In its attempts to rescue the euro, Germany is often seen as the odd country out. However, what is seldom understood abroad is that the German position is about more than limiting its own fiscal exposure.
In its attempts to rescue the euro, Germany is often seen as the odd country out. It blocks constructive solutions with its resistance to either using ECB funds or creating sufficiently large rescue mechanisms for indebted countries and banks, all while insisting on pronounced austerity. However, what is seldom understood abroad is that the German position is about more than limiting its own fiscal exposure.
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It is often claimed the German approach to the euro crisis, and its emphasis on price stability in particular, is based either on its narrowly defined interest as a capital surplus country or on the historical experience of hyperinflation in the Weimar Republic. These two factors do play a role, however they are not sufficient in explaining the German debate. The danger of a devaluation in external assets through inflation is almost never mentioned in public debate and is less important in German policymaking than the potential losses that would occur if Germany’s foreign debtors defaulted. Second, countries such as Austria and Greece have also experienced hyperinflation, but do not share either Germany’s fear of inflation or its resistance to ECB intervention in sovereign bond markets.
An important but rarely discussed reason for Germany’s emphasis on price stability is the influence on German economic thinking of “ordoliberalism”—a theory developed as a reaction both to the consequences of unregulated liberalism in the early twentieth century and subsequent Nazi fiscal and monetary interventionism. The central tenet of ordoliberalism is that governments should regulate markets in such a way that market outcomes approximate the theoretical outcome in a perfectly competitive market. Inflation is seen as distorting valuable price signals, hence creating high economic costs.
Ordoliberalism differs from other schools of liberalism in that it places a greater emphasis on preventing cartels and monopolies, but it keeps a number of beliefs central to other strands of economic liberalism. For example, it shares a neoliberal opposition to activist monetary and fiscal policies. Politically, the concept of ordoliberalism is closely linked to the first phase of the German social market economy from 1948 to 1966, as the legislation of this time included many basic premises of ordoliberalism.
Germany’s “Neoclassical” Mainstream
There are very few academic economists explicitly working in the ordoliberal tradition today. However, most influential economists in today's universities and in the public sector have been influenced by ordoliberal ideas during their education. Unlike in other European countries and the United States, Germany has very few influential Keynesian economists and most academic economists would consider themselves to be liberal. Their ideas filter through to ministries and to the Bundesbank, which mainly hire from German universities.
In fact, the German consensus is close to what is known internationally as “New Classical Economics”—that is, the modern branch of macroeconomics that builds on neoclassical microeconomics, with its strong influence of rational expectations. Economists of this paradigm believe that markets always work smoothly—that is, financial markets always get the price of assets in a way that reflects all relevant information correctly. They also believe national economies have the capacity to swiftly adjust to shocks. If prices and wages sometimes do not react quickly, they would argue that this is due to institutional barriers such as collective bargaining or legal minimum wages. The solution is structural reform to make markets more flexible. Fiscal problems are mainly a consequence of irresponsible behavior by policymakers, which in turn react to incentives. This perception of economic mechanisms leads to a number of policy positions.
Budget Consolidation and Bailouts
The German economic mainstream believes in quick and decisive budget consolidation to be achieved through reducing government expenditure and, to a lesser extent, increasing taxes. Significantly cutting the deficit favorably alters debt dynamics. As a result, the risk of future insolvency is reduced. At the same time, less new debt and less government spending today mean less taxation in the future. All this increases private sector confidence, which can in turn be expected to lead to more investment. According to this view, harsh austerity measures do not necessarily lead to a deep recession but rather improve the outlook for growth. Consequently, difficulties in reaching fiscal targets are seen as a failure on the part of the political class to make or pass the necessary cuts or tax increases and hence amount to a lack of political will. Since excessive government borrowing is seen as the cause of the crisis, bailouts are seen as a genuine threat. Rescue packages are at best a necessary evil.
ECB Bond Purchases and an ESM Banking License
Using the ECB as a crisis fighting tool is similarly seen critically, both when one discusses the ECB's direct bond purchases and giving the ESM access to the central bank`s refinancing mechanism. In both cases, it is feared that ECB action would lower financing costs to governments and hence give incentives for governments to borrow more, rather than embark on structural reforms. Moreover, the German mainstream sees the danger that in the end, using the central bank in any rescue attempt might lead to an expansion of the monetary base and ultimately higher inflation.
Economic Policy Coordination
Although many outside Germany believe in coordinating economic policy (fiscal policies, wage increases, social security contributions, and taxation) across the eurozone, Germans have been more skeptical. For example, when Germany lowered social security contributions in 2008 and increased VAT, French experts perceived it as a beggar-thy-neighbor policy. German exports became cheaper because of lower wage costs and imports dropped as increased VAT lowered real disposable income and hence aggregate consumption. In Germany, however, few thought the move would have an impact on the rest of the eurozone. Instead, it was seen as a measure that would improve supply conditions and hence boost growth. This German view should be seen in the context of neoclassical economic thinking, which ignores how improvements in supply-side conditions in one country affect the demand conditions in others. The cut in social security contributions in Germany improved supply-side conditions there, leading to more output and employment. The lack of aggregate demand was not considered a serious potential problem. As a result, the German elite neglected the fallout for the rest of the euro area.
A closely related issue concerns external imbalances in the euro area. Since 1999, current account deficits and current account surpluses in euro countries have increased to record levels. Greece, Portugal, and Spain have experienced deficits of 10 percent of GDP or more while Germany has run surpluses of more than 7 percent at times. These imbalances are now seen by many outside Germany as major contributing factors to the euro crisis.
Strong aggregate demand in one country increases imports and hence leads to a deterioration of the current account. However, the German mainstream sees current account imbalances in the eurozone as a consequence of lost competitiveness and excessive consumption in deficit countries and weak investment in Germany itself. Consequently, German neoclassical economists believe the solution is wage restraint or outright wage cuts in deficit countries. In their eyes, such a policy would increase price competitiveness in deficit countries to such an extent that exports would increase and imports would fall. Stronger wage growth in Germany, on the other hand, would simply hamper German competitiveness and reduce German investment.
The “New Keynesian” Alternative
Of course, even in Germany, there are dissenting voices. The approach of these economists, who could be called “New Keynesians,” provide an alternative to the neoclassical mainstream approach. They see their allies in prominent American and British economists such as Paul Krugman and Martin Wolf, both vehement critics of the official German position.
In particular, New Keynesian economists take a different view on the flexibility of an economy and how quickly prices and wages adjust. They emphasize a number of underlying economic reasons why, even after comprehensive structural reform, wages and prices only adjust slowly. For example, irrespective of the legal environment, a company does not like to cut its employees’ nominal wages because it undermines morale and productivity. Changing prices are also associated with a number of costs, such as that of printing new catalogs or menus. If prices and wages are sticky, however, a lack of aggregate demand increases unemployment. If high unemployment persists, it may turn structural and hamper a country’s long-term growth outlook.
According to this view, the development of aggregate demand in the euro area and in any given country is a key factor. Output will expand only if aggregate demand is increasing fast enough. Thus the demand side of the economy determines growth and employment to a large extent. In this view, austerity measures dampen economic growth, lower tax revenue, and increase government transfers. If administered incorrectly, such austerity might actually damage debt sustainability. Economists following this way of thinking argue that financial markets might overshoot prices and interest rates, possibly leading to insolvent governments. In such a situation, using the central bank as part of the rescue mechanism is seen as the most effective way to solve problems. With regard to the adjustment of current account imbalances, New Keynesian economists disagree with the mainstream German position that it is only deficit countries that should use wage cuts to adjust. Such a policy of nominal wage cuts or of prolonged nominal wage stagnation is seen as creating problems of its own for deficit countries, as this depresses domestic demand and leads to non-performing loans in the banking sector. Therefore, these economists demand a more symmetric approach to current account imbalances with surplus countries taking measures to support domestic demand, which can increase deficit countries’ exports.
German Political Parties and the Euro Crisis
While the programs adopted by political parties are seldom completely formed by a single strand of economic thinking, one can clearly see the shadow of ordoliberalism in the policy of most traditional German parties.
The Christian Democratic Union (CDU) (and its Bavarian sister party, the CSU) sees itself strongly in the tradition of the “social market economy” developed under CDU economics minister Ludwig Erhard following World War II. In the euro crisis, it sees a lack of fiscal discipline as the primary cause of the sovereign debt crisis and therefore called for austerity and fiscal surveillance in an effort to increase Europe’s productivity and growth. The CDU argued against mutualizing debt and Eurobonds, invoking the Maastricht Treaty’s “no bailout” philosophy. It believed any “community of debt” would reduce political leverage for structural reforms and increase moral hazard within the EU. The CDU opposed the ECB bond purchase program—which it saw as tantamount to “printing money.” The CDU advocates an independent ECB and opposes any monetarization of government debt.
Nevertheless, there are some indications the CDU may be willing to make some concessions in its approach to the euro crisis if and when the institutional conditions are met for the EU to eventually move towards common debt issuance. Rumors suggest the party will eventually accept Eurobonds when they receive fiscal guarantees from other eurozone countries and see signs of successful structural reform in Italy, Greece, Spain, and Portugal. However, there are also legal barriers in Germany to a mutualization of European debt along with ideological barriers. In fact, some argue that Germany would need to create an entirely new constitution in order to allow this.
The Free Democratic Party (FDP) is a classical European liberal party and has even stronger roots in ordoliberal thinking. As a coalition partner in the federal government during the euro crisis, the FDP’s position has, of all the five main political parties in Germany, been closest to mainstream neoclassical thinking. The FDP has defended the idea that indebted countries that find it difficult to access financial markets are in this position because of their own policy failures.
It advocates harsh austerity measures and structural reform. It has long been in favor of high penalty interest rates for rescue loans to maintain pressure on crisis governments to cut budget deficits and engage in structural reform. It demands automatic sanctions for violations of the Stability and Growth Pact and a stricter control of national budgets for violations of EU debt and deficit limits. FDP politicians have also warned of the possible inflationary dangers posed by ECB bond purchases.
During the 1960s, the Social Democratic Party (SPD) integrated many Keynesian elements into their thinking and policymaking. Karl Schiller, economics minister from 1966 to 1972, brought Keynesian ideas into the public debate. However, in the late 1990s, the SPD moved away from Keynesianism. Under Gerhard Schröder, the party passed a number of neoliberal reforms, which included income and corporate tax cuts and reforms to the labor market and welfare system (“Hartz IV”).
Since leaving the coalition after the general election in 2009, the SPD has moved slightly to the left again. Social Democrats have attempted to square a belief in fiscal responsibility with European solidarity. They have made a clear commitment to rescue packages for indebted countries but also insisted on austerity as a condition for support. Unusual for a European center-left party, the SPD has therefore come out in favor of a stricter Stability and Growth Pact. It agreed with the government on the need for constitutional “debt brakes” to limit budget deficits in all eurozone countries and has voted for the fiscal compact. Unlike the CDU/CSU and the FDP, the SPD has also stated repeatedly that closer economic policy coordination at the European level is needed, and that such coordination should include financial market regulation and taxation issues. Moreover, in the negotiations for the fiscal compact, the SPD sided with the French Socialists, demanding a growth pact as well. Leading Social Democrats have also spoken out in favor of Eurobonds, but official party documents emphasize they can only be part of a package deal that would include much stricter rules for fiscal austerity in other countries. The SPD is also opposed to ECB bond purchases.
The Greens have long been advocates of better financial market supervision and regulation, a financial transactions tax, the abolition of bonuses in financial services, and the semi-nationalization of banks and financial institutions. This background has shaped the Greens’ approach to the euro crisis. A significant part of the party adheres to fiscal austerity, albeit for different reasons than neoclassical economists. They argue that in an economy without economic growth (which some Greens favor), government debt is not sustainable and hence public budgets should be balanced. The Greens never thought austerity was enough on its own and did not see fiscal surveillance mechanisms as the sole solution to the crisis. Yet, in the end, they voted for the fiscal compact in the German Bundestag. The Greens also committed to the introduction of Eurobonds very early on. Unlike mainstream neoclassical German economists, the Greens accept that Germany’s trade imbalance affects the economic equilibrium of the eurozone and they want “symmetric” rather than “asymmetric” adjustment within the eurozone.
The anti-capitalist Left Party was created in 2007. Although it is not against the EU or the euro, it voted against the Lisbon Treaty and aims to radically reorganize European economic policy to deliver market regulation, financial market control, tax harmonization, and a financial transactions tax; and to control speculation and capital flows and improve social justice. As a result, the Left’s approach to the euro crisis is very different from that of the German neoclassical mainstream. It has criticized the incapacity of the EU as a whole to control financial markets. Unlike the German mainstream, it has argued that the euro crisis is a structural crisis touching financial markets and also a crisis of neoliberalism. The Left is also in favor of Eurobonds. Of all the five main German parties, the Left is the most New Keynesian. But although some of its left-wing arguments are sound, it lacks credibility in the German party system due to its former connection to the SED (the ruling party of East Germany); but also because it still is not accepted as a serious coalition party and has thus largely been excluded from mainstream politics in Germany.
What this overview of the party positions shows is that some elements of the German approach to the euro crisis are unlikely to change, even if majorities shift. The mainstream neoclassical belief in the need for stricter fiscal rules is shared by the Social Democrats and also has strong support inside the Green party. The same goes for the question of current account imbalances. There is a broad consensus that the burden of adjustment should be borne by deficit countries. Although some Social Democrats would like to implement elements of an expansionary wage and fiscal policy that might lower Germany’s current account surplus, this is not official party position. A significant portion of the SPD still thinks that “Germany cannot be punished for its export successes.” A change in government would therefore not overly affect the German position in this regard. The most decisive difference between the government and the SPD in the euro crisis is the different focus on growth. While the Social Democrats have been arguing that growth enhancing policies including fiscal stimuli are important in the crisis solution, the government has long held the position that structural reforms are good, but no additional money should be spent on growth programs.
When negotiating with Germany, its European partners should focus on issues where some movement in the German position can be expected, rather than expect a change on issues on which there is a consensus in Germany. For example, instead of attacking excessive austerity and demanding a renegotiation of the new fiscal treaty, a more promising strategy would be to demand pan-European growth and investment programs with more spending and taxation power shifted toward the European level. One approach would be to demand the channeling of unused EU funds into investment programs for the ailing eurozone periphery to provide a short-term stimulus and build a more permanent institutional structure later. Similarly, instead of opposing balanced budgets, asking for more time in reaching them might be met with more understanding from Berlin.
The article first appeared in IP Journal.
The European Council on Foreign Relations does not take collective positions. This commentary, like all publications of the European Council on Foreign Relations, represents only the views of its authors.