The eurozone’s ‘German paradox’

In: Uncategorized

12 Sep 2011

This is the first of my regular weekly articles for Fund Strategy magazine.

It is hard to see how the eurozone’s economic crisis can be tackled without resolving what could be called “the German paradox”. The eurozone model is built on two incompatible goals: fiscal discipline and the drive towards European integration. Within the eurozone framework these two ideals co-exist in a permanent state of tension.

The problem is not with the principle of a unified European economy but with the particular way it has been implemented. A single European economy could in theory boost growth by removing economic barriers and making it easier to organise production on a larger scale. But the form of integration pursued by the European Union (EU) is a top-down bureaucratic process that evades tackling the key economic challenges.

Originally the motivation for integration – as opposed to simply having a free trade area – was encapsulated in the discussion of what became known as “eurosceloris” in the 1970s and 1980s. The idea was that Europe’s economic stagnation needed to be overcome for it to compete with America and the emerging economies of Asia. Many concluded that a more united Europe was a good way to bolster competitiveness.

From the start it was accepted, largely at Germany’s insistence, that fiscal disciple was essential to stop the weaker countries free-riding on the stronger ones. The fear was that the less productive nations might use a united Europe to cash in on the strength of the larger economies.

As far back as 1992 the EU’s Maastricht treaty, which created the basis for the foundation of the euro, stipulated strict rules for fiscal discipline. For example, the government deficit was limited to 3% of GDP and the ratio of government debt to GDP was not meant to exceed 60%. These rules were further institutionalised in the EU’s Stability and Growth Pact of 1997.

Proponents of tighter EU rules on fiscal discipline need to explain why the earlier framework was so often breached. Years before the Greek debt crisis emerged in 2009 the rules were widely flouted by France and Germany as well as the peripheral countries.

The most common explanation for the failure of the economic framework is the difference in productivity levels between eurozone member states. For example, according to the Organisation for Economic Cooperation and Development (OECD) the output per hour worked by the average German in 2010 was $53.4 compared with $32.4 for Greece and $32.2 for Portugal.

Locking such disparate economies into a monetary union creates problems. If interest rates are kept low it is likely that bubbles will emerge in the weaker economies as a result of cheap credit. If interest rates are too high the risk is that ­economic activity is choked in the less productive nations.

But this inherent imbalance was not the only reason that the eurozone framework has consistently failed. It should not be forgotten that the stronger countries have also broken the rules. Even Germany preferred to keep its economy ticking over by bolstering state spending rather than tackling the structural barriers to bolstering growth.

The German elite was keen to impose fiscal discipline on everyone else, including its own population, but not itself. Although real wages in Germany have stagnated for two decades the level of state spending has remained stubbornly high.

What emerged was a bizarre set-up in which Germany restricted popular consumption at home but in effect subsidised it elsewhere in the eurozone. The eurozone framework allowed other member states to buy German goods more cheaply; often with credit provided by German banks. Germany’s large trade surplus was at least in part the result of this combination of restricted domestic consumption and the indirect export subsidy.

Under such circumstances it is hardly surprising that many Germans came to resent Greek and Portuguese consumption. As it happens German consumption levels are still higher in absolute terms than those of southern Europe. More importantly, the citizens of the member states should not be blamed for the failed framework as they played no role in creating it. Nevertheless it must have been galling for ordinary Germans to see their own incomes stagnate while the eurozone periphery enjoyed a consumption boom.

This brings us to the heart of the German paradox. It is hard to see how the eurozone can work without some kind of indirect subsidy, and therefore more lax discipline, for the weaker states. Otherwise the periphery is likely to find itself in a state of permanent stagnation. But having differential rules for less productive states calls into question a common European framework that is predicated on applying uniform regulations on all members.

The instinct of the euro elites is to try to impose ever more centralised bureaucratic control while muddling through. Even though there are no popular calls for a more integrated eurozone, with the general population having good reason to be wary, governments apparently see no alternative. Wolfgang Schäuble, the German finance minister, was recently quoted in Bilt, a German tabloid, as saying more economic powers needed to be transferred to Brussels.

Under such circumstances perhaps it is time to consider the possibility that the eurozone has intensified the region’s economic problems rather than helping to resolve them. It has led to the creation of disastrous financial bubbles while at the same time allowing Europe’s leaders to evade tackling structural weaknesses.

Abolishing the eurozone would not resolve all the region’s economic problems but it would at least remove what has become an evasion from tackling them. It would also open the way for democratic participation in the process rather than relying on the disastrous bureaucratic machinations of the euro elites.