Costly Commitments

"German deficit hawkery ... has nothing to do with fiscal realism. Instead, it’s about moralizing and posturing. Germans tend to think of running deficits as being morally wrong, while balancing budgets is considered virtuous, never mind the circumstances or economic logic."

I wonder if we could make sense of German austerity using an approach that focuses on politics rather than national character. Der Speigel notes:

Bonds worth about €3 billion are now being purchased on every trading day [by the European Central Bank], with €2 billion of the bonds coming from Athens. At the moment, there is no improvement of the situation in sight.

This policy effectively makes the ECB a so-called "bad bank" (a bank that buys up toxic assets as a means of helping out other institutions), all protestations of its president to the contrary. The pile of junk bonds on the ECB's balance sheet continues to grow. The fact that the ECB is keeping prices artificially high is downright encouraging banks to unload their risky assets onto the central bank.

But in pursuing the policy, the ECB has backed itself into a corner. What will happen if it stops supporting the market? Will the prices of the bonds of highly indebted countries then hit rock bottom?

[Many] German central bankers [say that] by deciding to [purchase bonds]...the ECB has lost its status as an independent central bank -- and, along with it, so has the Bundesbank.

Maybe German austerity, therefore, reflects the German response to the struggle over monetary policy in monetary union. German policymakers view austerity in the PIIGS as the only way to end ECB bond purchases, and they view the end of bond purchases as necessary to restore independence to the ECB. Germany is in a much better position to push austerity on the PIIGS if it accepts austerity at home. Hence, Germany embraces austerity in order to get the ECB out of sovereign debt markets and get politics out of the ECB.

More broadly, the outcome of this struggle likely determines how the ECB and monetary union will function in the future. German policymakers are saying: "we will not accept a soft money union." Of course, German policymakers have always said this. But until now, such statements have been cheap talk. Making the German commitment to a hard money union credible requires German policymakers to demonstrate their willingness to pay costs (and to force others to do the same). Germany is now demonstrating its willingness to do so by embracing austerity in the face of a recession and debt crisis.

In short, maybe German policymakers have embraced fiscal austerity because they believe they are in a struggle for their monetary future. Is this good policy? Probably not in so far as the focus is on short run economic performance. In the long, though, is the EU better off with a soft or a hard monetary union?