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Interview

We can`t stop prices

Interview mit Hans-Werner Sinn, Gazeta Wyborcza, 23.04.2008

We can do nothing about the energy prices. They will raise and raise forever, because energy fossils become scarcer and scarier. But we do can prevent the rise in food prices. All it takes is to stop this total nonsense of biofuels production - says Professor Hans Werner Sinn, Ifo's president*

Konrad Niklewicz: Has Europe become an island of economic stability, much to our suprise? America is entering the recession period now, yet we in Europe can still boast a modest, but stable growth. Are we immune to the crisis that originated in America?

Hans-Werner Sinn: We are not immune. We will see the crisis as well, but later. It is nothing unusual: there is always at least one year gap between a movement in world's business cycle and the European business cycle. Europe cannot cushion the crisis in the United States alone. We will see the downturn in European Union possibly in second half of 2009. Eastern Europe of course will also be included.

What will be consequences of this late downturn?

Europe will have lower tax revenues. It will again become difficult to maintain a balanced budget. Unemployment in Euro zone will go up. And the GDP growth will go further down. But once again: this is no immediate risk, but will take more time to develop.

Is there anything Europe can do to soften the incoming economical blow?

Well, yes, structural reforms would help, the sort Germany did carry out three years ago. It would also be appropriate not to have a lax budget now - so that there remains some possibility to allow for budget deficits when the crisis does reach Europe. In this respect, the European Central Bank is wise enough not to cut the interest rates already now. It waits until the crisis really comes to Europe and keeps its powder dry.

How long will the crisis last?

I expect the American crisis to be more severe than the crisis that hit that continent in 2001-02. At that time, the recovery was very quick. Now it will be more severe simply because of the magnitude of write-offs. The IMF has spoken about 1000 billion dollars, but even if the OECD’s more cautious estimate in the range of 400 billion is correct, the numbers are huge by all means. American banks will have to bear the lion's share of write-offs. The trouble is, however, that total equity capital of American banks is only 1200 billion dollars. So I think this crisis has unusual dimensions.

In one of your recent papers you have said that the world economic party is over because United States lived beyond it means. Did Europe lived modestly enough not to aggravate the fever? Is there anything we could have done - but we didn't - in order to preempt the trouble?

Contrary to what happened in US, we in Europe did not have such enormous spending boom. And we didn't stop saving, as the US did. Europe is saving. And saving means investment, which in turn prepares for the future. In that regard - Europe behaved much better. US has a huge current account deficit, it peaked at 6 per cent of their GDP, which is beyond all historical comparisons. It was not sustainable. Such excessive borrowing is not advisable even in good economic times...

But that was the way the American economy functioned for quite a long time. Maybe Europe should have alerted the US partners, that the situation is not sustainable in the longer run?

That might be true. We could have stopped buying American securities, in particular the problematic mortgage backed securities, earlier. But European banks continued to buy them because of the higher return. And they neglected possible risk. Had Europe not done that, then the crisis would not have happened, at least not to this extent. Banks are run with too little equity capital. And this leads them to overly risky behavior, because in the event of bankruptcy, they lose only their equity capital and do not have to repay their loans fully. The less equity you have, the less prudent you are in your investment. It would have been better to have tougher banking regulation in Europe, with much higher equity asset requirements than we have actually. Had these provisions been in place, we would not be in such trouble now. To be sure, the accounting standard has to be changed, so we do not have just market-based reporting, but precautionary reporting principle in accounting. And then we need higher equity asset requirement. This cannot be left to self-regulating. Governments have to step in!

Are there any bright spots on the horizon? When speaking about Europe's economy, is hard not to mention the positive developments in Germany. Everybody says that Germany, the powerhouse of Europe, is back. Export is booming, even with the strong euro. What is the source of success? Can the rest of Europe follow?

Germany increased the competitiveness of its workers by having a real devaluation of prices and wages, relative to the other euro-zone countries. That of course cannot be easily imitated. But the thing we can learn from Germany is that the labour market can be made more flexible. Here I talk about Chancellor Gerhard Schroeder’s „Agenda 2010” - his famous package of reforms. He basically gave less money for people who do not work, therefore reducing the wage claims and creating a low-wage sector of economy which did not exist in Germany before. He also introduced wage-subsidies on a massive scale: 1,3 million of Germans receive government subsidies while working now. This made it possible for people to accept low-paid jobs. And employers had the incentive to create such jobs. So Germany experienced an enormous employment boom due to the Schroeder's reforms. Surprisingly, the productivity in Germany did not increase very much. If you include low wage, low productive labour into the workforce - you will water down the whole productivity level. So this was not really the driving force of the German export success. The good performance of German exports is the result of abovementioned process, the comparatively low inflation. Germany had the lowest inflation rate in the eurozone. By far. This made German exports more competitive.

What is currently the biggest threat to the European economy? Is it inflation?

I don't think that the inflation rate will be high enough to become a threat. At the moment, it is true, we do have some inflation. This results primarily from the German VAT increase. This effect is gradually disappearing. So I do not think that Europe has a lasting inflation problem. In Britain and in Spain, there is a deflation of house prices.

What about food and energy prices? Many economists warn us that the inflationary pressure, stemming from those two factors, will further mount. Is there anything we can do to stop this trend in short term?

Economists should distinguish between inflation and relative price changes. This is of course true: the energy prices went up due to the scarcity of oil, but this is not because of Europe. Food prices went up in the whole world, primarily due to the use of agriculture areas for the productions of biofuels. And this affected Europe too. We cannot do anything about the energy prices. They will raise and raise forever, because fossils fuels become scarcer and scarcer. Food prices are different story: we can prevent their rise by stopping the utter nonsense of biofuel production. Biofuels are the new element that created the extra demand for agriculture products in the last few years. It triggered the food price increase in the whole world.

So maybe Europe should follow French advice and re-orientate the Common Agriculture Policy? French government proposes to go back to policy of sixties, when the CAP subsidized mass production of food. And not the quality, preferred in today's CAP...

Absolutely no, by no means! I know why French government wants that. Because French farmers would be profiting a lot from such policy. Reintroducing the subsidies for the mass production would be even bigger mistake, than the one we are experiencing now. Governments should neither subsidise the production of the ordinary food, nor should it support the production of biofuels. Governments should just step out of the market!

Are you proposing to abolish CAP?

Yes!

But this proposal may not fly in European Union...

I'm afraid so. There are too many vested interests. The European agriculture policy was always a disaster. In previous years, under the rule of the French-preferred policy with subsidies to mass production and market control) there were even higher prices, because food has been withdrawn from the market and stored, destroyed or sold in the world market, in order to keep the prices high to the delight of some farmers, but at the expense of Europe’s consumers and taxpayers. Now, the CAP subsidises the production of biofuels, which also push the agricultural prices up, because the production of biofuels withdraws the land from the production of „normal” food.

If the inflation is not the threat to the European economy, as you suggest, what are the real dangers? Is it the strong euro?

Of course it is true that the euro is strongly overvalued. It is now worth nearly 1,6 dollar. The exchange rate should normally be something between 1 - 1,3. At least that are the levels suggested by Purchase Power Parities. We are way beyond the normal band of exchange rate.

Is there anything we can do to weaken euro against the American dollar? If the current exchange rate continues, European export industries - such as car and aviation industry - will be hurt.

Well, the revaluation of the euro that we have experienced was necessary. That helps the US reduce its colossal current account deficit.

What European Central Bank can do, in order to weaken the euro, is to lower the interest rates. But such a move would be premature. I do understand the ECB's president Jean - Claude Trichet's willingness to wait. The ECB might want to intervene only at the time when the economic crisis is visible in Europe.

Europe can live with the strong euro. There are some ways to make it easier: for example, Europe should try not to have inflation. We can achieve that through moderate wage negotiations, so that the workplace in Europe stays competitive. Besides, I do not see the risk that euro will be so strong forever. The current weakness of US dollar is a necessary adjustment phase, to get rid of American current account deficit. It may be with us for a couple of years, but not in the long term. In the long term the euro will certainly fall down.

*Ifo Institute is one of the leading economic research institutes in Germany. Founded in 1949, it is based in Munich. It is closely linked to Ludwig Maximilian’s University.

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