The US economy seems to be climbing out of the hole it entered during the financial crisis. Unfortunately Europe can’t say the same. Unemployment in the euro zone is almost twice the US level and inflation is far below the official target. Deflation has become a looming risk.

Investors have taken note: European interest rates have plunged, with German long-term bonds yielding 0.7 per cent. That's the kind of yield we used to associate with Japan and markets are signalling they expect Europe to have its own lost decade.

Dire straits

Why is Europe in such dire straits? The conventional wisdom among European policymakers is that it’s the price of irresponsibility: some governments have not behaved with the prudence a shared currency requires.

If you ask me (and a number of other economists), this analysis is essentially right, except for one thing: The identity of the bad actors.

The bad behaviour at the core of Europe's slow-motion disaster isn't coming from Greece, Italy or France. It's coming from Germany.

I’m not denying that the Greek government behaved irresponsibly before the crisis or that Italy has a problem with stagnating productivity. But Greece is a small country whose fiscal mess is unique, while Italy’s problems aren’t the source of Europe’s deflationary downdraft.

Out of line

If you try to identify countries whose policies were way out of line before the crisis, have hurt Europe since the crisis and refuse to learn from experience, everything points to Germany.

Consider the comparison between Germany and France. France gets a lot of bad press, with much talk about its loss in competitiveness. Such talk exaggerates the reality; you’d never know from most media reports that France runs a small trade deficit. Still, to the extent that there is an issue here, where does it come from? Has French competitiveness been eroded by excessive growth in costs and prices? No.

Since the euro came into existence in 1999, France’s GDP deflator (the average price of French-produced goods and services) has risen 1.7 per cent per year, while its unit labour costs have risen 1.9 per cent annually.

Both numbers are in line with the European Central Bank’s target of slightly under 2 per cent inflation, and similar to what has happened in the US. Germany, on the other hand, is way out of line, with price and labour-cost growth of 1 and 0.5 per cent, respectively.

It's not just France whose costs are about where they ought to be. Spain saw rising costs and prices during the housing bubble, but at this point all the excess has been eliminated through years of crushing unemployment and wage restraint. Italian cost growth has arguably been a bit high, but it's not nearly as far out of line as Germany is on the low side.

In other words, to the extent that there's anything like a competitiveness problem in Europe, it's overwhelmingly caused by Germany's beggar-thy-neighbour policies, which are in effect exporting deflation to its neighbours.

Fiscal woes

But what about debt? Isn’t non-German Europe paying the price for past fiscal irresponsibility? That’s a story about Greece only. It’s especially wrong in the case of France, which isn’t facing a fiscal crisis; France can borrow long-term at a record low interest rate of less than 1 per cent, only slightly above the German rate.

Yet European policymakers seem determined to blame the wrong countries and the wrong policies for their plight. True, the European Commission has floated a plan to stimulate the economy with public investment – but the public outlay is so tiny compared with the problem the plan is almost a joke. And meanwhile, the commission is warning France, which has the lowest borrowing costs in its history, that it may face fines for not cutting its budget deficit enough.

What about resolving the problem of too little inflation in Germany? Very aggressive monetary policy might do the trick (though I wouldn’t count on it), but German monetary officials are warning against such policies because they might let debtors off the hook.

What we're seeing, then, is the immensely destructive power of bad ideas. It's not entirely Germany's fault – it is a big player in Europe but it is only able to impose deflationary policies because so much of the European elite has bought into the same false narrative. And you have to wonder what will cause reality to break in. – (New York Times)