It wasn’t so long ago that the euro zone’s peripheral countries were shouldering all the blame for the region’s financial woes. Whether it was Greece’s outsized debt load and tax-allergic citizenry, Ireland’s over-leveraged banks or Spain’s property bubble, most people agreed that the profligate peripherals were the culprits behind the crisis. But lately, the house in the European neighborhood drawing the most ire isn’t the one with the overgrown lawn and broken windows – it’s the nicest place on the block.
A growing chorus of voices is calling for Germany to do more — much more — to help speed up euro-zone economic growth. Over the last few months, the U.S. Treasury, International Monetary Fund and European Commission have all called on the German authorities to take steps to encourage German consumers and businesses to spend more. The European Commission has even instituted a review of the country’s large trade surplus to determine whether it has focused too heavily on promoting exports at the expense of demand at home.
Review or no review, those calling for change may get their wish before too long. Credit Suisse Head of European Economics Neville Hill says that with German unemployment relatively low at 6.9 percent, there is bound to be upward pressure on wages. And German politicians are doing their bit to fatten paychecks, too. Chancellor Angela Merkel’s center-right CDU party and the center-left SPD agreed late last month to introduce the first-ever national minimum wage as part of an agreement to form a coalition government. The federal pay standard would disrupt a system of industry-wide collective bargaining that has helped keep German wages relatively low to this point. And the higher Germans’ wages go, the more they will hopefully spend.
To many, however, the minimum wage measure is the least the Germans could do. The periphery has already done its share to get Europe back in fighting form, the argument goes, having followed through with actions that the better-off Germans insisted on as a prerequisite for backing euro zone bailouts, including politically-controversial government budget cuts and private sector deleveraging that have in turn driven unemployment to historically high levels and put downward pressure on wages. The resulting reduction in demand for imports and increased competitiveness in exports has seen most periphery countries turn trade deficits into surpluses. But the drop-off in domestic demand has had the additional effect of pushing inflation to dangerously low levels. Consumer prices were flat in Spain and Portugal in October, but they actually declined in Greece, Ireland and Cyprus. The euro zone’s overall inflation rate was just 0.9 percent in November and 0.7 percent in October.
The ECB has already cut rates from 0.5 percent to 0.25 percent and talked up its other deflation-fighting policy tools. But Germany is a critical piece of the puzzle. Part of Europe’s current deflationary risk stems from the fact that the region’s healthiest economy has acted more like a relatively poor, indebted southern European nation than the only one large and strong enough to give the euro zone a hard shove forward. Case in point: Chancellor Angela Merkel’s cabinet signed off on a €50 billion stimulus package in 2009, but the very next year, politicians approved a budget that slashed government spending by €80 billion over four years. Such fiscal tightening is a big reason that domestic German demand has been lackluster over the last four years. Germany’s own inflation rate was only 1.6 percent in November, though that was an improvement over October’s 1.2 percent annual rate.
Sluggish demand at home has left Germany disproportionately reliant on exports for growth. As a late October report to Congress from the U.S Treasury’s Office of International Affairs points out, Germany’s current account surplus rose to more than 7 percent of GDP in the first half of this year, and exports accounted for a “significant” one-third of growth in the second quarter. Nobody is criticizing the country’s export success. What they’re concerned with is its failure to encourage more spending by its own citizenry. “When I or the U.S. or anyone else says Germany should do something about its current account surplus, what we’re really saying is that Germany should increase consumer spending, investment and imports,” Hill tells The Financialist. “We have no problem with German exports – we just wish they would spend more money on other people’s exports.” It’s not even a short-term trend.
The roots of the current imbalance, Hill explains, lie in the fact that the financial crisis upset a wrong-for-everyone equilibrium that had allowed a 17-country bloc of very different economies to exist under a one-size-fits-all monetary policy. Before 2008, the European Central Bank’s rates were too low for the periphery and too high for Germany. That led to a massive borrowing and consumption binge in the former and export-led economic growth and low inflation in the latter. Things reversed course in the periphery as the sovereign debt crisis gathered steam: Nervous investors drove borrowing rates in the periphery much higher than the ECB’s policy rate, forcing an immediate and deep deleveraging. But the reversal wasn’t matched by an equal and opposite reaction in Europe’s core, including Germany. Even near-zero interest rates out of the European Central Bank couldn’t shake German consumers and businesses out of saving their pfennigs. “The crisis created an asymmetric adjustment and forced peripheral countries to eliminate their trade deficits very quickly through the very deep recession they experienced,” Hill said. “But because financial markets drove this adjustment, and not the ECB, you didn’t get an offsetting change in Germany that would have boosted domestic demand, and therefore, imports.”
When it comes down to it, any debate about Germany’s role in the financial crisis is really a conversation about how much austerity a region can take before the cure becomes another disease. In an October paper entitled “Fiscal Consolidations and Spillovers in the Euro Area Periphery and Core,” European Commission economist Jan in ’t Veld shows that for every euro of either budget cuts or tax increases in a given country, the economy shrinks by an additional €0.50 to €1. He also finds that economic growth suffers more when every economy in the region contracts at the same time. His model, which includes France, Germany, Spain, Italy, Portugal, Greece and Ireland, suggests that so-called spillovers from belt-tightening in neighboring countries reduces GDP by an additional 1.6 percent to 2.6 percent over what a nation would have suffered if it were the only one consolidating.
In ‘t Veld notes that fiscal stimulus from core countries such as Germany, France, Austria or the Netherlands wouldn’t have solved all of the periphery’s problems, but it might have muted their impact. But by scrapping infrastructure investment plans and holding off on planned maintenance, he says, core countries helped to depress regional growth further and “made adjustment in the periphery harder.”
Still, change seems to be arriving in Germany even without a specific stimulus program. Perhaps the low-earning workers who will benefit immediately from the minimum wage will buy more imported goods from their ailing neighbors. If austerity won out in the austerity vs. growth debate that dominated policy discussion in the throes of the sovereign debt crisis, it’s becoming clear that the lopsided victory was less than optimal. How to prevent the same thing happening next time around? “There needs to be a much higher sense of organization, coordination and responsibility at the higher levels of the EU for aggregate fiscal policy,” Hill tells The Financialist.
While it was always a tough sell to the German people that the best-managed and strongest economy in Europe should spend its taxpayers’ money to benefit the entire region, there’s a growing realization that doing so might actually benefit the Germans more than the alternative. It’s still not an easy sell, but it’s getting easier. Ultimately, Hill says, the only sensible solution is a tighter fiscal union in Europe. Someone has to tell the nicest house on the block that property values go up for everyone when the neighborhood prospers.