Will German Austerity Help or Hurt the Global Recovery?

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Johannes Eisele / AFP / Getty Images

German Chancellor Angela Merkel addresses a press conference on June 7, 2010

Announcing a tough austerity plan when your government's popularity has hit rock bottom is a high-risk strategy, but Germany's Chancellor seems ready to ride out the storm of protest. Even as trade unions warned of a summer of unrest, Angela Merkel put on a brave face when she announced the biggest round of spending cuts since World War II on Monday afternoon. "These are serious times, these are difficult times. We can't afford everything that we want if we also want to look after our future," Merkel told reporters in Berlin after her coalition government hammered out a framework deal to bring down Germany's swollen public debt.

The austerity plan is ambitious — the aim is to save up to $95 billion by 2014 through a combination of deep spending cuts and revenue-raising measures. The savings include controversial cuts to welfare payments for the long-term unemployed and reductions in parental allowance for families. Merkel tried to head off critics by pointing out that the plan was fair because it included cuts to industry and the public sector. Under the plan, 10,000 civil servants working for federal ministries would lose their jobs; 40,000 jobs would be cut in the armed forces; there would be a new "ecological levy" on air travel; a tax would be imposed on the nuclear power industry; and, from 2012 on, there would be a tax on financial transactions. Even prestige building projects have been put on ice: the German government has postponed plans to build a replica of Berlin's former Prussian palace.

"We've lived beyond our means over the past few years," Guido Westerwelle, Vice Chancellor and leader of Merkel's coalition partners, the Free Democratic Party (FDP), bluntly told a news conference on Monday. As a concession to the FDP, which campaigned on a tax-cutting platform in last September's election, Merkel said there would be no hike in income tax and no increase in sales tax, while spending on education and research would be protected. "The last few months have shown — in connection with the crisis in Greece and the euro zone — how crucial solid finances are, and they are the precondition for being able to live in stability and prosperity," said Merkel.

Some economists welcomed the fact that the government steered clear of tax hikes; others said the round of spending cuts was too severe and could stall Germany's fragile economic recovery. "The government should have postponed the cuts until the economy is really back on its feet again," Gustav Horn, director of the Macroeconomic Policy Institute in Düsseldorf, told TIME. He said the austerity plan was "piecemeal," made up of "real cuts in the social security system but halfhearted cuts to business," and pointed out that the financial-market-transaction tax was conditional on other countries' adopting it. "Chancellor Merkel could have introduced a tax on the wealthy and tougher measures against the banking sector — that would have made a difference," said Horn. Germany's focus on deficit reduction could end up affecting the global recovery. There is also concern that German cutbacks may hobble the feeble global recovery. At a meeting of G-20 finance ministers in South Korea on June 5, U.S. Treasury Secretary Timothy Geithner called for "stronger domestic demand growth" in European countries like Germany and in Japan. As his European counterparts urged speedy implementation of austerity programs, Geithner reportedly counseled reform "in the medium-term."

Still, as Europe's biggest economy, Germany is hoping to set an example of budget discipline for other countries so they in turn will also tighten their belts. Greece, Portugal and Spain have already announced crippling austerity plans — while Britain's Prime Minister David Cameron has warned of "decades of pain" to rein in the U.K.'s massive budget deficit. Although Germany's public finances are in better shape than those of other countries in the European Union, Berlin's budget deficit reached 3.1% of GDP in 2009, and it's expected to exceed 5% of GDP later this year, which would be in breach of the 3% deficit limit set by the E.U.'s rules.

On top of that, Germany has a constitutional limit on borrowing — a "debt brake" — which obliges the government to scale back borrowing over the next few years. "We have a result which will enable us to meet the limit on borrowing in this legislative session," said Wolfgang Schaeuble on the sidelines of the meeting of euro-zone finance ministers in Luxembourg on Monday, claiming there was a "very reasonable [social] balance."

Merkel may have to pay a heavy political price in her backyard. Trade unions, welfare groups and opposition parties slammed the austerity plan as "socially unjust" and threatened to fight the measures when they go through Parliament. "The jobless will bear the brunt of virtually half of these spending cuts," said the head of the Social Democratic Party, Sigmar Gabriel. The Left Party accused Merkel's government of making the jobless, pensioners and families pay for the "reckless gambling" of bankers. "This is an attack on social peace and democracy," said Gregor Gysi, head of the Left Party's parliamentary group, urging Germans to take to the streets.

Already, union leaders are planning a nationwide day of protest with a series of demonstrations in major German cities on June 12. "The government is punishing the weakest in society," Frank Bsirske, head of Germany's public-sector union Verdi, told reporters on Monday, warning that the savings would lead to a spike in unemployment. The German press was also baying for blood, with tabloid paper the Berliner Kurier branding the austerity plan as a "list of horrors" and claiming that every German would have to fork out $1,200 to pay for the cutbacks. The government has "ruined the summer" screamed the left-leaning paper Die Tageszeitung on its front page. Even the conservative daily Die Welt was skeptical that the measures would be able to restore public finances in the long-term. "The poorest of the poor seem to be worst off in the austerity drive, and this will give plenty of ammunition to opposition parties — they'll fight these measures tooth and nail," Uwe Jun, professor of political science at the University of Trier, told TIME. And with members of the social wing of Merkel's conservative party criticizing the austerity drive, Jun predicts "yet more splits in the coalition government."