The German economic trinity is easy to agree with

“It’s impossible to agree with a German economist. They don’t get it.” How often did we hear this kind of statement over the past five years?

Implied is that Germans are so much detail obsessed that they miss the big picture. To be fair, Germans are indeed obsessed with detail. They are the engineering nation, aren’t they?

Then again, they are also a nation of philosophers, who almost by definition are big picture thinkers. And when it comes to economics, philosophers are indeed what German are. Big picture thinkers in search of sound economic principles (not surprisingly, in Germany econometrics is normally not a mandatory subject in an economics degree programme and the overall level of mandatory math courses is quite shallow).

The German economic model itself is the result of a big picture approach to problem solving. It goes like this: reality is far too complex and unpredictable to be mathematically modelled with great detail. So, let’s focus on what we know and put in place some principles that if followed will guarantee the achievement of sustainable economic prosperity. The result is the German economic principles trinity.

Principle one: a fully independent central bank whose only mandate is price stability

Why? Because…..

….the only way to increase a country’s economic living standards sustainably over time is by increasing productivity. The way to increase productivity is by continuously investing in education, training on the job, innovation and technology (increase a country’s human and physical capital). How can we force companies to continuously re-invest part of their profits in training, innovation, technology instead of paying out bigger dividends to shareholders? By putting them continuously under competitive pressure. How do we do that? By having a stable currency.

If we devalue whenever there is a loss of competitiveness relative to foreign competitors, local companies won’t make a great effort in investing in training, innovation and technology. Why should they? When in trouble, they know that a currency devaluation will bail them out and restore their competitiveness. However, if a regular currency devaluation is not an option – and on top of it currency devaluations do happen regularly in countries where some of their competitors are based – they know that the only chance they have to remain competitive is by continuously investing in their human capital and technology.

How can we make sure, that politicians do not resort to regular currency devaluations? Simple: by ringfencing monetary policy from their interference (politicians are not allowed to access the “printing press”). This is achieved by creating a fully independent central bank, whose only mandate is to keep price stability and thus a stable currency. In addition, such a fully independent central bank will over time make the “promise” of a stable currency credible by committing to it. This credibility will lead to lower interest rates (with no risk of recurrent devaluations, international investors will ask for an ever lower interest rate risk premium to lend money to local issuers – government and corporates). Lower interest rates will reduce the cost of financing for the local government and companies. Making in turn massive investments in human and physical capital more feasible. Thus, companies have the pressure to continuously invest in human capital & technology and the financial means to do so.

In short, principle number one intents to set in motion a virtuous sequence of events: fully independent central bank whose only mandate is to keep price stability ---> stable currency---> put companies under permanent high competitive pressure----> forcing them to permanent high investment in human capital, innovation and technology ---> increase in productivity ----> sustainable increase in citizens’ living standards

Principle two: a balanced current account (or a current account surplus)

How do we know if the country is staying internationally competitive? By monitoring the current account balance. If the current account is balanced or in surplus nothing needs to be done. Everything is under control. If the current account swings consistently into deficit, something is not working. Structural reforms are needed to improve the countries competitiveness (think about Schroeder’s Agenda 2010)

Principle three: solid & solvent public accounts at all time

No matter how well the economy is run, there will always be recessions, unexpected disruptive events, negative external shocks that adversely impact the economy. In such situations, decisive government intervention is needed to stabilise it. In order for the government to be able to act forcefully, and run large public deficits in times of economic crisis, it has to have available fiscal space at inception of a crisis. It has to be solvent and public debt low when the crisis hits. Putting it differently, to run large deficits when the going gets tough, the government has to run a reasonably balanced budget in good times.

Finally, principles two and three combined also mean that the economic authorities don’t have to worry much about private debt levels. If the current account is at least balanced and the government is running a small deficit (in good times) it follows that the private sector (families and corporates) is running a surplus. So, either it is not accumulating debt or the debt is backed by assets denominated in the same currency as the debt - which makes dealing with situation of overleverage, and its impact on the financial system, much easier.

If you look at the Eurozone crisis from the perspective of the German economic trinity principle, you quickly understand why Germans insist so much on structural reforms in the peripheral countries. Since the second world war, Spain, Portugal and Greece have run current account deficits the vast majority of the time – making them dependent on external financing. Such external imbalances will eventually trigger a “sudden stop” in international financing and a financial crisis. They way out of this structural weakness is to expand the countries’ export base. This in turn can only be realistically achieved by attracting massive amounts of foreign direct investment. How to do it? By doing structural reforms that make the countries’ attractive to foreign direct investors (the Siemens, the Sanofis, the Googles, the deutsche Mittelstand & Co of the world).

So the question is: should we waste our energy and intellect in building ever more complex and elegant mathematical models instead of focusing on what we know about economics and keep things simple? The German answer is “Nein”. That’s surely not something so difficult to agree with, is it?