration is needed as otherwise at some point peripheral sovereigns must default…. A common eurozone budget is needed; eurobonds can no longer be a taboo. Europe’s monetary union always implied some measure of fiscal union. Those who signed the Maastricht treaty either should have known it – or knew it and should have admitted it….

But, in return, there needs to be meaningful structural reform in all eurozone states. The German belief in a quid pro quo is quite right. The illusion was to imagine that such reform could somehow be induced via a fiscal compact--Ms Merkel’s attempt to Germanise the periphery….

The German Michel… [is] returning to the Michel of the pre-1848 era, that Biedermeier figure much given to self-pity over the extortion perpetrated against him by his wily neighbours. That may be good domestic politics. It may even help Ms Merkel secure re-election in September. But it is really terrible economics.

What Ferguson still misses is that if Germany wants to avoid the collapse of the Euro project, it has two options:

  • To pay and pay and pay through the nose via fiscal transfers for the next twenty years to keep the costs of slow deflation in the europeriphery low enough to keep the periphery from bolting as European relative costs slowly return to equilibrium.

  • Spend on upgrading Germany's own infrastructure and living standards and so produce four years of moderate inflation in Germany to quickly return European relative costs to equilibrium.

Pay more or pay less. In the second option, not only is less paid, but also what is paid is spent making Germany a better place, and also the periphery is better off than if it spends 20 years as a depressed recipient of German transfers. The second option is better.