It is said that a picture is worth a thousand words and an economist would probably agree that a chart has similar value. And if one chart can make the claim that Germany has been the single country in the Eurozone to most benefit from the common currency, then this is it: the current account balances of all Eurozone states over the past two decades. The implications of this chart are staggering. Since the Euro was adopted in the year 1999, Germany’s current account balance (which basically sums up the balances of trade in goods and services, as well as income and transfers) has ballooned from a mild deficit into a colossal surplus – in absolute terms it is now the second largest surplus in the world, only behind China’s. German policymakers will not stop boasting that the country’s surplus is actually a reflection of its competitiveness, itself a consequence of the efficiency of its export-based manufacturing base, as well as in the self-sacrifice of the German labor force who accepted a decade of stagnant real wages and consumption in order to stay competitive. This is partly true. Yet in the last decade before adopting the Euro, Germany was actually running a deficit. Looking at the other side of the line is equally interesting, for those countries now running massive deficits were actually doing quite well during the 1990s: Italy and France all had surpluses and Spain’s deficits were negligible. Is this all just one giant coincidence or did the Euro have a fundamental role in widening the imbalances of the Eurozone to critical proportions?
To answer that question, it’s important to recall the ways in which unproductive economies (mainly the southern European periphery), stayed competitive in the bygone days of national currencies: by devaluation. The constant debasement of their currencies would offset the productivity differences with their more efficient trading partners (such as Germany), and also offset the differentials in inflation rates which worked against them (a country with higher inflation sees its currency strengthen in real terms to its partners). By keeping their currencies weak, they kept their exports strong, the flip side being that little effort was made to address the structural issues behind their lack of competitiveness since there was such an easy way out of the trap. But the Euro changed all this. By having the same currency as their main trading partners, the easy route of instant competitiveness disappeared. This was exactly what the Germans wanted, for according to Germanic logic such limits would naturally push these countries into “turning German”, i.e. becoming competitive the right way, through increased productivity. The Eurozone would therefore turn into a hyper-competitive economic giant to rival, if not surpass, the United States which since the 1980s had widened the productivity gap with its trans-Atlantic rivals.
What really happened
Of course this plan backfired colossally. The reason was that adopting the Euro had the other consequence of lowering interest rates across the region, and making cross-border financing cheap. Having a current account deficit, after all, is not a problem insofar as you can finance it though capital inflows. And during the boom years before the crisis, money coming in was never a problem, the only problem was that it went towards mostly unproductive use (like housing). This should not have been surprising: in a free market, money doesn’t automatically gravitate towards its most productive use, but rather its most profitable. So we had massive housing bubbles in Spain and Ireland (which in relative terms actually dwarfed the bubble in the US), and deeply indebted countries like Italy and Greece (both had debt-to-GDP ratios above 100% before 2007) had no problem in refinancing themselves. Furthermore, the growing intra-European imbalances on the current account were masked by the fact that the Eurozone seemed to be in balance with the rest of the world. And if the biggest trading partners of Eurozone countries were other Eurozone countries, then you can see the folly in not considering the imbalances between them. Unsurprisingly, the decade after the Euro was established did not see the productivity gap with the US narrow, and even ambitious-looking measures such as the Lisbon Strategy (not to be confused with the Lisbon Treaty) barely made an impact.
So why did the German current account deficit turn into a surplus and swell to such titanic proportions just a few years after the Euro was introduced? The answer is simple: the Euro gave it a huge competitive edge by virtue of being weaker than what the Deutsche Mark would have been under the same circumstances. Since the value of the Euro is an aggregate of the values of all national currencies in the bloc, countries with perpetually strong currencies (like Germany) would weaken by having a new currency which is being averaged with weaker currencies like the Franc, the Peseta or the Lira. The reverse is equally true: those countries with perpetually weak currencies would strengthen by having a new currency which is being averaged with the Deutsche Mark. A naturally competitive economy boosted by a weak currency would therefore see its exports skyrocket, which is exactly what happened to Germany after adopting the Euro, while those uncompetitive economies with a now stronger currency would be swamped by imports. Another factor worked against them: in that same decade, the Euro strengthened viz-a-viz the two other main trading currencies, the US dollar and the Chinese Reminbi. This affected Germany less because its competitiveness allowed it to hold on to its overseas markets, but for other European countries, the results were doubly disastrous as they became less competitive within the Eurozone and out of it as well.
The end result was a net transfer of wealth over the course of a decade from the formerly weak currency nations of the European periphery into Germany and the rest of the core (basically other northern European countries, notably the Netherlands) as their current account deficits fueled Germany’s surpluses. Furthermore, these deficits required financing which also came from the core (this was the consequence of being able to borrow cheaply across borders). The swelling of the periphery’s external debt, be it public debt and/or private debt, is therefore a consequence of this pattern of capital flows. I’ll leave it to the conspiracy theorists to argue that this was the plan all along, or that – as I suspect – it was simply a case of Germanic naivety which assumed that everyone would respond to the limitations of a common currency by making the structural reforms needed to become competitive. But in any case, what is more than evident is that if one country disproportionally benefited from the Euro, it was Germany über alles.
Why Germany needs accept a fiscal union
A successful resolution to the Euro crisis will therefore require Germany to recognize its role in creating it. This is not to say that the periphery should be absolved of its blame, but German insistence on avoiding a fiscal union at all costs is not only disastrous to the future of Europe but a gross neglect of responsibility. Under the guise of avoiding moral hazard at all costs, Germany has so far refused to even consider the possibility of losing a single euro to a permanent mechanism of fiscal transfer (such as the Stability Bonds recently proposed by the European Comission), which according to many people (myself included) is the only long-term solution to bringing stability to the troubled continent. This reticence is all the more shocking considering that billions of euros are being siphoned every day from the periphery into the core through the buying up of Germany’s exports and by paying the interest on the periphery’s ever growing external debt. Even more insulting (if not downright pathetic) is Germany’s recent attempt to get China to help finance the EFSF despite its own unwillingness to foot the bill for Europe’s salvation. Unsurprisingly China said no. And let’s not fool ourselves: for all of Ms Merkel’s talk about wanting a fiscal union, what she is proposing is everything but. It’s simply a treaty change to institutionalize a more draconian version of the failed Stability and Growth Pact to limit Eurozone deficits and debt levels by giving European authorities quasi-control over national budgets. This is not fiscal union, this is fiscal fanaticism of the worst kind.
With no other Eurozone having the financial muscle to make Germany budge from its narrow-minded obstinacy to avoid a fiscal union, the result is that negotiating an end to the crisis has all but become a single-country affair, with the rest of the Eurozone bloc at best managing to extract some topical concessions (which like the French-backed insistence on absolving bondholders from the burden of ever facing a haircut on Euro debt is actually counterproductive). I suspect that tomorrow’s EU summit will follow the same pattern of all the grandiosely mediocre plans before it: at best a brief period of market euphoria and hope (if at all), followed by common sense sinking in that it has been too little and too late. And as the region slides into an even deeper crisis of confidence, placating the market forces which hold the continent at gunpoint will be an even more ardous task. Because like the emperor with no clothes, markets will see behind the façade of Germany’s pedestrian and self-interested attempts at saving the Eurozone and one day call its bluff.