_The German question never dies. Instead, like a flu virus, it mutates. (The Economist, 21 October 2010)_
In late September 2010, Brazil’s Finance Minister Guido Mantega commented in Sao Paulo that the world was “in the midst of an international currency war.” His comments effectively ended all the premature praise for the G-20’s efforts at international cooperation with regard to the global financial crisis. In vogue came the assessment of the actual lack of cooperation as evidenced by the growing tensions and fault lines between the new global institution’s main protagonists, China and the United States, who disagree so starkly on the origin of the global macroeconomic imbalances. Those systemic imbalances – a large US current account deficit balanced by large current account surpluses in China, Japan, and Germany – have been identified as one of the main causes of the credit crunch of 2007-8 which led to the Great Recession. The central issue preventing a unified solution to the current crisis is whether the main cause of those imbalances is a global savings glut in Europe and Asia, or deficient savings and too loose monetary policy in the United States. This disagreement has risen to the forefront of the existing crisis debate as evidenced by Mantega’s remarks. No one point of view, or ”narrative,” so far seems to have won the day and allowed cooperative steps forward.
Recent developments only seem to have made a bad situation worse. The United States claims that China is prolonging and worsening global imbalances by deliberately keeping the Chinese currency, the renminbi, undervalued vis-à-vis the US dollar. China points to the US Federal Reserve’s fresh round of quantitative easing (a policy Wolfgang Schäuble, Germany’s Finance Minster, has called “clueless”), which pushes down long term interest rates and fuels speculative capital flows into the emerging markets, forcing many emerging markets to respond with short-term protectionist measures such as capital controls. China argues that the US should take fiscal austerity measures at home, while the US argues that China should develop its internal demand and allow its currency to float according to market principles. With no agreement reached on how to deal with global imbalances during the November 2010 G-20 meeting in Seoul, notwithstanding vague commitments to “mutual assessment processes,” the sense of malaise in the global economy due to the lack of a clear policy direction has only been reinforced.
All comparisons are flawed, but without too much of a stretch of the imagination, one can see a smaller version of the global economic debate being played out within the Eurozone today. Strong, “competitive,” and export-led Germany is playing the role of China, and the United States is being played by the “spendthrift” Mediterranean countries of Greece, Portugal, Spain and Italy, as well as former Celtic “Tiger” Ireland (inauspiciously referred to by financial markets analysts as the “PIIGS” countries). Of course, the comparison is not entirely apt, since the PIIGS obviously do not (or no longer) enjoy the United States’ “exorbitant privilege” of being able to borrow internationally at low rates in their own currency. Furthermore, just like at the global level, the Eurozone is currently in turmoil, facing a “crisis of survival” in the words of European Council permanent president Herman Van Rompuy in late October 2010, which has caused many analysts to doubt the future of the European project altogether.
In effect, the global financial crisis – triggered by the fall of Lehman Brothers in September 2008 – and the subsequent European sovereign debt crisis – prompted by Greece’s pending default in February 2010 – saw two dormant economic powers rise to the fore in the battle for economic ideas: China in the G-20, and Germany in the European Union of 27. The rise of Germany and China has been a long time in the making, at least twenty years. What is striking, however, is the similarity between their political-economic positions. China and Germany have always been skeptical of the Anglo-Saxon model of short-term finance capitalism. Their economic models – based on robust export growth and long term investment in the real economy (read, manufacturing) – have weathered the financial storm of the past three years remarkably well. While the real growth data of both economies has been impressive, what matters for the purposes of my analysis is that German and Chinese policy elites fundamentally _believe_ they had it right all along: that their political economic model is superior to that practiced elsewhere, and in particular, to that of the Anglo-Saxon world.
Just as the ideological divide between the United States and China at the global level has significantly widened since the financial crisis began, so has the divide between Germany and the PIIGS in the Eurozone, particularly in recent months. Germany has taken on a more and more strident and uncompromising tone while driving its own political-economic ideology in the face of competing crisis narratives.
The role of Germany in exacerbating the EMU sovereign debt crisis has been particularly controversial. First, let me put Germany’s role in context. As Carmen Reinhart and Kenneth Rogoff remind us in their recent book _This Time Is Different_, financial crises often lead to fiscal and sovereign debt crises. Eurozone governments, after having bailed out their financial sectors with an unprecedented infusion of public money, found themselves with all the bad debt they had taken on from those private sectors on their own balance sheets. As the initial focus of the financial markets shifted from private debt in 2008-2009 to sovereign debt in 2010, concerns about the long-term fiscal solvency of Europe’s periphery led to the collapse of confidence in PIIGS bonds and subsequent capital flight to safety. Bond traders sold risky Mediterranean sovereign debt and purchased perceived risk-free assets such as German Bunds and US Treasuries. This led to a highly fluctuating euro-dollar exchange rate and widening sovereign yields within the European Economic and Monetary Union. Now, it is the rescuers that are in need of rescuing.
As Peter Spiegel and Gerrit Wiesmann reported in the _Financial Times_ in mid-November 2010, the drive by Angela Merkel, Germany’s chancellor, to amend the Lisbon Treaty to set up a new bail-out system where private investors bear more of the cost of future Greek-style rescues, was very much resented by other EU leaders when she appeared to steamroll it through a Brussels summit in late October 2010. This resentment has only grown since bond markets plummeted in reaction to Merkel’s proposals in the weeks since, and as the Irish crisis resulted in yet another messy European bailout, the bond markets shifted their focus to Portugal and Spain, and the crisis refuses to go away. Since Europe finds itself now in a moment of unusual uncertainty, any solution to the crisis will depend on the competing explanations, or crisis “narratives,” that are lying around. I can identify at least five competing – but not mutually exclusive – crisis narratives that are currently out there.
The first explanation of the EMU sovereign debt crisis is summed up by Martin Feldstein’s view that this is a crisis of institutional design. The EMU never was and never will be an optimum currency area, so they “had it coming all along.” The Commission’s theory of “endogeneity” was always flawed, if not dangerous, according to this view, since it confused European federalist dreams with economic and political realities. Introducing a single currency was not going to speed up the process of integration, but would create a whole new host of economic problems. The current crisis seems to vindicate this view, even though there is little evidence for it.
The second explanation, partly associated with the German policy elite view, is that this is a budgetary or fiscal crisis. The Stability and Growth Pact (SGP) was far from “stupid” – as Romano Prodi once called it – but a rather good idea, and ignoring the SGP and its “excess deficit procedure” in 2003 as the Council of Ministers did in the case of France and Germany itself set a dangerous precedent for smaller, peripheral countries that their fiscal profligacy would go unpunished. This was in many ways the German nightmare scenario of the early 1990s: other EU members would free ride on German credibility and be able to borrow cheaply, eventually undermining the credibility of the whole Eurozone.
The third explanation – the other half of the German policy elite view – is that this is a crisis of competitiveness in Southern Europe. North-South divisions grew after the euro launch in 1999, with labor costs widening and total factor productivity divergences pricing Mediterranean goods and services out of the European market. In this view, Germany is more competitive than the rest of Europe because of the painful reforms enacted under the Schröder governments during the early 2000s (Hartz IV, etc.), serious wage restraint and high productivity. The introduction of the euro in 1999 took away all incentive in Southern Europe to continue the “necessary” structural reforms, hence leading them to continue along their old bad ways.
The fourth explanation – the Martin Wolf view – is that this is a crisis of intra-European macroeconomic imbalances. Initial bond spreads in the 1990s allowed financial market participants to buy higher yield Mediterranean bonds and sell their lower yield Northern European bonds. This flooded Southern European countries with capital, fueling a cycle of housing booms and consumer spending, causing their current accounts (and goods markets) to adjust. Since EMU members indirectly share liability for private sector debt, the SGP would have to be complemented with an ESP (“External Stability Pact”).
The fifth explanation, often ignored, is that this was a crisis of “efficient” financial markets. Interest rate convergence took place while financial markets were asleep: the EMU crisis would have never happened if financial markets had “correctly” priced the sovereign debt holdings of different European countries. As Jacob Kirkegaard from the Peterson Institute for International Economics has argued, the current high yields for certain countries mean a return back to “normal” as deficient policies are now met with instant default premiums. If one takes the fifth explanation seriously, governments should think twice before they try to please the markets: austerity as a response to spiraling debt is likely to make matters worse in the short run. This explanation asks the rhetorical question: if it is true that financial markets tend to under price risk during economic booms and over price it during recessions, why should we trust them next time? They never make the same mistake twice?
All five explanations for the 2010 EMU crisis are plausible to some extent and should probably all be addressed if the Eurozone wants to emerge stronger out of its current shambles and prevent a similar future crisis. However, some explanations are more plausible than others. There is no doubt that Greece and Portugal suffered from more chronically weak public finances, while Spain and Ireland had very healthy fiscal positions for the past ten years, but saw their booms being financed with large inflows of private capital. The competitiveness argument applies to the whole Mediterranean, but not to Ireland. Given the environment of high uncertainty, the crisis narrative is just as important as the objective facts themselves, and to understand the solution to the crisis, we need to look at how the European Union has responded, which economic ideas have informed those decisions, and why.
In many ways, it is remarkable how the two main “German” explanations of the crisis – fiscal profligacy combined with a lack of competitiveness in the South – have informed European decision making thus far. This has led many analysts to conclude that Germany is “powering” its way through European Council meetings and using its influential position of economic strength to bully its European partners. From that point of view, the “German problem” – dormant for some sixty years – is back with a vengeance, and a new generation of German leaders, with no sense of historic guilt for World War II, sees Germany as a ‘normal’ country with legitimate domestic and national interests. German solidarity with the European Union has reached its limits and the current crisis is nothing more than the country finally flexing its economic muscle.
Now, as tempting as this explanation may be, the reality is much more complicated than that. Germany does not “run Europe” or impose its will on its fellow Eurozone members – like some kind of _Diktat_ from Berlin. Rather, it uses its powerful position as Europe’s “indispensable economy” to persuade their European partners during the decision-making process of puzzling a solution together that their ideas are ultimately the right ones. The fact that their economy has seen the fastest quarter-on-quarter economic growth in 2010 since reunification and that business confidence in the country is at record highs obviously only strengthens the German view that their anti-Keynesian austerity approach to their domestic economy has been right along.
As both the _Wall Street Journal_ and the _Financial Times_ reported this year, the initial European crisis solution was puzzled together in a series of messy, panicky and often rather embarrassing meetings at the level of the Eurozone’s finance ministers in Washington and Brussels during the spring of 2010. Those accounts would seem to suggest that the final outcome to the Greek crisis in May 2010 was a compromise between the major players with help from the IMF and the Americans. It also shows that the EU bureaucracy works quite well, given their lack of experience in dealing with “real time” financial crises. However, Germany still seems to be the linchpin, without which any solution would have been elusive.
I would argue that Germany had the most convincing crisis narrative, in the sense that it is considered the most appropriate by Eurozone leaders. Of course, the Germans are all too aware that their own well-being is bound up with the fate of the euro. But, even more so, the Eurozone’s fate is bound up with Germany. And given German banks’ heavy exposure to Greek, Irish, Portuguese and Spanish bonds – and the calamity those countries’ default would mean for the German economy – Germany saved Greece and Ireland partly to save itself, just as it is likely to save other EMU members in 2011. In the case of Greece, Germany did so against huge popular discontent at home, where the voters were all too aware who was footing the bill for the Mediterranean party. So, naturally, without strict conditions on profligate states and the imposition of losses on risk-happy creditors, all would be taking free rides on Germany. Even though critics rightly pointed out that a formal debt restructuring mechanism would raise the cost of borrowing in the PIIGS countries and frighten already skittish markets, once Angela Merkel convinced Nicolas Sarkozy that it had a case, the others could not do anything else but grudgingly agree.
However, just because Germany seems to have won the narrative debate for now does not mean that the German position is inherently sustainable. The point remains that the current EU proposals for a formal debt restructuring mechanism might go a long way to calm the markets in the short term (even though that is questionable, given recent events in the Eurozone), but they do not solve many of the crisis’ underlying problems. In the case of Ireland, it is hard to understand why a fiscally sound country which has slashed public spending and public sector wages over the past two years in response to the 2008 financial crisis could solve a banking crisis with even more austerity measures. Yet, that is what they are doing. And it is even harder to believe that the Irish population will support these policies for the next ten years just to remain in the Eurozone, when its main trading partners are the US and the UK.
It is simply impossible for the rest of Europe to become more like Germany if the whole point is that Germany could only be Germany because the others were not. German growth was fueled by buoyant demand in Southern Europe made possible by excess German savings. Any current account surplus means that another country has a current account deficit. By the iron logic of the balance of payments, that also means that one country’s capital inflows are another’s capital outflows.
If Germany wants the Eurozone as a whole to become more like Germany, this would only exacerbate the existing global macroeconomic imbalances, with the next financial crisis just around the corner, putting into doubt the fragile “green shoots” of recovery most heads of state keep pointing towards in order to reassure their grumbling electorates that the worst is over.
So, the German lesson for the world economy is clear. China has been growing at record levels partially thanks to a surge in net exports, not solely because the Chinese are inherently more competitive (even though there is probably something to that point), but because someone else wants to buy their goods. If the world wants to avoid another 2008-style credit crash, something will need to give.
If all that happens is that the US does its share towards global re-balancing by slashing its own budget deficit, we risk deflating our way to another Great Depression. China, just like Germany in Europe, will need to respond to fiscal austerity abroad with an accommodating demand stimulus at home, and allow other countries to rebalance their economies, especially their trade balances. The current state of the global economy is a “catastrophic equilibrium” at best.
