Germany’s Europe Deficit

Those days are over. The euro is in crisis, and Germany is the main protagonist. Germans don’t feel so rich anymore, so they don’t want to continue serving as the deep pocket for the rest of Europe. This change in attitude is understandable, but it has brought the European integration process to a halt.

By design, the euro was an incomplete currency at its launch. The Maastricht Treaty established a monetary union without a political union – a central bank, but no central treasury. When it came to sovereign credit, euro zone members were on their own.

This fact was obscured until recently by the European Central Bank’s willingness to accept the sovereign debt of all eurozone members on equal terms at its discount window. As a result, they all could borrow at practically the same interest rate as Germany. The banks were happy to earn a few extra pennies on supposedly risk-free assets and loaded up their balance sheets with the weaker countries’ government debt.

The first sign of trouble came after the collapse of Lehman Brothers in September 2008, when the European Union’s finance ministers decided, at an emergency meeting in Paris that October, to provide a virtual guarantee that no other systemically important financial institution would be allowed to default. But German Chancellor Angela Merkel opposed a joint EU-wide guarantee; each country had to take care of its own banks.

At first, financial markets were so impressed by the guarantee that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but interest-rate differentials within the eurozone remained minimal. That was when countries in Eastern Europe, notably Hungary and the Baltic States, got into trouble and had to be rescued.

It was only this year, when financial markets started to worry about the accumulation of sovereign debt, that interest-rate differentials began to widen. Greece became the center of attention when its new government revealed that its predecessors had lied about the size of the 2009 budget deficit.

European authorities were slow to react, because eurozone members held radically different views. France and other countries were willing to show solidarity, but Germany, traumatized twice in the twentieth century by runaway prices, was allergic to any buildup of inflationary pressures. (Indeed, when Germany agreed to adopt the euro, it insisted on strong safeguards to maintain the new currency’s value, and its Constitutional Court has reaffirmed the Maastricht Treaty’s prohibition of bailouts.)

Moreover, German politicians, facing a general election in September 2009, procrastinated. The Greek crisis festered and spread to other deficit countries. When European leaders finally acted, they had to provide a much larger rescue package than would have been necessary had they moved earlier. Moreover, in order to reassure the markets, the authorities felt obliged to create the €750 billion European Financial Stabilization Fund, with €500 billion from the member states and €250 billion from the IMF.

But the markets have not been reassured, because Germany dictated the Fund’s terms and made them somewhat punitive. Moreover, investors correctly recognize that cutting deficits at a time of high unemployment will merely increase unemployment, making fiscal consolidation that much harder. Even if the budget targets could be met, it is difficult to see how these countries could regain competitiveness and revive growth. In the absence of exchange-rate depreciation, the adjustment process will depress wages and prices, raising the specter of deflation.

The policies currently being imposed on the eurozone directly contradict the lessons learned from the Great Depression of the 1930’s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralyzed or destroyed by the rise of xenophobic and nationalist extremism.

If that were to happen, Germany would bear a major share of the responsibility. Germany cannot be blamed for wanting a strong currency and a balanced budget, but as the strongest and most creditworthy country, it is unwittingly imposing its deflationary policies on the rest of the eurozone. The German public is unlikely to recognize the harm German policies are doing to the rest of Europe because, the way the euro works, deflation will serve to make Germany more competitive on world markets, while pushing the weaker countries further into depression and increasing the burden of their debt.

Germans should consider the following thought experiment: withdrawal from the euro. The restored Deutsche Mark would soar, the euro would plummet. The rest of Europe would become competitive and could grow its way out of its difficulties but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative, and there would be widespread unemployment. Banks would suffer severe losses on exchange rates and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations; German pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Of course, this is purely hypothetical because if Germany were to leave the euro the political consequences would be unthinkable. But the thought experiment may be useful in preventing the unthinkable from actually happening.

George Soros is Chairman of Soros Fund Management and of the Open Society Institute.

© Project Syndicate 1995–2010