Is It Time For The Eurozone To Get Rid Of Germany?

Back in April 2010 when it first seemed the Eurozone was about to crack up, I did a post on the lessons of the Eurozone crisis. I argued then that the main lessons were, one, countries joining a currency union should take seriously the optimal area criteria and the real exchange rate and, two, central banks should take seriously the task of stabilizing the growth of nominal spending. I still think these points are valid, but I now see a more important lesson from this ongoing crisis: avoid relationships where one party to the relationship is domineering and has a history of abuse. In short, avoid bad relationships.

In the case of the Eurozone relationship the dominant party is Germany. Its desires have largely shaped the direction of the Eurozone and continue to do so today, even though it only has historically made up at most about 30% of the Eurozone economy. This uneven relationship has been very apparent lately as the future of the Eurozone seems to hang on the day-to-day developments in Germany. For example, the fate of the currency union inched closer to collapse a few weeks ago when German's constitutional court ruled against a supranational fiscal authority and when a German vote of no confidence was effectively issued for the

by the resignation of the German representative Jurgen Stark fromboard. Then, last week the mood improved when German Chancellor Angela Merkel the Eurozone must stick together. Now new polls show Merkel loosing influence and the Eurozone's breakup looks more likely. That these German developments can so easily drive the ups and downs of the Eurozone outlook speaks to dominance of Germany in the Eurozone relationship.Another way to see the inordinate influence of Germany is to look at the inflation-hawk culture of inherited from the Germans and its influence on the evolution of ECB monetary policy. Many studies, such as this 2010 Barclays Capital or this one from the WSJ, have shown using Taylor Rule estimates that while ECB monetary policy has been stabilizing for Germany over the past decade it has been destabilizing for the periphery. In particular, monetary policy was too loose for the periphery when the Eurozone was first formed and more recently have become too tight for them.monetary in a manner that best serves Germany can be vividly seen by looking at the history of nominal spending for Germany and for the rest of the Eurozone. The first figure below shows the case of Germany along with a trend. It shows that not only has Germany's nominal spending returned to trend, but that it is has slightly exceeded it in recent quarters. This explains why the ECB raised interest rates earlier this year and has failed to cut them despite the severity of the crisis. The German economy needed some tightening and the delivered it.