The American-German Divide

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.

Global
Ramifications

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.[1]

Notes

[1] 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.