How Germany Can Save the Euro

After nearly two years of nonstop economic shrinkage, Europe has officially entered the longest recession since the creation of its single currency in 1999. But you wouldn’t know it in Stuttgart, Germany. A birthplace of the automobile and the heart of Germany’s export engine, this is a prosperous city of rolling green hills, bustling luxury boutiques and tidy white houses occupied by many an affluent engineer and thrifty homeowner. Per capita GDP is a whopping $84,000, more than double that of Berlin. In Stuttgart, Germany’s famous Mittelstand firms–small and midsize family-owned export companies–churn out top-notch auto components, lasers, high-tech machinery and health care equipment.

These industrious world beaters are at the heart of Germany’s middle-class prosperity; Mittelstand firms employ 60% of the nation’s workers and contribute more than half of Germany’s economic output. They also embody certain social and moral values, like thrift, conservatism, family orientation and long-term thinking. “Mittelstand means, ‘I don’t think about the next quarter–I think about the next generation. I don’t try to be cheaper but better,'” says Nils Schmid, finance minister for the state of Baden-Württemberg, of which Stuttgart is the capital. “These values stretch out beyond our firms and into our society.”

Those values, many in Stuttgart and across Germany believe, are what the rest of Europe should aspire to. If only Europe followed our example, Germans say, there wouldn’t be a crisis for us to fix–but now that the crisis is upon us, the rest of the continent must match us in frugality as we all tighten our belts together. As Chancellor Angela Merkel has frequently said, Germans must set an example for others by continuing to rein in spending, cut budgets and practice austerity. “Balancing our own budgets is the solidarity that we show to Europe,” says Schmid. “It’s right and good that we do so.”

The problem is that universal austerity isn’t working. The economies of the 17 countries that use the euro as their currency shrank by 0.6% in 2012, and they will likely shrink again this year. Unemployment in the euro zone is 12.2%, and youth unemployment is up to 24%. The social blowback from austerity has become extreme: 10% of Greek schoolchildren go hungry on a regular basis. Right-wing parties are gaining popularity in Greece, Italy, France, Eastern Europe and elsewhere. Street protests and riots have become commonplace after new austerity measures. A recent Pew poll found that people in nearly every major European country put Germans at the top of their “least compassionate” and “most arrogant” lists.

But it is economic, not political, logic that should drive Germany to reconsider its approach to Europe’s persistent woes. Austerity alone is like the sound of one hand clapping; to make thrift profitable, someone else still has to spend. For years, Germany’s model of domestic frugality worked thanks to the lavish spending of the southern countries Germans now criticize. It was southern Europe’s debt-fueled consumption that helped yield massive German trade surpluses and the profits that came with them. Germany may be right that those countries now must control their excessive reliance on spending. But if Europe is to follow that path back to prosperity–and is to continue supporting the German economy in the process–it is the frugal Germans who must learn to spend.

The Trouble With Thrift

Even in the peaceful rolling hills of Stuttgart, Europe’s economic turmoil is starting to have an impact. At the massive headquarters of auto giant Daimler, there’s plenty of hand wringing about the recession. “Sales of cars to Western Europeans have fallen back to 1993 levels,” says Daimler’s chief economist, Jürgen Müller, who notes that a third of the company’s revenue still comes from that region. Müller believes Germans must increase their domestic consumption to help spur regionwide growth.

It’s a shift supported by many economists, like Peking University finance professor Michael Pettis, who also thinks it would increase financial stability in the euro zone. Before 2000, yearly wage growth in Germany was 3.2%; in the decade after, it averaged 1.1%. The result has been a 16% household savings rate, which, lent out by German banks to fund real estate and business projects in places like Spain, Italy and Greece, actually helped contribute to those countries’ debt bubbles.

But abandoning traditional frugality will come hard to the thrifty entrepreneurs of the Mittelstand. The argument that Germany should become more of a consumer society to help with European economic rebalancing “is absolute nonsense,” says Nicola Leibinger-Kammüller, the second-generation family leader of Trumpf, a $3 billion-in-sales Baden-Württemberg-based lasermaker that is 100% owned by her family. It’s the southern nations that need to change, she says, not Germany. “Solidarity with Europe, yes–but other nations will have to do their homework if they want to have lasting success.”

To Leibinger-Kammüller and many other Germans, it’s utterly baffling that they have become scapegoats for Europe’s economic troubles. After all, they are the ones who’ve done the hard work of reform. Others should follow, not criticize. Ten years ago, through a series of reform targets called Agenda 2010, instituted by then Chancellor Gerhard Schröder, Germany got its fiscal house in order and dramatically increased the global competitiveness of its labor markets, in large part by cutting high wages and using more temporary workers to increase flexibility.

The reform agenda was accomplished because of Germany’s successful public-private partnerships. Governments, companies and unions cut deals together, a process aided by the fact that they are all represented on corporate boards, and Germany’s family-owned Mittelstand firms were able to take the long view rather than be beholden to the short-term-profit pressures of the typical Western public multinational. “Ten years ago, Germany was the sick man of Europe,” says Stefan Wolf, CEO of ElringKlinger, a 130-year-old Swabian export firm that sold $1.5 billion in auto parts last year. “Now people look at us and see we’re doing a pretty good job,” he adds, echoing a view common among his Mittelstand peers. “The southern European economies,” he says, likewise “have to reform.”

When you spend time in Stuttgart and hear the stories of how the Mittelstand firms have weathered the past several years of debt crises and recession, it’s easy to understand why Germany’s feelings about its role as both savior and scapegoat of Europe are tinged with moral outrage. The Mittelstand firms embody something close to an ideal of corporate responsibility. Consider how Trumpf made it through the crisis of 2008, when revenue suddenly dropped by more than 40%. Rather than lay off workers, as any American firm would have done, Leibinger-Kammüller used $100 million of her family’s money to keep the business afloat, while working with labor to establish flexible schedules that would make it possible to weather the crisis without a single layoff. “Our employees helped us bear the brunt of things by accepting wage reductions,” she says. “We wanted to avoid layoffs at any price, first because we feel responsible for our long-term employees, but secondly because we knew that after the recession, things would improve and we’d need our workers again.”

They did. By 2009 the company was growing again. Throughout the crisis and recovery, Trumpf continued investing 8% to 10% of its annual turnover into research and development. (The average global multinational invests 2% to 3%.) “None of this needs be a blueprint for the rest of Europe,” says the CEO. “But the fact remains that it does form the basis of success for many German companies.”

Playing to Type

The “let Germany be Germany” idea is ubiquitous in Stuttgart. “You can’t change national models overnight,” says Schmid, the Baden-Württemberg finance minister. “We have a model, which is export-led growth, that works well for us.” He and others understand that German wages, which have been unnaturally low relative to productivity for some time, need to rise; in January, the megaunion IG Metall fought for and won a 5% wage increase. But it’s a slow process. “Don’t bet on Germany adopting the Anglo-American model,” says Daimler’s Müller. Germany, after all, is one of the few rich countries that have been able to keep a strong manufacturing sector, which creates the sort of middle-income jobs that foster a thriving middle class.

Yet in order for Germany to be Germany, Spain, Italy and Greece would also have to be their old spendthrift selves. The notion that every European country can cut public and private spending at the same time and prosper has always been flawed. Basic economics says that trade surpluses and deficits between countries, also known as current account balances, must always add up to zero. If one country, like Germany, runs a surplus, others–like Italy, Greece and Spain–must run equal deficits. As the export giant with artificially low wages, Germany maintains constant surpluses, while other euro-zone countries like Italy, Spain, Greece and Portugal run deficits, buying German goods and using Germany’s excess savings to fund investment at home.

The entire dysfunctional cycle was made possible by the euro, which forced countries to give up independent monetary policies in exchange for the benefits of a single currency. Pettis points out that after the introduction of the euro, “all these countries saw their trade deficits expand dramatically or their surpluses turn into large deficits.” To be fair, the southern nations didn’t use the days of plenty to reform as the Germans did. And Germans benefited greatly from the euro, as even the conservative Mittelstand leaders of Stuttgart acknowledge. Sales to other euro-zone countries were no longer affected by currency fluctuations, says Leibinger-Kammüller. Daimler could compete with, say, Fiat without the fear that a weak lira would make German cars unreasonably expensive in the global market and give the Italians an advantage. The benefit to German companies has been enormous, since sales to other euro-zone countries make up roughly half their exports.

Europe’s Endgame

Now that Southern Europe isn’t as able to fund Germany’s trade surplus, the euro may survive only if Germany picks up the slack. But getting Germans to spend is a huge political challenge for Merkel. There’s a general election coming up in September, and while Merkel remains popular and will most likely be re-elected, it’s unclear what kind of coalition she will be able to form.

There are a few glimmers of hope. Germany has begun talking about exporting something aside from machinery and austerity: a new plan to fund the efforts of countries like Portugal to replicate Germany’s much lauded vocational-training program. It’s an important step not only because it would help address southern Europe’s youth-unemployment epidemic but also because it acknowledges the fact that investment, not just budget cuts, is required to help Europe grow out of its debt problems. There’s also been some increase in German wages recently, though not enough to make up for the previous decade of slow growth. But urgent policy reforms at home–like lower consumption taxes or fiscal stimulus to help bolster growth at a time when the rest of Europe is shrinking–are unlikely to happen anytime soon.

And so Europe’s slow-motion crisis continues, and its recession deepens. Recent European Commission steps to solve the crisis included no deeper conversation about what surplus countries like Germany should do to help turn the tide. That’s a pity, because the truth is that if the euro-zone crisis is to be solved, not all of Europe can, or should, look like the rolling hills of Stuttgart. Rather, Stuttgart may ultimately have to look a bit more like the rest of Europe.