(a shorter and edited version of this article was published on Social Europe on 2 Jan 2020)

A fierce debate is raging about European macroeconomic policy. First, German media is increasingly attacking the ultra-loose monetary policies of the European Central Bank (ECB), claiming that keeping interest rates at record low (even negative) levels hurts prudent saver households and risks higher inflation. Outgoing ECB president Mario Draghi was depicted as a vampire sucking the accounts of German savers, while former and current (mainly Northern) central bankers came out publicly criticizing the unconventional easing policies of the ECB. Second, it is not just monetary hawks pushing for tight money, but also fiscal orthodoxy resisting calls for loosening public budgets. The German government is reluctant to deviate from its “schwarze null” policy of balanced budgets, and in fact, it has been running fiscal surpluses for years now. Finally, core eurozone countries, who generally oppose more risk-sharing among members of the currency union, tend to oppose loose money and budgets also for benefiting “profligate” periphery countries, for “letting them off the hook” and encouraging further irresponsible behavior.

As we will see, the hawks are not just wrong about currently necessary monetary and fiscal policies, and risk-sharing mechanisms in Europe, but their calls are also inconsistent with each other.

Europe’s savings-excess

Private sector saving in Germany has increased dramatically in the past two decades. The reasons for this are beyond the scope of this writing, but contrary to common stereotypes it is much less about the infamous “Schwäbische Hausfrau” and rather about redistribution from German workers to the rich (who do not consume as much of their income), i.e. from suppressed wages to profits. In addition, after the financial crisis there was a large deleveraging pressure in the indebted euro periphery as well as harsh fiscal austerity imposed on their governments. Arguably, the euro area experienced a significant rise in saving desire.

At the macro level, for somebody to save, there must be someone else to borrow. This means that a rise in private saving desire must either be: A) discouraged by lower real interest rates, which also stimulate private borrowing/investment demand; B) offset by fiscal deficits and public borrowing; or C) channeled abroad via current account surpluses (essentially by lending to foreigners). If none of the above happens, then rising saving desire manifests itself in a fall in overall spending, and since one person’s spending is another’s income, this means that D) incomes must fall, leading to higher unemployment. Option D) is the classic illustration of Keynes’s paradox of thrift, whereby a rise in saving rates is self-defeating on the aggregate level, since it destroys the very income from which people want to save, thereby ending up with less saving rather than more.

ECB’s monetary stimulus

In order to avoid unemployment and support aggregate demand, the euro area exploited channel A) via extensive monetary stimulus. Under Mario Draghi, the ECB has cut short term nominal interest rates below zero, and further lowered long-term rates via quantitative easing (QE). Granted, lower returns on their deposits are not great news for savers but this is precisely the point: to discourage excessive saving. In addition, putting up with a smaller interest income is most likely preferable to the alternative of losing a job (especially for those without net savings). In any case, blaming the ECB makes little sense, as lower equilibrium real interest rates are caused not by the central bank but rather by excessive saving itself. Equilibrium interest rates are where the economy is at full employment, and this rate goes down as the economy wants to save more. Monetary policy is just trying to follow with the actual real rates to where the equilibrium rate fell due to the rise in saving desire. Keeping or raising actual policy rates above the equilibrium rate wouldn’t solve the underlying problem of excess saving but would rather exacerbate it. Spending would be depressed, hurting the incomes from which saving is possible, and resulting in unemployment as demand is weakened. This is similar to the tomato market: if everybody just wants to sell tomatoes (save), but few people want to buy them (borrow), its price (interest rate) must fall, otherwise not many tomatoes will be sold (unemployment).

A missing fiscal thrust

However, as evidenced by persistently weak demand and high unemployment in the eurozone, monetary policy failed to reduce interest rates enough due to the zero-lower-bound (ZLB) constraint. This brings us to option B), fiscal stimulus. With monetary policy out of firepower, central bankers and macroeconomists increasingly call for a larger role for fiscal policy in cyclical demand stabilization at the ZLB, instead of being concerned with public debt stabilization. On the one hand, this entails more flexible fiscal rules in the euro area as well as a more clear monetary backstop role for the ECB in public debt markets in order to accommodate the necessary fiscal expansion, and rule out self-fulfilling confidence crises. However, without such reforms enabling a better monetary-fiscal coordination (even despite Draghi’s famous “whatever it takes” speech), euro periphery governments were not just unable to maintain persistent fiscal support but also had to undergo harsh austerity after the euro crisis broke out. On the other hand, this also means that governments like Germany, who are constrained neither by the EU’s fiscal rules nor by financial markets, should wield their fiscal firepower in support of aggregate demand. Although this leads to higher budget deficits and public debt, it is precisely this extra public borrowing which can soak up the rise in private savings, and prevent a large fall in the equilibrium real interest rate. This not only did not happen, but Germany actually increased its primary budget surpluses, further contributing to excess saving, putting further downward pressure on the equilibrium real interest rate. As a result, the overall fiscal stance of the euro area remained overly tight and rather than countercyclically stabilizing demand, it hindered the recovery in a procyclical way.

So wishing for higher interest rates will not work together with a push for continued government debt reduction. Alternatively, if in the name of prudence the priorities are the frugal budgets and primary fiscal surpluses of the “schwarze null”, then its advocates must accept that this world of excess saving goes together with ultra low real returns for savers, and monetary policy stuck at the ZLB. But hawks cannot have it both ways. Not that they should have it either way: Europe failed to provide enough demand stimulus during the recent crisis. Rather than advocating for tighter monetary and fiscal policies, the fragile recovery needs the opposite.

Help from abroad

German policymakers can counter that even without domestic A) monetary and B) fiscal stimulus they still have option C), i.e. relying on foreign demand. Indeed, Germany’s excess saving over its domestic investment is mirrored in its large and persistent current account (CA) surpluses which reflect lending to foreigners. The problem with this, however, is that it relies on foreigners’ willingness to spend and run the corresponding CA deficits which exposes German exporters to whether trading partners stimulate or not, and to trade uncertainties like Brexit and the US-China trade war. If the rest of the world decides to save more too, then this option is no longer available to Germany – even if their exporters are very competitive.

In addition, running CA surpluses in a global liquidity trap environment (where interest rates cannot adjust any more) is a zero sum game: it captures already scarce demand from trading partners, unleashing deflationary forces elsewhere. It is precisely why Keynes has proposed that in a world of excess saving and weak demand surplus countries should bear more of the burden of CA rebalancing by spending more, instead of forcing deficit countries to save more. A German fiscal boost could have eased the balance-of-payments adjustment of the periphery countries during the euro crisis, saving them from painful internal devaluation, debt-deflation and high unemployment. This would not have constituted “letting them off the hook”, but would have contributed to stabilizing demand across the euro area: the irresponsible in a liquidity trap are not those who borrow, but those who do not spend (“virtue becomes vice, and prudence is folly”). While this assumes some degree of risk-sharing, if the euro is to work, Germany cannot shun this responsibility.

And here lies the other inconsistency. Refusing more risk-sharing, and insisting instead that profligate periphery countries should “suffer for their past sins” by implementing more austerity, undermines the very strategy of relying on the foreign demand of trading partners: running CA-surpluses necessarily requires deficits elsewhere. (Now, these deficits might be also outside the eurozone, but it still makes this strategy harder). It should also be noted, that borrowing in the euro periphery had been more than willingly financed (if not encouraged!) by the excessive supply of German loans, so shifting blame in a morally superior way is at least questionable.

In any case, relying on fiscal stimulus (B) instead of running CA-surpluses (C) should not be viewed as a sacrifice which Germany would do in the interests of others: it would also benefit the German people. Let’s see why.

Additional arguments for German fiscal stimulus

Calls for German fiscal stimulus are often rejected on the basis that their output gap (the difference between actual and potential GDP) is not negative: unemployment is record low so apparently there’s no need for a cyclical demand boost. If anything, in the spirit of countercyclicality, budgets should now be tighter. However, despite low unemployment, German GDP growth is quite weak. If the output gap is indeed non-negative, then this implies low potential growth and supply side problems (e.g. depreciating capital stock, crumbling infrastructure, slow productivity, lagging digital innovation). Overheating the economy with excess demand (eg. through public investment) might “pull up” the supply potential with itself, like a “reverse-hysteresis” effect. In other words, a fiscal demand stimulus could not only be needed to close output gaps, but to fix supply side issues as well.

In addition, even if the level of GDP was okay, its composition might not be. Reliance on exports could provide jobs and income, but if that income is just saved instead of consumed, then household welfare is not okay. The consumption and living standards of the median German household do not reflect their country’s status as the strongest European economy. And this is not even necessarily due to high saving rates by the middle class, but rather due to redistribution from labor to richer capital owners (who save more) through depressed wages. A well-designed fiscal stimulus could not just provide more public consumption, but via raising wages could also help rebalancing towards private consumption, halting rising inequality. (High wealth inequality is another reason why low interest rates do not hurt many German households who do not have any net savings).

Moreover, Germany can lock in negative real interest rates for 30 years. As Olivier Blanchard has pointed out, with real interest rates below GDP growth, the fiscal costs of higher budget deficits are very low, since they don’t necessarily require tax increases later: in such a case, a country could run primary deficits forever, without exploding debt-to-GDP ratios and worrying about debt-sustainability. Even lower-yielding projects are worth pursuing, let alone supply-potential-enhancing public investments into infrastructure, digital and human capital, which could end up paying for themselves. The effect of fiscal policy on GDP (fiscal multiplier) is also larger at the ZLB, where the crowding-out effect on private investment through higher interest rates is absent.

Finally, the high saving appetite and the ECB’s quantitative easing program lead to a safe asset shortage in the euro area. German government bonds, while liabilities of the state, are also the safest assets which serve as a saving vehicle for the private sector as well as collateral for various financial transactions – similarly to the liquidity services of money. In other words, public debt, just like money itself, should not necessarily be viewed as a liability to be ever fully repaid, but rather as something of which the economy might actually need more rather than less. Worrying about debt sustainability, or repayment “burden on future generations” is therefore not warranted, at least not at the current very low levels of German public debt and low real interest rates. If anything, the real burden on future generations is if they fail to get a job as youngsters due to austere budgets.

As for the other issue, i.e. blaming the common monetary policy for being too loose for a Germany with non-negative output gap, first it must be seen that the ECB sets interest rates with a view to the euro area as a whole and not just a single country. Also, as we’ve seen, weak demand in the eurozone has much to owe to German excess saving. Second, it is worth asking whether an autonomous Bundesbank would do things differently. Higher interest rates would strengthen the Deutschmark’s exchange rate, making it more difficult to channel excess savings abroad in the form of CA surpluses. To the extent that real exchange rate based competitiveness matters for export performance, the relative weakness of the euro compared to keeping the DM has actually helped Germany maintain its export and saving surpluses. With a stronger DM and lower CA surpluses the alternative again would have been higher unemployment or higher budget deficits. Blaming loose ECB policy is therefore not just out of line with what the eurozone actually needs, but it also goes against Germany’s own pride in being the fiscally prudent “Exportweltmeister”.

The fiscal dogma of “schwarze null” is not prudence, but instead hurts Germany’s long term growth, suppresses German households’ living standards, contributes to inequality, exposes German jobs to volatile global trade, drains global demand and starves the economy of safe assets. It is harmful for Europe. It should be abandoned.