The French and German governments recently issued a joint statement titled “Together for a stronger Europe of Stability and Growth”. The communiqué emphasizes strengthened policy coordination and the use of indicators in establishing a common assessment of economic conditions in the currency union as a whole, member states, and particular markets. The new push for deeper policy coordination is intended to prevent future crises by identifying early on any incipient imbalances that might point toward fresh troubles ahead. Overall, the initiative aims at making the European economy more resilient and competitive.
Such an exercise begs the question of what should be the benchmark and underlying model in the envisioned common assessment. In this regard, Germany has sharpened its diplomatic skill-set, and is keen to have France on its side at the launching platform. For at some point the benchmark will need to be spelt out. While today’s German authorities may not wish to say so all too loudly, it is clear that they view Germany as the model to follow for its crisis-stricken euro partners. So it was left to Angela Merkel’s predecessor, Gerhard Schröder, to be a little more suggestive in a recent op-ed in The Financial Times titled “France should copy Germany’s reforms to thrive”. Referring to the experiences with Germany’s Agenda 2010 reforms of 2003-5, which apparently took a few years beyond Mr. Schröder’s chancellorship to bear fruit, the former German chancellor closes charmingly with the words: “I am confident that our friends in Paris will act accordingly.”
For it is France in particular who has come under immense pressure of late to finally do the right thing to get its ailing economy back on track. The right thing being to do the German thing of course: to embark on allegedly growth-friendly fiscal consolidation together with supposedly growth-boosting structural reform. Legend has it that this strategy restored Germany’s competitiveness and provided the foundation for the country’s miraculous resurrection from the depressing status as the “sick man of the euro” only so very few years ago. But is Germany really the model of excellence or perfection when it comes to the optimal economic management of the euro-zone economy?
The crucial issue to grasp here is that there are certain policies, principles, or behaviors that may work very well indeed for parts of a system but utterly fail when applied to the working of the system as a whole. Keynes famously made this argument in his General Theory by pointing at the core of what macroeconomics is really all about: avoiding “fallacies of composition”. Highlighting the simple truth that the economy as a whole cannot earn more than it spends, Keynes alerted the reader to the macroeconomic consequences of a joint effort at saving more by spending less; also known in introductory economics textbooks as the “paradox of thrift”. Advanced countries experienced a more practical refresher course in this matter when in 2008-9 everybody was keen to cut back on spending only to find out that poverty in plenty would be the dismal result. Keynesian ideas had a brief comeback shortly after as global policy coordination made sure that the global community was moving in tandem and freeloading on one’s neighbor’s stimulus packages avoided.
While hugely successful, in Europe that comeback of reason and virtue in positive joint action proved to be short-lived. Even before the Greek crisis was allowed to get out of hand, the German authorities had started pushing for a policy U-turn from stimulus to austerity. Market pressures on Greece and other countries then provided a welcome excuse. For the markets never pressured Germany itself. Instead, Germany acted out of conviction, imposing a sharp retrenchment in 2011-12, with the result that the German economy stalled too last year.
This may have even come as a surprise to Germany. For it was not the first time since the early 1980s for Germany to embark on growth-friendly consolidation, albeit with decreasing success. For a reason. In the past Germany could rely on others to behave differently from itself, though less and less so as the Maastricht Treaty spread the German “stability culture” across Europe. In his magnum opus Keynes mainly theorized in terms of a closed economy model. As the global economy is a closed economy it would have been foolish of him to make the case that a country can recover by boosting its competitiveness. True, an open economy can earn more than it spends by running up a current account surplus, but that requires others to lose competitiveness and spend more than they earn. The experiences of the 1930s convinced many that such an exercise was not a constructive way forward.
So how did Germany’s strategy work out in the 2000s? In a nutshell, it first made Germany sick and sicker. Investment plunged and consumption stagnated while unemployment and inequalities surged. Fiscal austerity failed in reducing the deficit. Eventually, however, by depressing German wages, Germany turned über-competitive and its current account surplus sky-rocketed; the trade and financial counterpart of which were mainly residing in Europe. In short, Germany earned more than it spent, and eventually recovered and balanced its public budget in this way, precisely because others – mainly Europeans – spent more than they earned. Germany fed on others for its growth until – predictably – crisis struck.
What would be different today if Europe were to follow the German model? It depends. If Germany were willing to return the favor and spend more than it earns, this would enable its former host to heal. Alternatively, the rest of the world could tolerate Europe running German-style external surpluses. The German model requires some welcoming host for it to work. Otherwise the joint effort to save more and delever has Irving Fisher join Keynes with another fallacy of composition: “The more the debtors pay, the more they owe.” Actually, coming to think of it, Europe is already at war with the macroeconomic insights of Fisher and Keynes. So the question is whether the German model applied across Europe will open up more fronts of currency and trade warfare with the rest of the world.
Europe’s leaders must be aware of this as they prepare for the EU council meeting later this week. Recent experiences with Abenomics and the yen factor on the one hand and solar panels and Chinese wine connoisseurs on the other are only a foretaste of what Europe is begging for as other nations see their European markets shrink while European nations are in overdrive gear to lifting their economies out of trouble through exports only. The lessons of the 1930s had inspired the immediate global policy response in 2009. The same lessons had also inspired the euro, which was meant to ban competitive devaluations forever. But somehow the authorities missed that competitive wage underbidding would end with the same devastating consequences for the currency union as a whole. As if this blunder was not bad enough, Europe’s leaders are now risking a re-run of the same mistake at the global level.