Why Germany Must Save the Euro

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 homes occupied by many an affluent engineer and thrifty hausfrau. Per capita GDP is a whopping $84,000, more than double that of Berlin. In Stuttgart, Germany’s famous Mittelstand firms — the term commonly used to denote small and midsize family-owned export companies — churn out top-notch auto components, lasers, high-tech machinery and health care equipment.

These Swabian 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. Few would say flatly that Europe would be better off if it were more German — after all, Germans are forever mindful of their history — yet that’s clearly the message coming out of Berlin and from Brussels, seat of the European Union. Because of its economic clout, what Germany says sotto voce booms across Europe. Since the euro-zone crisis began over three years ago, wealthy Germany, the only country in the rich world to enjoy higher economic growth and lower unemployment after the global financial crisis than it did before, has paid for $73 billion worth of bailouts in countries like Greece and Cyprus and has either implicitly or explicitly backed hundreds of billions more of debt restructuring and stimulus efforts by the European Central Bank (ECB).

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The conventional wisdom among the economic chattering classes (at least those outside Germany) has always been that Germany should continue to underwrite bailouts — be they in Cyprus, Portugal, Spain or Italy — as the price of keeping the euro afloat. But Germans have fought this logic, arguing that they shouldn’t be responsible for endlessly supporting fiscally imprudent neighbors. 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, Europe should follow us to salvation. Hence the German push for austerity, not only among the debt-ridden Mediterranean states but also at home. 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 austerity isn’t working: taken together, 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%. Governments busy cutting budgets at Germany’s bidding can’t afford to spend money on retraining or on a better social safety net, which deepens the problem. Since it’s impossible to grow while both the private and public sectors are cutting costs, deficit problems in southern Europe are getting worse, not better. In the first six months of this year, Italy’s central-government deficit was 2.7% of GDP, far higher than the 1.9% figure for the same period last year. Spain is foundering too, with its tax take down nearly 7% from last year.

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 even riots have become commonplace in the euro zone after new austerity measures.

Germany’s insistence on austerity has contributed to the country’s growing unpopularity across Europe. 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” list. (On the upside, they are also listed almost unanimously as the “most trustworthy.”)

Nevertheless, the German message today is exactly what it’s been for the past several years: European nations need to buckle down and reduce wages and benefits, slash budgets and shrink debts. But this logic fails to take into account that Germany grew rich because while it practiced austerity, other Europeans spent freely. When the Germans suppressed wages in the 1990s in order to bolster their export economy and spur growth, it had terrible ramifications for the rest of the euro zone. While Germans sold relatively more and consumed much less thanks to their lower wages, everyone else was forced to do the reverse. Germans got richer, but everyone else got into debt, a process that was exacerbated by a low-interest-rate monetary policy supported by Germany. “Low German wages, rather than southern European profligacy, is at the heart of the euro-zone crisis,” notes Jörg Bibow, a professor of economics at New York State’s Skidmore College, in a recently published paper for the New America Foundation on why Germany is making the euro-zone crisis worse.

There are plenty of examples of free-spending southern European nations that should have managed their public finances much, much better — Greece being the most notable. But the truth is that Germany’s own mercantilist economic strategy has played an even larger part in the European debt crisis. Basic economic logic holds that current account balances between countries must equal out. As German trade surpluses rose over the past few years, deficits in the rest of Europe increased. Now, if the rest are to cut budgets and spend less, Germans must spend more. Yet Germany has for years resisted boosting domestic consumption with major wage hikes, lower consumption taxes or fiscal stimulus designed to boost spending (ideally, on products produced by other European nations).

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Meanwhile, even as Germans have enjoyed the currency advantages of the euro, which make exports cheaper in the global marketplace, they’ve resisted giving unequivocal support to the single currency, either by backing euro bonds or by aggressively supporting a banking union that would move Europe toward real fiscal union. The bottom line is that unless Berlin can impose its fiscal policy on its neighbors, it doesn’t want to expose itself to the risks — or costs — of further integration. A small but vocal group of academics recently founded an anti-euro party, which says something about how little even well-educated Germans understand about how much their country has to lose if the euro goes under. Although the party is supported by fewer than 5% of Germans, its very existence has opened a conversation about a return to the deutsche mark at a time when European leaders are struggling to keep the euro zone together.

Even in the peaceful, rolling hills of Stuttgart, the belt-tightening and economic turmoil are 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 revenues still come from that region. “In Italy, the market for premium cars is the same size today as it was in the early 1980s.” He believes that major political decisionmakers have focused too exclusively on austerity. “A diet can’t make you build muscles. The easiest way to fix your budgets is with growth, not just cuts.”

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 whopping 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.

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Müller, Pettis and many others believe Germany should do whatever it takes to bail out the euro, since it has contributed hugely to the country’s global competitiveness. In the pre-euro era, currency exchange and currency risk cost German firms as much as half of every deutsche mark. A return to the old ways would be very expensive indeed. Germany’s Bertelsmann Foundation released research in April showing that a return to the deutsche mark would cost the country $1.6 trillion in economic growth over 13 years, cutting GDP by an average of half a percentage point from 2013 to ’25.

To be fair, Chancellor Merkel and her team understand that Germans would likely suffer the most from a collapse in the euro zone. “Germany has 80 million people. That’s nothing in a globalized world,” notes Labor Minister Ursula von der Leyen. On the other hand, “500 million Europeans together are something. [Germany is] strong because of Europe, not despite it.”

But it’s a view that’s not always shared by the thrifty Swabian entrepreneurs of the Mittelstand, who believe that the southern countries simply need to do more to emulate Germany. 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-sales, Baden-Württemberg — based lasermaker that is 100% owned by her family. Indeed, the economic view from her office near Stuttgart is bright; 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.”

The Morality of Austerity
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 workers’ 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,” says Wolf, 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 revenues dropped suddenly 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 to bear the brunt of things by accepting wage reductions,” says Leibinger-Kammüller. “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 a whopping 8% to 10% of its annual turnover into research and development. (The average global multinational invests 2% to 3%.) “None of this need 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.”

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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 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 has 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 must also be themselves. Just as China has contributed to higher unemployment and greater debt in the U.S. by keeping its currency and wages lower than they should have been over the past decade, so Germany has played the same role in Europe. 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. Southern Europe got lower borrowing rates, easy money and, for many years, a false sense of prosperity. But it also got much higher debt and lost the ability to use currency and trade policy to maintain competitiveness, a loss that came home to roost after the financial crisis, says Pettis, who recently authored The Great Rebalancing, which outlines why the current economic structures in both Europe and the world at large must change to foster healthier, more sustainable growth.

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.” Daimler could compete with, say, Fiat without the fear that a weak lira would give the Italians an advantage within Europe or in the wider world. The benefit to German companies has been enormous, since sales to other euro-zone countries make up roughly half their exports.

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Yet Germany’s halfhearted efforts to save the single currency mean that the euro zone is in some key ways already broken — and Germany is beginning to pay the price. One reason the ECB is having to pump so much money into Europe (it recently announced it would keep the easy-money spigots open even as the Fed starts to tighten things up in the U.S.) is that banks on the Continent, fearing the next wrinkle in the debt crisis, are reluctant to lend beyond their national borders. The whole point of the euro was that lending rates to Germany and, say, Portugal should be the same. Now the latter has to pay much more than the former. The irony is that Germany is on the hook for much of the ECB money dump, via cash transfers from the Bundesbank. And only the Germans can ultimately solve the euro-zone crisis, by making it clear that they’ll a) underwrite whatever debt restructuring and payments are necessary to keep the euro zone together, or b) shift their economic model to help economic rebalancing — or, preferably, by doing both.

Europe’s Endgame
That is, however, a huge political challenge for Merkel, who has deftly walked a tightrope between reassuring her countrymen that she’s not throwing good money after bad and doing just enough to maintain the basic integrity of the euro zone. Her ability to be both prudent German and generous European has held things together — until now. But 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 government will be formed. There are those in Europe and beyond who’d like to see Germany go all in and write a blank check to the euro zone in exchange for greater fiscal — and ultimately political — power in Brussels. But Merkel and her team argue that it’s not possible to make the required financial commitments without a new European constitution that allows Brussels the power to actually run the economic affairs of member nations.

The problem is that Europe today is stalled on both fronts. The E.U. can’t move toward deeper economic and political integration without strong German leadership and unequivocal financial commitment to the union and the single currency. And the idea of Germany remaking Europe in its own fiscal image is an economic impossibility.

There are a few glimmers of hope. Recently, Germany began talking about exporting something aside from heavy 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 wages recently, though not enough to make up for the previous decade of slow growth. Meanwhile, 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. The European Commission recently gave a number of countries, including France, Spain and the Netherlands, permission to continue breaking E.U. rules in order to get their budget deficits down under the E.U.’s 3% legal target, after a knuckle-rapping about reforming themselves faster. The exercise was a charade on many levels. For starters, the E.U. isn’t yet integrated enough that Brussels could do much to penalize violators. And there was no deeper conversation about whether the 3% target is still realistic as the region spirals further into recession — or 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.

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