July 8, 2009
German Chancellor Angela Merkel has just completed her first official visit to Washington since President Barack Obama took up office. At home Mrs. Merkel has only a few months left to go until an upcoming general election will determine her own political future. This was surely one more reason to send a message of harmony with President Obama back home, as the new U.S. president, much in contrast to his predecessor, enjoys great popularity among German voters. Elections aside, such harmonious gestures can hardly deflect from the fact that U.S.-German relations have been strained even under the Obama administration, with economic policy as a prominent bone of contention. While the ongoing global crisis may have been the trigger to the current episode of disharmony in this area, the issue is actually not an altogether new one and reflects deep and diverging undercurrents in economic policy thinking guiding policymakers in the U.S. and Germany.
This divergence is significant because, like it or not, German views matter to the U.S. They matter because of their influential role in European policymaking. With Europe's economy being similar in size to that of the U.S. and the two areas together carrying a heavy weight in the global economy, recovery from the global crisis will be made much more difficult if the two players fail to pull their weight in harmony.
Global Crisis, Global Response?
A global crisis calls for a global policy response. The challenge is that in dealing with globalized markets, national governments have to cooperate internationally if effective policies are to come forth.
Globally integrated and interconnected economies naturally experience spillovers and contagion through a number of channels. The collapse in global trade highlighted the rapid transmission of demand shocks between trade partners. Similarly, as the global inter-bank network seized up, synchronous declines in the prices of risky assets across the globe, together with currency market instability and disruptions in capital flows and trade finance, underlined the extent of interconnectedness in global finance. Modern communications and information technologies, those much praised motors of globalization, helped turn these events into a truly global crisis of confidence.
Spillovers and contagion in globalized markets work both ways. Recovery in one part of the world tends to support recovery elsewhere in the world. Therein lies both a blessing and a curse. Global interdependencies are a blessing because countries can mutually gain from recoveries of one another. They are a curse because incentives arise to rely on the recoveries of others to sponsor one's own, which, in turn, may either lead to a general holding back on efforts to bolster recovery, or give rise to protectionist measures to limit sponsorship of external recovery if the benefits are not mutually shared. Global recovery from the current crisis thus involves a collective action problem: if free-riding is not contained, policy measures in support of joint recovery may be in under-supply.
In preparation of the L'Aquila Summit of world leaders on July 8-10, international coordination of policy efforts for recovery was what finance ministers from the Group of Eight leading countries met to discuss on June 12-13 in Lecce, Italy. Discussions between U.S. Treasury Secretary Timothy Geithner and his G-8 counterparts for the first time also included "exit strategies": the issue of unwinding the extraordinary policy measures taken in response to the crisis. Differences in views as to exit strategies have emerged on that occasion that are much in line with earlier controversies surrounding the G-8 Summit in Washington last fall and the G-20 Summit in London earlier this year. At the heart of the matter, then and now, is a deep-running American-German divide as to the usefulness of applying macroeconomic policies to stabilize market economies.
Characteristically, at the Lecce meeting, German finance minister Peer Steinbrück was reported as being most emphatic about the need to address inflationary pressures, implying an early exit from any stimulus measures. The urge for an early exit follows a very late entry in applying any stimulus in the first place. Back in late September last year, after the Lehman Brothers failure earlier that month, the same Mr. Steinbrück commented on US rescue measures by declaring that "This crisis originated in the US and is mainly hitting the US ... [In Europe and Germany, such a package would be] "neither sensible nor necessary". The core of Europe had entered recession in the spring, but Mr. Steinbrück and his European Union (EU) partners remained in complete denial until the fall, pretending that they had nothing to do with that "U.S. crisis." Quite uncharacteristically, the International Monetary Fund's had urged its members to set stimulus plans in March 2008, around the time when the U.S. launched its first stimulus package. Only with extreme reluctance the German government finally agreed on a meaningful fiscal stimulus package early this year, of some 1.5-2 percent of GDP in both 2009 and 2010. Other EU member countries' stimulus measures are generally even smaller.
One argument put forward in Europe's defense of timid discretionary stimulus measures is that European welfare and tax regimes feature more powerful automatic built-in stabilizers. Another argument is that such measures risk undermining the credibility of the "Stability and Growth Pact" (SGP). The SGP prescribes members to aim at a budget in balance or surplus over the cycle and limits tolerable recessionary deficits to three per cent of GDP; unless exceptional circumstances prevail. Upholding the credibility of the SGP is seen as a vital confidence booster by its proponents, who generally belittle the effectiveness of discretionary measures or even claim that those would do more harm than good.
Whether arguments like these have any substance or not, the fact is that Europe is in an even deeper recession than the U.S. The latest IMF forecasts show a GDP contraction of 2½ percent in 2009 for the U.S., followed by a modest ¾ percent expansion in 2010 on a year-average basis. Both the 27 member countries of the EU and the Euroland subgroup of countries that share the euro as their common currency are forecast to contract roughly four per cent this year followed by flat GDP in 2010. Germany in particular is forecast to contract by some six per cent this year, followed by a further mild contraction next year. In Germany's case, this would completely wipe out the country's cumulative GDP growth since 2001. Germany and the United States were equally hard hit by the Great Depression of the 1930s. So far the current crisis is hitting Germany harder than the US.
Germany is also among the most severely hit countries in Europe. And yet, even as unemployment is rising sharply and capacity utilization plunging, the German finance minister's greatest worry appears to be rising inflation. Little more than a week earlier German Chancellor Angela Merkel had attacked some leading central banks, suggesting that the Federal Reserve and the Bank of England should reverse their expansionary measures. In breaking what some observers described as a cardinal rule of German politics - to refrain from commenting on monetary policy out of respect for central bank independence - her attack even included the European Central Bank, namely for bowing to international pressures and taking recourse to the unconventional measure of purchasing a rather small quantity of covered bonds. Most likely, Mrs. Merkel's attack was not altogether unrelated to a suggestion made around that time by Axel Weber, President of the Deutsche Bundesbank (and an unofficial advisor of Mrs. Merkel), that the ECB should soon start hiking interest rates as a precautionary measure even as inflation is currently zero or below and forecasts show inflation rates way below the ECB's declared tolerance level of two per cent. Mr. Weber together with his German colleague on the ECB's key decision-making body strongly objected to the ECB's recent purchase of covered bonds. Suffice to mention that Germany's parliament three weeks ago voted to amend the country's constitution, essentially banning public borrowing both at the Federal and the Länder levels of government from 2016 or 2020 onwards, respectively, except for temporary deficits that may arise in downturns or disasters.
Germany and Euroland
These, then, are some more recent incidents reflecting Germany's peculiar policy views. Should anybody care? After all, while Germany may still be the fourth largest economy in the world, after the U.S., Japan and China, its GDP is actually only a fifth of U.S. GDP and Germany has having experienced significant relative decline since the early 1990s both vis-à-vis the U.S. and its European neighbors.
Nonetheless the answer is a resounding yes. The point is that the creation of the euro has transplanted German policy traditions onto the European level or, more precisely, onto the level of "Euroland" -- the countries that have adopted the euro as their currency -- but with wider European ramifications. And the Euroland economy is roughly similar in size to the U.S. economy, while the EU's as a whole is actually larger. In terms of international trade and investment flows and holdings of international investments, Europe is America's foremost partner or counterpart in the world. It is through wreaking havoc in Europe's economy that German policy views should be seen as a world-wide cause of concern, not least because by turning Europe into a major drag and stumbling bloc for recovery from the current crisis. I need to go back in history to explain and elaborate on these warnings.
(West) European reconstruction and recovery following World War II started out within the Bretton Woods regime of exchange rates pegged to the U.S. dollar. It did not take long for Europe to start thinking about alternatives that would make exchange rates within Europe even more stable but Europe less dependent on the U.S. The interwar experience of "beggar-thy-neighbor" competitive devaluations provided the background to this craving for stable exchange rates. In the German case, the importance of European export markets later provided the key motivation to accept compromising impacts of exchange rate commitments on monetary policy. In the French case, envy of the "exorbitant privilege" enjoyed by the issuer of the world's reserve currency may have led France to see European monetary integration as the way to level the playing field with the U.S. Of course the U.K. has traditionally been less keen in participating in any of this, preferring to limit its European engagement to the common European market only.
While earlier initiatives did not come to much, the establishment of the European Monetary System (EMS) in the late 1970s marks the starting point of the process that led to Europe's Economic and Monetary Union (EMU) as we know it today. By intention and design, the EMS was supposed to be a "symmetric" system of equal partners, bestowing no special status on any particular country or currency to act as "anchor," but constructing the synthetic European Currency Unit as a basket of participating currencies instead. Ideals of equality were one thing; in reality the EMS evolved into a larger deutschmark zone over the course of the 1980s, with the Deutsche Bundesbank pulling the monetary shots in Europe. It is easy to see that especially Germany's larger European partners did not really appreciate this outcome and came to see EMU as their best option partly to regain monetary sovereignty, namely by establishing shared control over a common European currency. Credit must be given to responsible German leaders who acknowledge at the time that the status quo of German monetary hegemony in Europe was not a politically tolerable long-term solution; particularly after German unification, an event that may have accelerated EMU. Nor was it economically sound to have a central bank with the mandate to maintain price stability in Germany set monetary policy for Europe. That is like having the Federal Reserve determine monetary policy for the U.S. by looking at inflation numbers in New York. Whatever notorious assertions about Europe's too rigid labor markets and insufficiently mobile labor force might seem to suggest, at least in principle the euro is economically the better currency for Europe than the deutschmark.
European Financial Policy: Made in Germany
There is an important caveat here, however. The policy regime and policymaking for EMU in Europe would need to be such as to suit a large economy, an economy as large as if not larger than the U.S. economy. Unfortunately that is not the case. The policy regime hammered out at Maastricht in 1991 is essentially of German design and is based on German experiences and follows German policy traditions. In particular the ECB is modeled on the Bundesbank as its blueprint. It is easier to see why German policy views prevailed over others' at Maastricht than it is to understand why the Maastricht regime is not working for Europe and is also posing a global threat.
Given the deutschmark's anchor role within Europe, Germany was de facto the only country left to yet surrender its monetary sovereignty, and therefore in a strong bargaining position. For domestic political reasons, Helmut Kohl, German Chancellor at the time, had to make sure to have the Bundesbank "on board", as selling the euro to the German populace would hardly have been possible without public sanctioning by the trusted guardian of the beloved deutschmark to be given up for the new currency. This meant the Bundesbank could dictate the conditions of its own abdication of monetary rule over Europe. The conditions it laid down were such that probably even the Bundesbank itself considered it unlikely that Europe would swallow them. When Europe did so after all, if anything reflecting their yearning to overcome Bundesbank supremacy, the Bundesbank later on made sure that the fiscal screws were tightened even further, by having the SGP added to the Maastricht fiscal requirement of keeping the budget deficit below 3 percent of GDP to be allowed entry into the euro club.
As a result, Euroland members today share sovereignty in monetary control, but much of Europe ended up operating under a central bank single-mindedly focused on maintaining price stability and national finance ministers who are constrained in making a balanced budget the primary goal of their policymaking. The euro is a currency without a state or federal treasury backing it. In this regime monetary policy has no role in stabilizing the economy apart from maintaining price stability. And national fiscal policies have no such role to play either, apart from whatever support might come from built-in automatic fiscal stabilizers. It is not the economy, but policy itself, that needs to be stabilized. Germans like to speak of "stability policy" rather than stabilization policy.
But this is a problem for Europe and the world.
National Virtue, International Vice?
The euro is both a currency of shared sovereignty in monetary control and the monetary embodiment of German "stability culture" as transposed to the European level. Approaching the intricate issue as to why the regime does not work for Europe and why this is an issue of global concern, one has to begin by acknowledging that "stability policy" did in fact work for Germany in the past. Certain myths about the Bundesbank enjoy popularity even outside of Germany, and Germany's peculiar export dependence has attracted some media attention, too. But the reasons why the model underlying the Maastricht regime of today worked for Germany in the past are not widely understood.
Within German "stability culture" the Bundesbank's part was to enforce discipline, both budgetary discipline and wage discipline. The result was not only low inflation, but inflation lower than inflation of Germany's trading partners. And that is an important factor within any system of pegged nominal exchange rates: over time a country with relatively low inflation gains in competitiveness which is boosting its export performance. Stability policy worked well under the Bretton Woods regime, establishing both Germany's export-oriented growth strategy and the Bundesbank's claim to fame as inflation fighter.
Essentially, the establishment of the EMS then recreated the same conditions within Europe in the 1980s. As Europe pegged its currencies to the deutschmark while still having significantly higher inflation, rising competitiveness again fired Germany's export motor and the country ran up a 5 per cent of GDP current account surplus over the 1980s.
Another factor is important here. In the late 1970s, Germany had for once bowed to international pressures and agreed to act as "locomotive" and applied fiscal stimulus. As inflation soared with the second oil price shock the outcome was judged a policy failure. German policymakers habitually refer to the lessons from this "straw fire" experience today as something never to be repeated. In fact, with the change in government in 1982 Germany officially ended any attempt at demand management, with balancing the budget attaining policy priority. The predictable result was domestic demand stagnation and rising unemployment. What rescued Germany in the first half of the 1980s was the Reagan expansion and strong U.S. dollar. The export motor was then sustained in the second half of the 1980s as the competitiveness gains within the EMS came through. Germany ended the decade not only with a large current account surplus but also with a balanced budget. It can be done, German policymakers concluded.
Bundesbank virtues of stability and discipline thus found all the support they needed within the German political elite when it came to laying down the right policy regime for Europe. What works for Germany will also work for Europe. In fact, if everybody were to adopt German stability culture things would work even better for everyone, they must have thought.
Alas, a vital error had crept into their reasoning here. The point is that the German model worked for Germany precisely because and as long as others behaved differently. In particular, in the 1980s, Germany had low inflation and a balanced budget, but the rest of Europe did not. Germany got away with budgetary discipline while ignoring domestic demand as others did not, thereby creating sufficient demand for German exports.
Exporting the German model to Europe through the Maastricht regime meant inflation would be low across Europe, while all countries would try to balance their budgets at the same time. When German stability policy was jointly applied across Europe in the early 1990s, the predictable result was domestic demand stagnation and rising unemployment. Even by 1996 it looked as though EMU was not going to fly because stagnation kept budget deficits above the 3 per cent ceiling across the continent. Luckily, the U.S. "new economy" boom and strong U.S. dollar came to the rescue, and eleven countries qualified in the spring of 1998 to launch the euro in January 1999. In other words, laboring under the Maastricht constraints, Europe failed to generate sufficient homemade demand growth, but benevolent external forces allowed the euro to get off the ground just on time.
Some important global ramifications of the euro became immediately visible. They were vigilantly observed early on by the IMF. Referring to the rise in the U.S. current account deficit of 1.5 percent to nearly 4.5 percent between 1995 and 2000, the Fund observed in its May 2001 World Economic Outlook that "rapid U.S. GDP growth and relatively weaker growth in other parts of the world, notably Europe and Japan, as well as a sharp increase in the real foreign exchange value of the U.S. dollar driven in large part by capital inflows, contributed to the rise in the deficit" (IMF 2001, p. 14). And in September 2002 the Fund observed that "external imbalances across the main industrial country regions widened steadily during the 1990s [with these imbalances being] dominated by the euro area and Japan, respectively" ((IMF 2002, p. 65-7).
The euro area actually experienced a brief period of stronger domestic demand growth towards the end of the 1990s. A key driving force behind this burst in growth was "interest rate convergence." As the introduction of the euro neared, interest rates in incipient member countries converged towards their lower German levels. This process provided an important temporary boost to asset prices and domestic demand in countries other than Germany, in countries such as Spain and Ireland. The same kind of process was repeated around the time of entry of the new EU member countries in eastern and central Europe as the prospect of EU membership - to be followed by euro adoption - again encouraged markets to engage in "convergence play." Between 2003 and 2008 these countries were the recipients of massive capital inflows; leaving uncompetitive exchange rates, asset price bubbles and domestic demand booms, and huge current account deficits in their trail.
These developments indicate that Europe has seen some large divergences and imbalances built up over time. Some peripheral parts of Europe went through credit and property price booms much larger than those of the U.S. While pockets of strong growth thus existed at the core, and especially in Germany, protracted domestic demand stagnation ruled. Remarkably, and in stark contrast to the United States, private consumption in Germany has not grown at all since 2001. One key factor behind stagnating consumption in Germany has been stagnating wages. Another is the fact that German policymakers doggedly aimed at balancing the budget "no matter what" throughout. With domestic demand flat and dead, whatever meager GDP growth Germany experienced over this period came only from exports and some induced corporate investment.
Domestic demand turned out somewhat stronger in other core countries like France, where, as non-German policymakers still show some resistance to inflicting budget austerity at times when their economies are not doing well anyway. Overall, growth in Euroland was disappointing for many years despite a global boom. Martin Wolf put it succinctly, observing that "between 2001 and 2005, the eurozone was the sick giant of the world economy" (FT 27 Mar 2007). Importantly, what prevented Europe from freeloading on the global boom this time round was the euro's strong appreciation after 2001. The euro's appreciation may have kept Euroland's current account in near balance, so that its policymakers pretended they were no party in global imbalances, but slow growth in core Europe surely continued to act as a drag on U.S. export growth. Between 1999 and 2006 the bilateral trade imbalance between the U.S. and Euroland increased from a deficit of $27bn to $88bn; with some decline since then.
Relying on the Recoveries of Others
In view of Germany's sole reliance on exports for its growth it is not much of a surprise that the country has been especially hard hit in the ongoing crisis, featuring a collapse in world trade. But Euroland and Europe as a whole too are struggling even more than the U.S. today. The truth is that Europe is dealing with much more than a global crisis, which would be bad enough. Not only has the external growth motor that it formerly relied upon gone into reverse, but also Europe is bogged down by its own homemade crises. Again, Germany is at the heart of the matter. I remarked above that wages have stagnated in Germany for much of the time since the mid 1990s. This arose as convergence to German stability culture and protracted stagnation in much of Europe, Germany's key export markets, failed to jumpstart the German export motor. Convergence to the German standard was precisely what the Maastricht regime prescribed, exporting the German model to Europe. The point is that as the rest of Europe converged to the German norm, Germany could no longer improve its competitiveness by just being part of that common norm. And so the German model failed to work in its home country, much to the surprise of German policymakers. Following old habits Germany then diverged from its own previous norm by prescripting itself wage stagnation. In this way, the German export motor was jumpstarted once again, and the global boom finally reached Germany in 2006 despite the euro's appreciation. Germany had a current account surplus of 7.5 per cent of GDP in 2007.
Germany also achieved a (near) balanced budget in 2008. But it paid a very high price for it in terms of protracted wage and domestic demand stagnation. And much more than that. For Germany's policies were also behind Europe's internal divergences and imbalances, which then imploded as homemade crises just as the external global crisis hit. Protracted stagnation in Germany meant European interest rates were low enough for asset price bubbles to arise in the periphery. With Germany becoming super-competitive thanks to its wage underbidding strategy, corresponding competitiveness losses accumulated among its European partners. As Germany ran up huge current account surpluses, its neighbors in Europe ran up huge deficits. External imbalances and internal asset price bubbles were related, as in the U.S.
As intra-European imbalances are imploding, non-Euroland members may see their competitiveness restored through currency crises, crushing their aspirations for catch up and euro membership. Currency devaluation is not an option available to Euroland members though, countries such as Ireland and Spain may be facing even harsher adjustments ahead. In March this year, market speculation about an impending breakup of Euroland reached a first climax.
What does all this mean for the collective action problem which, as I said at the start, the world is facing today? Recovery from the ongoing global crisis requires everyone to pay their dues and pull their weight. Built into the German model is a strategy to rely on the recoveries of others to sponsor one's own. The German model has become the European model (pace the U.K). ECB president Jean-Claude Trichet said as much in 2004 when Euroland was last hoping for external sponsors of recovery: "Growth starts with exports, then passes on to investment and then to consumption. That is the normal sequence for Europe in this phase of the cycle." (FT 22 April 2004). The trouble is that Europe's economy is as large as America's or even larger, and the German model wholly unsuitable for a large economy. In addition, Europe has its hands full with its own homemade crises, crises which are largely the consequence of the German model as well. Recent statements made by key German policymakers clearly indicate that enlightenment is not a realistic prospect. Perhaps Germany has to re-learn the experience of the Great Depression, an experience deleted from its collective memory, since it led straight into an episode no nation would be proud of. Unfortunately German ideas and their European ramifications are posing a global threat today.
German economic policy wisdom may have served (West) Germany well in the post-war period until the 1990s. Ironically, it has failed the country exactly in what, in the minds of German policymakers, should have been its greatest hour of glory: the export of the German model to Europe through the euro as Europe's common currency. The German model relies on competitiveness gains through price stability as fueling the export motor of an economy otherwise unassisted by growth-friendly macroeconomic policies. Essentially the more difficult part in macroeconomic policy is thereby left to those who have the courtesy to stimulate German exports. Exporting the German model has not only undermined the model's working at home by requiring what are Germany's key export markets to converge to the German model. Its export has also created an economic giant that fails to pull its global weight by being overly reliant on exports to pull it along. Waiting for a fresh global export current to lift its boat is what the German model requires Europe to do. From the perspective of the U.S., or indeed the rest of the world, this can not be considered a particularly constructive contribution.
Let me add that the author of the above is European, in fact, German, and a euro enthusiast. A common currency is right for Europe. It is the ideas behind the euro regime which are rotten and dangerous.
 Many features of Europe's crisis today were clearly diagnosed before the fact in "Euroland and the World Economy: Global Player or Global Drag?", a conference volume which I co-edited/co-authored with Andrea Terzi in 2007.