Germany’s Hour

Who runs the European Union? On the eve of Germany’s general election, that is a very timely question.

One standard reply is, “The EU’s member states” – all 28 of them. Another is, “The European Commission.” But Paul Lever, a former British ambassador to Germany, offers a more pointed answer: Berlin Rules is the title of his new book, in which he writes, “Modern Germany has shown that politics can achieve what used to require war.”

Germany is the EU’s most populous state and its economic powerhouse, accounting for over 20% of the bloc’s GDP. Determining why Germany has been so economically successful appears to be elusive. But three unique features of its so-called Rhineland model stand out.

First, Germany has preserved its manufacturing capacity much better than other advanced economies have. Manufacturing still accounts for 23% of the German economy, compared to 12% in the United States and 10% in the United Kingdom. And manufacturing employs 19% of the German workforce, as opposed to 10% in the US and 9% in the UK.

Germany’s success in retaining its industrial base contradicts rich countries’ standard practice of outsourcing manufacturing to locations with lower labor costs. But Germany has never accepted the static theory of comparative advantage on which this practice is based. True to the legacy of Friedrich List, the father of German economics, who wrote in 1841, “the power of producing wealth is therefore infinitely more important than wealth itself,” Germany has retained its manufacturing edge through a relentless commitment to process innovation, backed by a network of research institutes. Its export-led growth has given it the benefit of increasing returns to scale.

The second feature of the German model is its “social market economy,” best reflected in its unique system of industrial “co-determination.” Alone among the major advanced economies, Germany practices “stakeholder capitalism.” All companies are required by law to have works councils. Indeed, large companies are run by two boards: a management board and a supervisory board, divided equally between shareholders and employee representatives, which take strategic decisions. The resistance to offshoring is therefore much stronger than elsewhere, as is a willingness to restrain wage costs.

Finally, there is Germany’s firm commitment to price stability. Germany needed no lessons from Milton Friedman on the evils of inflation. They were already hard-wired into its most famous post-war institution, the Bundesbank.

Lever suggests that it was as much the memory of the currency collapse of 1945-1948 as of the hyperinflation of the 1920s that drove home this lesson. Likewise, an aversion to public deficits mirrors the population’s resistance to private indebtedness.

Institutionally, the EU has become Germany writ large. The Commission, the European Parliament, European Council, and the European Court of Justice mirror the decentralized structure of Germany itself. The EU’s gospel of “subsidiarity” reflects the division of powers between Germany’s federal government and states (Länder). Germany ensures that Germans fill the leading positions in EU bodies. The EU rules through its institutions, but the German government rules those institutions.

Yet talk of “hegemony,” or even “leadership,” is taboo in Germany – a reticence that stems from Germans’ determination not to remind people of their country’s dark past. But denying leadership while exercising it means that no discussion of Germany’s responsibilities is possible. And this inflicts costs – especially economic costs – on other EU member states.

Germany has created a system of rules that entrenches its competitive advantage. The single currency rules out devaluation within the eurozone. It also ensures that the euro is worth less than a purely German currency would be.

The EU’s recent Treaty on Fiscal Union – the successor to the Growth and Stability Pact – prescribes binding legal commitments to balanced budgets and modest national debt, backed by supervision and sanctions. This precludes deficit finance to boost growth. And Germany’s insistence that non-wage costs be equivalent throughout the EU is less a device for enhancing Germany’s competitiveness than for reducing others’.

The EU, especially the 19-member eurozone, thus functions as a vast home base for Germany, from which it can launch its assault on foreign markets. And that base is strong. Germany exports to the EU 30% more than it imports from it, and runs one of the world’s largest current-account surpluses.

This is a benign rather than a brutal hegemony. But at its heart lies a massive contradiction. National accounts must balance. A surplus in one part of Europe means a deficit in another. The eurozone was established without a fiscal transfer mechanism to succor members of the family who get into trouble; the European Central Bank is prohibited from acting as lender of last resort to the banking system; and the Commission’s proposal for Eurobonds – collectively guaranteed national bond issues – has foundered on Germany’s objection that it would bear most of the liability.

Germany has been willing to provide emergency finance to debt-strapped eurozone members like Greece on the condition that they “put their houses in order” – cut social spending, sell off state assets, and take other steps to make themselves more competitive. The Germans see no reason to take measures to reduce their own super-competitiveness.

What can be done to achieve a more symmetric adjustment between Europe’s creditors and debtors? Barring a fiscal transfer mechanism, John Maynard Keynes’s 1941 plan for an International Clearing Union might be adapted for the eurozone. Member countries’ central banks would hold their residual euro balances in accounts with a European Clearing Bank. Pressure would be simultaneously placed on creditor and debtor countries to balance their accounts, by charging rising interest rates on persistent imbalances.

An EU clearing union would be a less visible intrusion on German national interests than a fiscal transfer union would be. The essential point, though, is that for the eurozone to work, the strong must be prepared to show solidarity with the weak. Without some mechanism to realize that, the EU will limp from crisis to crisis – probably shedding members along the way.

Republication forbidden. Copyright: Project Syndicate 2017 Germany’s Hour