Fiat justitia, et Pereat Mundus (Let Justice Be Done, Even If The World Perishes)

I have been reading and thinking a lot lately about the euro zone financial crisis, mainly because I think that it is holding the world economy in check and by extension the global financial markets. I have read many news articles and commentaries by economists, financial experts and reporters. Recently, I came across a Martin Wolf blog entry about his response to a letter he received from an official in German Finance Ministry. I think that the last line of Wolf’s posting – the title of this post – succinctly covers my feelings about whatever I have read regarding the German leaders’ – whether political or on ECB – attitude towards the crisis.

There is no doubt that Germany is one of few European economies that are doing very well. The unemployment is low, GDP is increasing, the country’s credit is good and it is able to raise money from investors at ridiculously low yields. It is also the largest economy of the EU. It has enormous influence on the ECB directly and through some other like minded officials from Germanic nations and the ones that are doing relatively better. So naturally it is in the driving seat but its response is not very comforting for many people around the world.

As I mentioned earlier, Chancellor Merkel is working harder to lower expectations than to lead and find a solution as soon as possible. On the other hand, her man on ECB, Jörg Asmussen is leading the charge that enduring more pain is the solution just like it helped Latvia and other Baltic nations.

The claim is that Latvian economy, which shrank by 24% from the late 2007 to late 2009, is doing better because of austerity polices. Rather than jettison the euro peg, Latvia embraced internal devaluation, cut spending and implemented structural reform. As a result, Latvian economy grew by 5.5% in 2011. The year 2010 was quite flat and IMF is predicting growth slightly less that 2% in 2012 and around 2.5% in 2013. This may sound good but as Paul Krugman writes, it is nothing to crow about.

As for Mr. Asmussen, I’ve already written about the extraordinary illogic of saying that a partial recovery from a Depression-level slump — one that has not, by the way, been accompanied by a large improvement in competitiveness — vindicates austerity.

The argument to use Latvian model as a solution for the crisis weakens even more in light of a study by the Center for Economic and Policy Research. The Authors Mark Weisbrot and Rebecca Ray studied the crisis driven devaluation of a number of countries in the past two decades. They found that Latvia fared very badly compared to countries that implemented counter-cyclical, expansionary fiscal and monetary polices, accompanied by external devaluation.

Latvia’s fixed exchange rate and pro-cyclical fiscal policies shrunk the economy whereas the opposing policy increased economy for most other countries. Most countries that devalued their currency, the GDP was higher than the pre-devaluation level. The average GDP loss for countries with devaluation in crisis situation was 4.5%. Latvia lost 24.1% of GDP. Three years later average economy grew by 6.5% over the pre-devaluation period. Latvia by contrast was down 21.3% of GDP, three years after the crisis began. The worst performing economy after three years was Indonesia, in 1997, with –7.9% GDP from pre crisis level. Her economy shrank by 13.4% during the crisis.

One obstacle to finding a quick to solution to current crisis is that EU countries have one currency and they do not have the luxury of individually employing inflationary-deflationary policies to address their problems. The economies in trouble are facing inflationary pressures but Germany is not. Germany is haunted by the problems of high inflation during the Weimar Republic and is reluctant to pursue a policy that will increase inflation.

Now, many experts are drawing parallel with 1930’s – especially with 1930’s Germany. Then, to address the depression, Chancellor Heinrich Brüning responded with austerity by tightening credit and a rollback of all wage and salary increases. Brüning’s objective was to pay off Germany’s war reparations burden and foreign debt. That looks eerily similar to the objective of cutting sovereign debts at no cost the current crop of ‘austerians’’ are demanding from EU’s troubled economies.

Marting Wolf writes in his blog that the rise of Hitler was preceded not by the great inflation but by the great depression and the austerity policy of Brüning. Nazi party received 810,000 votes in 1928. 6.4m in 1930 and 13.7m in 1932. Niall Ferguson and Nouriel Roubini write that Berlin is ignoring the lessons of the 1930s. They say the Germans are fixated on the non-threat of inflation. They are giving more importance to 1923, the year of hyper-inflation, than to 1933, the year democracy died.

There is definitely some credibility to the argument that the financial crisis has increased the hardships in many countries. And as Wolf writes, deep economic collapses are dangerous. The history mankind tells us that many such collapses gave rise to no only ultra-nationalist sentiments but also to fascist, Nazi and communist group.

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