A widely held view in Europe goes more or less as follows. After the shock of reunification, Germany has sought to enhance competitiveness through a variety of means. The policy was remarkably successful, turning the “sick man of Europe” into a highly competitive economy. One implication, however, was an imbalance with the rest of Europe. Germany’s current account surplus find its counterparts in, amongst other places, current account deficits in southern Europe, especially Spain, Portugal, and Greece.
This was not particularly worrisome – or at least not many complained – until the financial crisis. The recession and stimulus packages pushed up budget deficits and public debt throughout Europe but particularly in the Eurozone’s most vulnerable part – southern Europe. As a result, virtually everybody now agrees that southern European countries (and Ireland) have no alternative but to take a healthy dose of fiscal austerity, whatever the cost.
This situation, however, implies that these countries are now hit by two negative demand shocks.
- The German deflationary stance, and
- Their own fiscal austerity.
As a consequence, according to the standard story, this puts a double onus on Germany. It should reduce its competitiveness advantage, and stimulate consumption as it is now the only positive source of demand in Europe.
In the very short run, both of these goals can and should be accomplished, according to the standard story, with expansionary fiscal policy being the only tool available to German policymakers – perhaps with some inflation.
The standard story is wrong
This view is widely held by a host of economists and commentators in Europe. It is also the semi-official view of the US government as spelled out in the private letter sent by Treasury Secretary Geithner to his G20 colleagues at their last meeting.
We believe that both the diagnosis and the proposed cure are wrong. Of course, the world’s current account is always balanced, so Germany’s surpluses must appear somewhere else as deficits. But is it Germany’s fault if it became more competitive? And is it reasonable to ask the Germans to carry the burden of a country like Spain that has based its economic development in the past 15 years on construction – the un-competitive sector par excellence? Or of a country like Greece with its retirement at age 53, fake budgets, etc? Moreover, Germany’s fiscal policy in recent years has not been a particularly restrictive. Its improvements in competitiveness have come from other sources – limited and timid labour market reforms, but still some reform.
The cure is also wrong, and impractical
At the normative level, if government debt is what markets fear right now, it is not clear at all that markets would welcome an increase in the supply of debt by the country they perceive as the last bastion of fiscal and monetary control. The biggest and most immediate fear today is market worries linked to excessive European debt. How an increase in German debt would ease such fear is not clear to us.
The immediate effect of an increase in supply of debt would be only indirectly and partially compensated by indirect effects on the growth of other countries, if at all. After all, a realistically-sized German fiscal expansion could not rescue Europe from its slump and stimulate significantly growth. Asserting that it could requires one to believe in implausibly large government spending multipliers.
Both theory and some empirical evidence support the notion that the multiplier is small if not negative, although we admit that there is much uncertainty on this point. But the large Keynesian fiscal multipliers so popular in the 1960s are hard to defend today on either theoretical or empirical grounds. If this is true for domestic multipliers, cross-border multipliers are even smaller.
The cure is politically unrealistic
From a positive standpoint, the idea that Germany should carry Europe on its shoulders and internalize all the positive externalities it can provide (assuming they indeed exist) defies political reality. Asking a government do embrace the interests of a small, far-away country is a political dead end – especially at a time of financial crisis.
Arguments for undertaking this sort of altruism are often shrouded in the veil of “by doing this, Germany would enhance its long-run interest”. Maybe, but it is far from clear that Germany’s long-run interest involve a rescue of Greece or Spain. And even if this were the case, it would require a degree of far-sightedness that no elected government, German or otherwise, generally has. Myopia is especially a problem in an emergency situation like the one Europe currently finds itself. In any case, accusations of shortsightedness made by southern European leaders against Germany are a bit too much!
The constraint on European growth is not Germany’s fiscal policy. It is the supply side rigidities that riddle all European national economies – especially those of southern European countries. To obsess about the demand side is simply misplaced – a slightly outdated, and oversimplified Keynesianism. Perhaps supply side reforms are unfeasible, but that should not lead us to fool each other that a German budget deficit of 5% instead of 3% of GDP will take Europe out of its predicament.