Currency and Financial Markets Europe Public Finances and Financial Economics

The Costs for Germany if the Eurozone Collapses

This article first appeared in the Autumn 2013 issue of Europe’s World (www.europesworld.org).

It’s not a message that public opinion in Germany wants to hear, but a collapse of the EU’s troubled single currency would have devastating economic, financial and political consequences for the eurozone’s largest and most successful member.

Germans have long been among the most europhile of countries, but their mood is turning against Europe and its common currency, the euro. There’s now an openly anti-euro party and more than half of all Germans, say the pollsters, object to the European Central Bank’s (ECB) measures to support and stabilise the eurozone economy and the financial markets. Some German economists are calling on the Constitutional Court in Karlsruhe to stop the ECB’s hugely successful Outright Monetary Transactions (OMT) programme of potential and conditional sovereign debt purchases from eurozone countries, claiming that its support for eurozone governments is illicit.

Germans suffer from three illusions, and these help to explain why the mood in Germany has shifted so rapidly against Europe and the euro. They also tell us why so many Germans still don’t realise that Germany has the most to lose from a collapse of the euro area economy and from a failure of the single currency. The costs would not only be economic and financial but political too. The future of Europe depends on the ability and willingness of the new German government to provide leadership and develop a persuasive vision for the European integration process – and it’s the only government in the EU that has the means and ability to do so.

The first illusion is that Europe is an impediment to its own economic success. The general perception is that Germany’s economy is booming and its future would be brighter still but for the EU’s other laggard economies. Germans see themselves as having weathered the global financial crisis of 2008-09 and the European crisis since 2010 extraordinarily well; the country’s rapid recovery from its trough in 2009 has since added 8% to its GDP. The greatest success story is reckoned to be the German labour market, where not only has close co-operation between employers, labour unions and government helped avoid job losses, but also the unemployment rate has actually been falling throughout the crisis to reach 6.8%, the lowest level since Germany’s reunification. The German government is believed to have shown a remarkable determination to consolidate its finances, achieving a fiscal surplus in 2012 that by 2017 is projected to rise to 1% of GDP.

But all this euphoria is unwarranted. To take a longer perspective, the performance of Germany’s economy is rather disappointing. A recent study here at DIW Berlin shows that since the start of monetary union in 1999, Germany has recorded some of the lowest GDP and productivity growth rates in the euro area. Real wages have barely grown, and for the majority of German workers have actually fallen. Despite the depth of the economic crisis there, the wages of Spanish employees have risen substantially more when compared to their 1999 wages. Just as worrisome is the fact that Germany has one of the lowest investment rates, and consequently will have one of the lowest potential growth rates in the coming years. This means that the prospects for an improvement in wages and welfare for Germans are rather bleak.

It is certainly true that the crisis in Europe’s periphery is also weakening Germany’s growth prospects. Yet the selective nature of Germans’ collective memory ignores the fact that a decade ago the tables were turned, and as the “sick man of Europe” Germany benefitted substantially then from the strong growth and dynamism of other European countries. In other words, Germans need to realise that we Europeans are all in the same boat – what is good for Europe, is good for Germany, and vice versa.

The second illusion is the widespread belief among many Germans that other European governments are after Germany’s money. Much discussion in Germany is shaped by this notion and it strongly influences the debate over a banking union. It is a major reason for Germany’s reluctance to fully engage. Germans are concerned over how the banking union would treat legacy assets, and how it would influence the behaviour of other governments. A banking union, so the argument goes, implies a transfer of costs and risks to Germany because other governments will seek to get rid of problems in their own banks.

By much the same token, a growing number of German economists and politicians are becoming highly critical of the ECB’s monetary policy instruments. The lawsuits at the Karlsruhe constitutional court against the ECB’s OMT are a somewhat peculiar example of this because the mere announcement of the OMT programme was one of the most successful measures introduced by any central bank anywhere in recent decades. Such strong opposition to the OMT is hard to understand, yet it evidently reflects the deep mistrust many Germans harbour toward other European governments. If you believe that these governments cannot be trusted and that ultimately they will be insolvent, then indeed the OMT programme implies future transfers from Germany to these countries. “Why throw good money after bad” has become their catchphrase.

This leads me to German’s third illusion – the belief that ultimately the European crisis is a crisis of the euro and that monetary union and the euro are to blame. Of course it’s tempting to use the euro as a scapegoat, but it’s not the euro’s fault that Europe is today in such a deep crisis. On the contrary, the euro has brought huge economic and financial benefits through increased trade, financial intermediation and integration, better price stability, enhanced competition and efficiency. Can it really be the fault of the single currency that governments used the improved financing conditions after joining the euro to expand unproductive spending and increase debt? The introduction of the euro certainly provided the means, but it’s misguided to make it the culprit.

Another reason why the euro cannot be the culprit is that the eurozone crisis doesn’t have the characteristics of a currency crisis. A currency crisis implies that the currency in question is overvalued and badly managed, rendering the economy uncompetitive. The symptoms of a currency crisis consequently include the erosion of trust by financial markets and an erosion of confidence in that currency’s long-term stability. Both of these elements are missing in the eurozone crisis: the euro has not been overvalued, nor have markets lost trust in it. On the contrary, the remarkable resilience of the euro exchange rate vis-à-vis all other major currencies shows that markets continue to believe in the euro’s viability and stability. The euro has instead been a beacon of stability, preventing the crisis from spiralling out of control. While the financial markets haven’t lost trust in the euro, they have lost trust in politics and the ability or willingness of governments to do what’s needed to pull Europe out of the crisis.

Another reason the euro is so often blamed is the argument that the euro area is not an optimal currency area. This argument is wrong because no economy is ever an optimal currency area, there are large differences across the states in the U.S. and even across Germany’s Länder. What challenges the viability of the euro is not the heterogeneity of the euro area economy, but rather the lack of political will to put in place such complementary policies as a sound and credible fiscal union and the banking union.

These three illusions together make Germany so reluctant to provide leadership for Europe. But this is also because many Germans underestimate the cost to Germany if the euro area economy were to collapse or the euro fail. Any projection of the costs involved is necessarily speculative, but there are compelling reasons to think that Germany would itself be one of the main victims.

First, there’s the openness of Germany; few large economies are as dependent on exports for growth and employment. Germany has always taken great pride in this openness and its export success. In 2012, it recorded a staggering current account surplus of 7% of GDP, a mind-boggling number given that the slow-down in global growth reduced trade surpluses and deficits almost everywhere, even in China and Japan. Although German exports are increasingly outside of Europe, almost 40% of them still go to other euro area countries. The German economy would almost certainly be pulled into a deep recession if other large eurozone economies like France, Italy and Spain were to collapse.

A break-up of the euro would also imply a huge appreciation of the new German currency replacing it. German exports have so far been rather resilient to euro fluctuations, but they are unlikely to be unscathed by the massive appreciation that would almost inevitably follow. Switzerland’s experience with the Swiss franc is telling because it has only been able to prevent an even stronger appreciation of its currency through massive foreign exchange interventions. There would be no such escape for Germany, though, as it is far too big country to pursue such a strategy. And the strong appreciation of any new German currency – be it a reduced euro or a new Deutsche Mark – would risk doing major damage to Germany’s export sector; rapidly driving German companies out of the country with outsourced production. This might be good for countries like Spain, but it would cost German workers dearly.

A third reason for Germany’s dependence on the euro area is its creditor position. Germany holds net financial claims through portfolio investment, bank loans or foreign direct investment of about 40% of GDP vis-à-vis the rest of the world – with most of it against other European countries. Another recent study here at DIW Berlin shows that the value of this net foreign asset position is highly sensitive to what happens elsewhere in Europe. German companies and private households have already lost as much as €600bn in the value of their net foreign assets since 2006, equivalent to 22% of German GDP, with much of this due to bad investments in the eurozone’s crisis countries. It is not hard to imagine what a euro area collapse would do to the value of these German financial assets.

The costs to Germany of a eurozone and euro collapse wouldn’t, of course, be just financial and economic, but political too. Germany is better able as part of the EU to defend its interests around the world than on its own. As emerging economies push onto the world stage, only a cohesive European Union will be able effectively to defend its members’ interests, especially those like Germany that depend on global markets.

If there were to be a euro area collapse, it would most likely be blamed to a large extent on Germany and its reluctance to lead. Germany already sees itself as a scapegoat for Europe’s ills, so even if the blame it has been receiving is much exaggerated, it is the only EU nation with the economic might and political weight to pull Europe out of the crisis. The end of the euro would therefore risk isolating Germany within Europe, which is neither in its long-term economic nor political interests.

The outlook for the euro area economy has improved, but it is not out of danger. Any unexpected event, whether a political crisis, a bank collapse or a deeper than expected recession, could still push the eurozone economy over the brink. Not only would a deep crisis in a single member country be so contagious as consequently to become systemic, but also the costs for Germany would in all likelihood be particularly high. This is not just because of Germany’s openness to trade and finance but also because its current strength gives it a special responsibility to provide Europe with leadership.

These three false beliefs stand in the way of Germany assuming responsibility and leadership for Europe. One of the most urgent tasks for Germany’s new government is to rid Germans of these false beliefs and to work more forcefully to make Europe function as a union. This is no doubt a difficult task, as it requires building a deeper partnership and regaining trust among European nations, but one without good alternatives.

Leave a Reply

Your email address will not be published. Required fields are marked *

Time limit is exhausted. Please reload CAPTCHA.