Germany’s economy is among the most highly integrated among the world’s largest economies. The US and Japan are comparatively closed economies and China’s trade openness has been declining in the past few years. In recent years, Germany managed to maintain its share in international markets, while the share of most advanced and European economies declined. Manufacturing represents a more important share of economic activity than elsewhere. In a way, a line can be drawn from Imperial Germany’s over-industrialisation to today’s persistently large industrial and manufacturing sector and goods trade surpluses. Germany is particularly specialised in advanced manufacturing. Monetary union and the rise of Chinse have increased specialization. In Germany’s case, this has led to increased export dependence and two increased vulnerabilities in terms of external trade shocks.
European economic integration has has lead to agglomeration effects (Krugman 1993) as well as the emergence of complex supply chains. This has particularly benefitted Eastern European economies. Following their entry into the EU, Germany and less so other countries heavily invested in Eastern Europe in order to take advantage of a relatively low-cost and educated workforce. Eastern European economies benefitted from foreign investment and technology transfers. In practice, the high degree of integration has benefitted both Germany and new member-states. This is presumably why in spite of all the political antagonism over issues such as immigration and the rule of law, no Eastern European leader has ever questioned economic integration.
Germany has also been running the largest external surpluses. Germany has always tended to run trade surpluses. German has always run sizeable external surpluses. The only exception were the two oil crises and German reunification. Germany, like Japan, seem to run a structural trade and current account surpluses. Germany has generally been running trade and current account surpluses following the completion of economic reconstruction after WWII. So has Japan. Leaving aside the question as to what drives them, these surpluses translate into large net foreign financial claims. Foreign claims take the shape of foreign direct investment, credit or portfolio claims, both equity and debt.
European monetary union represents by and large an extension of the DM zone. No wonder Germany was better adapted to life under fixed exchange rate and low inflation While interest rate convergence led to a demand and in some cases a financial boom in the so-called periphery, relative German economic stagnation led to important labour market reform under the Schroder government. This helped intensify intra-EMU divergence. German surpluses began to surge under EMU and especially following the Hartz IV reforms. An important measure of competitiveness, unit labour costs barely increased just as other EMU members unit labour costs began to rise rapidly elsewhere. Fiscal consolidation also kept a lid on domestic demand and import growth. leading to large German trade and current account surpluses.
Germany is economically and financially the most powerful state in Europe. It has the largest economy and the most favourable fiscal position and lowest interest rate costs (among the larger European economies) and hence the greatest borrowing and lending capacity. Very large external surpluses and a commitment to low inflation make Germany the “safe haven’ of the Euro Area. Moreover, Germany’s commitment to fiscal rectitude has been institutionalised in constitutional law (so-called ‘debt brake’). Last but not least, it has Europe’s largest and most competitive export sector, allowing it more than other Euro Area members to tap external sources of demand (e.g. China, Russia).
In the 70s, 80s and 90s, German power was largely structural in nature. Today Germany’s economic strength allows it to exercise relational power and, ultimately, have its economic policy preferences prevail. It goes further. Not only is it able to maintain its economic policy preferences (monetary stability, fiscal discipline) and thereby, for better or worse, push the ‘transitory costs of adjustment’ onto the financially weaker countries. It seems also poised to export the German approach to macroeconomic policy to the rest of Europe by way of conditional financial support and by leading by example. This position of preponderance allows it to stick to its economic policy preferences, while getting others to adjust economically and financially. Naturally, Germany benefits from the support of other financial sound European countries. But Germany, by virtue of its size and borrowing capacity, plays the leading role. Without its financial support, a Euro Area would be impossible.
This does not mean that Germany is omnipotent in terms of having complete control over other countries’ policy choices. First of all, its borrowing capacity may be the largest among European countries, but it is not nearly enough to provide a bail-out package large enough to save the larger EZ members, should they run into re-financing difficulties. Being the financially strongest country, Germany has by far the largest say over rescue policies and retains an effective veto over rescue efforts and concomitant reform. Second, a sovereign default or a Euro Area exit would hurt Germany economically and financially. The German public and/ or private sector would incur significant financial losses as a result of a default and/ or currency re-denomination. It would also be faced with an appreciating currency, undermining its export competitiveness and potentially severely hurting economic activity. Nonetheless, it is clear that the costs to the defaulting (exiting) country would be far higher than to Germany in both the short- and long-term. Mutual dependencies are rarely symmetrical, but rarely are they completely asymmetrical either. It is this asymmetry in terms of vulnerability and the provision of conditional financial support that provides Germany with significant influence over on-going rescue efforts.
One solution is to force the entire burden of adjustment on the weaker countries, albeit flanked by conditional financial support. There may be political and economic limits to such a one-sided approach. Not only may deflation undermine the very fiscal adjustment that is required to make debt sustainable. Austerity and structural economic reform may lead to domestic political breakdown in some of the weaker countries against the backdrop of high unemployment, low growth and declining living standards (e.g. Argentina 2001). Another solution is for the fiscally sound countries to pump-prime and reflate their economies in order to generate growth and import demand, thus easing the adjustment burden for the weaker countries. Naturally, the two solutions can be combined. In practice, it is unlikely that Germany will allow itself to be forced into a fiscal expansion and internal revaluation. It almost certainly will not accept any arrangements that would lead to more symmetric burden sharing, other than providing conditional, temporary financial support (e.g. John Maynard Keynes versus Harry Dexter White at Bretton Woods).
Germany naturally prefers to push the burden of adjustment on the deficit countries by forcing them to implement fiscal austerity to re-establish government debt sustainability, to introduce structural reform to raise (medium-term) economic growth and to deflate the economy to make it more competitive. Germany is willing to support this by way of conditional financial support. But Germany is unwilling to reflate its economy by pursuing an expansionary fiscal policy, which would facilitate the adjustment of the debt-constrained Euro Area economies. Being in an economically and financially stronger position, Germany is not willing to compromise its economic policy preferences, notably low inflation, fiscal discipline and export-led economic growth.
Germany’s stance is, however, not solely determined by an ideological commitment to or a preference for s a certain type of economic policy. Reflating its own economy or going for the so-called ‘bazooka’ solution – whether in the form of offering unlimited financial resources or encouraging the ECB to intervene more aggressively – would create moral hazard and it could undermine Germany’s financial position. Eurobonds, permanent fiscal transfer or an ECB-led bail-out, to the extent to which these are options at all given the domestic and supra-national legal constraints, carries the risk of undermining the Euro Area´s commitment to price stability and, more seriously, could lead to a permanent weakening of the regime.
It is true that the gradual approach to solving the crisis and the ‘too little too late’ approach played a role in exacerbating the crisis. It is also true that imposing fiscal austerity on a country unable to gain competitiveness via currency devaluation makes achieving sustainability more difficult, perhaps impossible. These arguments carry a lot of weight if what Europe is dealing with is a liquidity crisis rather than a solvency crisis. If it is not, it is difficult to see how the provision of bazooka-like, even unlimited financial support will help solve the crisis. It would only end up undermining the entire regime. Thus the German approach does make political sense.
By providing conditional financing, albeit at subsidized rates, is the most cost-effective way to try to solve the crisis from a German perspective. It is also the more cautious approach. It limits the risk of a potential German financial over-commitment (or a weakening of ECM commitment to low inflation) by limiting the risks to its own balance sheet, which provides the backbone of any credible Euro Area rescue effort. While it is cumbersome and has worsened the crisis, it allows Germany to deal with moral hazard and to retain room for manoeuvre in case the current crisis is more than a liquidity crisis. Last but not least, by choosing a gradual approach and maintaining conditionality, it allows Germany to determine the characteristics of the newly emerging, more integrated fiscal regime.
Germany as the economically most powerful country has been able, by and large, to have its preferences prevail during the economic integration efforts over the past couple of decades (EMU, fiscal compact). Pre-EMU, it sought to prevent currency devaluation in its major European trading partners through FX intervention. Today, it is seeking to rescue the Euro Area by offering limited and conditional fiscal support. In both cases, the support was limited and pushed the adjustment burden on the financially weaker country. By institutional (constitutional) design, habit and, perhaps, cultural inclination, it will stick with a policy of –as some (critics) call it – competitive disinflation. Germany is visibly willing to act as a “financial stabiliser”, for good, self-interested reasons, ranging from the financial exposure of its banking sector over a potential EMU sovereign default to preserving EMU for both economic and political reasons. Germany’s policy DNA, a mix of institutions and beliefs, does not seem to allow it to act as a significant (discretionary) “economic stabiliser” in terms of generating intra-EU demand, but it is willing to act as a temporary “financial stabiliser” and as an economic moderniser by compelling other countries to implement structural reforms. This prudent, cautious and gradual approach has no doubt exacerbated the Euro Area crisis. Then again, leaving the domestic institutional and ideological commitment aside, would any government in the world run the risk of providing large-scale financial support without policy reform commitment.