The sick man of Europe
Europe’s economy seems in good health. Manufacturing activity has strengthened since last summer, and inflation is in a sweet spot: high enough to show deflation concerns were misplaced, but low enough that the European Central Bank can keep interest rates very low.
Against this healthy background, however, tensions are brewing and criticism of Germany’s economic policy has flared up again. Between the late 1990s and the early 2000s Germany was labeled “the sick man of Europe” because of its sluggish economic growth. Now it is one of the strongest economies in the Eurozone, but routinely accused of “stealing” growth from the rest of the world and undermining global financial stability through its excessive current account surplus. A few days ago Germany reported the largest current account surplus in the world, at about EUR270 billion, and the criticism reached a higher pitch. This criticism comes from both within and outside the Eurozone, and moves along two lines.
The first argument is that Germany has “manipulated” its way to a cheaper exchange rate by becoming part of the Eurozone — the Deutsche Mark would be a lot stronger than the Euro, if there still were a Deutsche Mark. The second argument is that Germany exacerbates the problem by saving too much and not spending enough.
These arguments are based on a true premise, but they are misleading:
- Eurozone members knew from day one the exchange rate would be too strong for some and too weak for others, unless their economies converged. Countries that needed to make their economies more competitive have stubbornly refused to undertake the necessary reforms, and today argue they have been tricked into the currency union. This is rewriting history.
- The Euro is not the only tie that binds Germany to the rest of the currency area. All the factors that make the Euro weaker pose a risk to Germany as well: the persistent crisis in Greece; Italy’s public debt; France’s politics. The weak Euro is not a free lunch.
- Germany would benefit from stronger infrastructure investment. But its economy is running above potential, at full employment, with healthy domestic demand — not to mention loose monetary conditions. There is no logical case for a massive fiscal expansion. And private sector wages are not a policy instruments — contrary to what some people seem to think.
Germany is under pressure partly because Europe, and the Eurozone in particular, face major challenges ahead.
- Without greater integration of policies, notably on the fiscal side, the Eurozone remains a fragile construct — which is why political risk has driven sovereign debt spreads up again.
• Banking sector weaknesses still need to be addressed.
• As in most other advanced economies, productivity growth has decelerated.
• Managing the UK’s exit from the EU will be a hard process.
The temptation — as always — is to look for easy fixes, and the criticism of Germany is another example. “Come on Germany, all you have to do is raise wages and spend more, how hard can that be? This will boost growth in weaker Eurozone countries, reduce global imbalances, and all will be well.” If only. Looser fiscal policy in Germany, focused on infrastructure investment, should be part of the solution. But it has to be accompanied by tougher measures in partner countries. These would include cuts in unproductive public spending, and additional reforms of labor markets and services. If there is a “sick man” in Europe today, Germany is not the only candidate — nor the most obvious…
Europe has great potential. Its innovation drive is strong and getting stronger. But we need to tackle the hard reforms as well, not look for an easy way out. Otherwise in a few years the sick man of Europe will be…Europe.
