Germany’s economic power allowed it to extend its economic model on the rest of Europe. It is not just Germany, of course. Other countries share German policy preferences, largely creditor nations. Germany’s economic power has been increasing over the past few decades. Today Germany is economically and financially the dominant economy in Europe. As such, its ability to influence the economic policies of other countries and its ability to influence the future evolution of the European macroeconomic policy regime is considerable.
What are the sources of German economic power? First, Germany is the largest economy. Second, Germany has very strong public finances. Third, the capacity to raise debt is significant. Fourth, Germany runs external surpluses and is a large net foreign creditor. Without German’s financial strength, any bail-out regime will be inadequate. This effectively means that German non-participation dooms any bail-out regime. If, for example, Finland decided not to contribute to a financial rescue, it would not significant diminish the regime. That said, rising trade and financial integration has also made Germany both more sensitive and vulnerable. Economic-financial interdependence often is asymmetric and this asymmetry provides Germany with a great deal of influence in European economic and financial affairs.
The (West) German economy has been characterized by a specific combination of institutions, ideology and interests, creating a German model of macroeconomic management. The combination of these institutions somewhat inadvertently led to the rise of Germany structural power (Strange). In a way, Germany obtained economic power as inadvertently as some people say Britain acquired its empire: in a fit of absent-mindedness.
What institutions underpin the German model? First, the West German government established an independent central bank tasked with maintaining low inflation. (This was largely the result of the experience with hyperinflation in the 1920s.) By contrast, central banks in other major West European countries were not as independent or not independent at all. Germany was able to establish a track record of monetary stability and maintain inflation rates at levels consistently below those of the other major European economies, such as France, Italy and the UK.
Second, the government made far more modest use of an activist fiscal policy to support economic growth. Keynesianism experienced only a very short-lived popularity in the late 60s and early 70s. Ultimately, it was the priority accorded to price stability rather than growth and an independent central bank unwilling to accommodate expansionary fiscal policies that put paid to activist fiscal policies. A relatively high degree of economic openness also limited the effectiveness of fiscal stimulus measures. Last but not least, German ordo-liberal thinking dominated economic policy. More speculatively, Germany, aware of its precarious position as a frontline state, was also more concerned about high public debt than other European countries.
Third, the structure of the German wage bargaining system, dominated by unions in the export sector, typically resulted in wage moderation. Thus export openness contributed to relatively lower wage inflation (adjusted for productivity) than in other countries where wage bargaining was dominated by unions operating in sheltered sectors, including public services, or more militant unions, period. An independent central bank whose actions would have helped increase unemployment rather than accommodate inflationary wage settlements was important. The wage bargaining ha undergone important changes since the nineties, but it remains geared to preserving German economic competitiveness.
These institutional features created a macroeconomic policy regime that prioritized low inflation over economic growth and ended up relying on exports for economic growth rather than activist and potentially debt-increasing fiscal policies. Not only did this allow Germany to establish a track record of monetary and fiscal probity. It also contributed to structural trade and current account surpluses throughout much of the post-war period. The commitment to financial stability and external surpluses increased German power as Europe became economically and financially more integrated. This became increasingly evident following the break-up of the Bretton Woods system and the creation of (various) European exchange rate regimes.
In the context of balance-of-payments imbalances, power derives from the “capacity to avoid the burden of adjustment required by payments imbalance” (Cohen 2006: chapter 2). This provides the surplus country with autonomy and constrains the policy space of the deficit country. While the surplus country is autonomous, the deficit country will sooner or later be forced to either devalue (so-called expenditure-switching policies) or adjust monetary and fiscal policies (expenditure-changing policies) to address the external disequilibrium. The external equilibrium needs to be restored via decreased domestic absorption and increased exports.
The autonomy of the surplus country is reflected in its greater power to delay and deflect economic adjustment. If the deficit country does not adjust, it will eventually run out of reserves, as the markets will become unwilling to finance the deficit. The surplus country, by contrast, is able to hold out much longer by absorbing balance-of-payments surpluses in to FX reserves. This may or may not have economic consequences somewhere down the line (e.g. inflation). But it is clear that, unlike the deficit country, the surplus country can choose to resist nominal exchange rate appreciation more easily and is less readily forced to adjust its macroeconomic policy mix. In general, the surplus country finding it easier to both delay and deflect adjustment is able to stick to its macroeconomic preferences, while the deficit country is not.
It is useful to distinguish between the permanent costs of adjustment and the transitional costs. The transitional costs associated with a change in economic policy typically falls on the deficit country. The permanent economic costs in terms of output and domestic consumption are always shared, even though they are typically felt much more strongly in the deficit country. After all, the deficit country needs to reduce domestic absorption and export more, while the surplus country (in a two-country model, at least) will need to increase domestic absorption and reduce exports, if balance is to be restored. Put differently, a devaluation of the deficit currency will lead to the revaluation of the surplus currency. The question hence is which country will adjust its economic policies and sacrifice or compromise its macroeconomic policy preferences. For instance, will the deficit country forego growth in the interest of monetary and fiscal discipline, or will the surplus compromise its monetary and fiscal discipline in order to help restore the external equilibrium.
This analysis becomes especially relevant in the context of fixed (but adjustable) exchange rate and particularly in the presence of an open capital account. There the so-called ‘unholy trinity’ emerges. In this context, the ability of the deficit countries to pursue an independent monetary and, to some extent, fiscal policy is heavily constrained. The country that benefits from the largest current account surpluses, the largest government debt market and the greatest financial credibility will tend to be the only country capable of pursuing an independent monetary and fiscal policy. Even the lesser surplus countries often find their policies constrained the so-called anchor country. If the capital account is closed, countries enjoy (short-term) policy flexibility, even if expansionary policies will ultimately result in devaluation. If the capital account is completely open, even short-term policy flexibility does not exist if the exchange rate peg is to be maintained.
Again, this does not mean that the stronger country is an invulnerable position in terms of the permanent adjustment costs. It simply puts it into a relatively less vulnerable position. For instance, a massive currency devaluation of a deficit country will lead to greater economic turmoil there in the surplus country that will see its currency appreciate, not least because the economy of the devaluing currency is only one among many trading partners of the surplus economy.
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| Source: Economist |
Again, this does not mean that the stronger country is an invulnerable position in terms of the permanent adjustment costs. It simply puts it into a relatively less vulnerable position. For instance, a massive currency devaluation of a deficit country will lead to greater economic turmoil there in the surplus country that will see its currency appreciate, not least because the economy of the devaluing currency is only one among many trading partners of the surplus economy.
The emergence of a fixed exchange rate regime in the 1970s and an increasingly open capital account regime in the 1980s in Europe led to the emergence of the deutschmark as the anchor currency in Europe. It increased the constraints on economic policies other countries were able to pursue. This provided Germany with structural power vis-à-vis other European countries. Structural power is the power of a state to indirectly influence others by controlling the structures within which they must operate (Strange 1996).
This type of power is not relational, however, in the sense that while it constrains it does not lend itself as a tool to exercise direct influence on another actor’s behaviour. Structural power (Susan Strange) confers broad policy autonomy, but it does provide the anchor county with direct leverage of other countries’ economic policies. Ultimately, countries not willing to be constrained in this way could always opt to float their currencies, typically at manageable economic - but not necessarily political - costs. Last but not least, structural power does not translate into readily quantifiable, tangibly economic gains, either. It simply means that the structurally dominant country can pursue its preferred economic policy, while indirectly and inadvertently forcing others to adjust their policies.
Famously, this type of power was put into relief during the early 1990s. Reunification had led to a rising demand and price pressures in the German economy, leading the Bundesbank to raise interest rates. However, other ERM countries were cyclically in a very different position. In the face of ‘speculative’ attacks, a number of countries were forced to devalue. This demonstrates neatly the structural nature of German power. German policy-makers, unlike others, enjoyed policy autonomy. By taking advantage of this autonomy, they set the constraints under which other policy-makers had to operate. By contrast, the other countries saw their own policy space heavily constrained.
The advent of EMU and actually one of the reasons why EMU came into existence was because the deficit countries were eager to remove the balance-of-payments constrained and thus diminish German power by supra-nationalising monetary policy. In the context of a monetary union (read: irrevocably fixed exchange rates), balance-of-payments deficits will always be financed by the private- or, failing this, by the official sector. On the flipside, the fiscal constraint becomes tighter for financially/ fiscally weaker countries. Fiscal problems cannot easily be addressed by way of a growth-boosting devaluation. The lack of control over monetary policy removes a further tool to address fiscal imbalances, at least in the short term. Put differently, monetary union removes expenditure-switching (read: devaluation) as a policy option and leaves weaker countries only with expenditure-changing policies (read: fiscal austerity).
The move from fixed (but adjustable) exchange rates to monetary union helped enhance the power of the economically stronger country in similar way the move from a closed to a an open capital account in the context of a fixed exchange rate regime strengthened the power of the surplus country. Similar to balance-of-payments imbalances, large fiscal deficits and/ or rapidly rising debt weaken the policy autonomy of the financially weak country. The fiscally stronger country, enjoying superior access to market funding at cheaper rates, enjoys far greater policy autonomy. Similarly, the ability of the fiscally weaker country to defer or deflect adjustment compared with the country with sound public finances is much weaker. The strong country can choose to maintain fiscal discipline or it can decide to pursue expansionary policies, thus supporting the short-term adjustment of the fiscally weaker countries via higher growth. However, not facing immediate market pressure to adjust policies, it is in a position to delay and deflect adjustment. The financial weak country is not.
Again, adjustment is always mutual, complementary and shared in the sense of the eventual economic costs. They are also typically much larger in the case of the weaker country. The question is once more who will bear the transitional costs in terms of adjusting fiscal policies. Will the fiscally stronger country boost domestic demand and, especially in the context of fixed rather than flexible exchange rate, help boost economic growth in fiscal weaker country, thus supporting adjustment there. Or the will the fiscally weaker country be forced into fiscal retrenchment, potentially leading to a decline in economic growth and a further deterioration of the fiscal position. To a significant degree, this is a question of whose policy preferences will prevail and which country will absorb the ‘transitional costs of the adjustment’.
The fiscally and financially stronger country is not invulnerable. Fiscal austerity will reduce export growth and, more extreme, a sovereign default would typically lead to financial losses in the fiscally stronger country to the extent that it holds claims. Potential financial contagion could further raise the economic and financial costs. However, the costs to the defaulting country will almost always by far exceed the costs incurred by the financially stronger country. The stronger country may not be invulnerable, but its relative stronger position confers its significant leverage vis-à-vis financially weaker governments by way of the provision of conditional financing. This leverage does lend itself more easily to the exercise of relational power, that is, the power get another state to take actions it would otherwise not have taken.
The sources of German financial and ultimately relational power are similar to the sources of structural power in the case of balance-of-payments imbalances. In addition to running external surpluses and having established a solid monetary and financial track record, other factors matter.
First, Germany is among the larger European economies the one with greatest borrowing and lending capacity. This is currently reflected in lower debt ratios, a lower fiscal deficit, an AAA credit rating and, most revealingly, in low yields on government debt. The combination of economic size and borrowing capacity makes Germany the most powerful country in terms of its ability to extend credit to other countries in financial need.
Second, Germany is constitutionally obliged to run a structural surplus (so-called ‘debt brake’). This provides investors with some assurance that government finances will remain on a sustainable path. Moreover, from a more short-term perspective, Germany’s short- and medium-term fiscal outlook will not force it to implement growth-diminishing fiscal austerity. It also has a greater capacity to generate economic growth through extra-EMU exports, offsetting weaker intra-EMU exports, than most other European economies.
Third, German debt is a ‘safe haven’ asset for EUR investors in the context of monetary union. Due to its track record of monetary and financial stability as well as its large current account surpluses, investors are willing to lend to Germany in times of market stress, typically at very favourable conditions. This has thus far led to an easing of Germany financing conditions, further underlining its continued ‘anchor’ economy function in the context of EMU.
In short, the Germany benefits from the largest borrowing capacity and the most favourable interest rates. The resulting ability to offer financial support to other governments, bilaterally or multilaterally, provides it with political leverage. Due to its ability to offer conditional financial support in exchange for a change in policy, Germany is the most powerful country in Europe as far as economic policy is concerned. EMU has enhanced not only enhanced German power by narrowing the policy and especially fiscal policy space of the other European countries relative to Germany. Naturally, this is not necessarily a permanent feature of EMU. Germany’s strength is to some extent the function of lack of fiscal discipline and/ or prudence in other countries. EMU has also led to a qualitative change. Power is (much more) relational today, as opposed to (primarily) structural pre-EMU. Germany certainly is not in a position to single-handedly bail out the rest of the Eurozone governments, but its participation in any rescue effort is indispensable if it is to be credible.
Is Germany a regional hegemon? According to Keohane (1986), the hegemon “must have access to crucial raw materials, control major source of capital, maintain a large market for imports, and hold comparative advantages in good with high value added, yielding relatively high wages and profits”. This definition is somewhat expansive. A weaker version requires the hegemonic state to be “powerful enough to maintain the essential rules governing interstate relations, and willing to do so” rather than “structural domination”. Germany does have access to raw materials, even though this access is taking place on a commercial rather than a political or jurisdictional basis. Depending on how narrowly one defines this characteristic, Germany may or may not meet it. It does however meet all the other criteria. Germany is undoubtedly the largest provider of capital in Europe. Its current account surplus (equivalent to net capital flows) is running at around 4-5% of GDP (or EUR 200 bn). It is also the largest producer of capital goods. Not only is Germany the largest economy in EMU, it is also the largest market of intra-EMU imports, accounting. Last but not least, it does hold a comparative advantage in terms of high value added goods and both wages are high and corporate sector is very profitable.
This definition of hegemony may be a somewhat arbitrary definition. Ultimately, it may be more interesting to analyse how, where and to what effect German economic power historically manifested itself. In economic terms, the breakdown of the Bretton Woods system left Germany’s macroeconomic preferences unchanged, while its own macroeconomic policies in the context of fixed exchange rate and increasing cross-border capital flows created increasing constraints for others. Germany’s power was largely structural in nature. While Germany had a strong preference for stabilizing intra-European exchange rate in order to maintain financial stability and export competitiveness, its ability to change other countries economic policy mix was very limited. Indirectly, however, structural power contributed to the decision of other countries to agree to so-called convergence policies and a German-style monetary union.
European monetary integration has increased German power, but has also increased its vulnerability. EMU may or may not have been a quid pro quo for German reunification. But EMU almost completely reflected German policy preferences and effectively led to the extension of Germany’s monetary regime to the rest of Europe. EMU ended up increasing Germany’s relative power (as well as its absolute economic-financial vulnerability). Rising market pressures punished fiscally weaker countries, while enhancing the political power of the fiscally stronger countries, namely Germany. Germany’s ability to successfully operate under the constraints imposed by EMU (low inflation, no competitive devaluation, generation of growth via exports) combined with a domestically institutionalised preference for fiscal discipline allowed Germany to out-compete most other countries and maintain sound public finances. This ended up conferring relational power, defined as getting somebody to do something s/he would not otherwise have done. Not only does the newly emerging Eurozone governance structure, including the initial rescue efforts, reflect German preferences.