Why Germany is right to "hold Europe ransom"

As I've stated in an earlier post, my recent trip to Germany has been full of positive experiences. Most importantly I gained insight into why Germany (i.e. its formal institutions) feels so strongly about the agenda for structural reforms and why it opposes any alternatives, particularly looser monetary policy and the idea that Germany should stimulate its economy to raise European aggregate demand.

A country that was once called the "Sick man of Europe", was the first to undergo painful reforms. Back in 2003 they started with preparation and implementation of the so-called Agenda 2010, which I covered on several occasions in the blog (see here or here). The Agenda carried a series of reforms, but the most notable and important ones were the labor market reforms (i.e. Hartz reforms), because of which Germany was able to cushion the blow of the 2008/09 crisis. Germany had the lowest increase in unemployment (virtually none) of all European countries during the crisis. 

The labor market reforms necessitated a joint approach from all sides, so the negotiations that started in 2003 included the federal government, businesses, unions, parliamentary representatives (i.e. all political parties) and even scientists. The centerpiece of the labor market reform was to curb the power of unions and craft guilds, making it easier for the young to enter the market, while contributing to the labor market flexibilization. The unemployment benefits were cut (a German can draw unemployment benefits only around half as long as an American), tax reliefs were introduced to those hiring, in addition to a whole set of marginal but important measures. The initial reaction was, as always, a shock. Unemployment increased as businesses started optimizing their labor intake (and hence firing more), coupled with dissatisfaction among the unions and guilds which in the end cost Chancellor Schroeder the elections. But the system was reformed. And it was precisely because of these reforms that Germany weathered the crisis much better than any other country in Europe. 

Leading by example: a balanced budget 

And once again Germany is leading the way in showing how to get out of the mess of unsustainable debt and sluggish growth. It is leading by example - next fiscal year Germany will have a balanced budget for the first time in decades. According to the debt projections, labor market trends and most importantly demographic trends (an ageing population), cutting debt is essential. An old population overburdened with debt is no promising future. Which is precisely why the number one priority of the government at this moment is to cut debt. How does one do that? "Easy", start by balancing your budget. The figures below show a strong statement of intent: Germany intends to have a budget surplus until the debt-to-GDP level is cut down to the Maastricht ratio of 60%. According to the existing projections, Germany will achieve this in 2018, so in only four years! Take note Eurozone periphery, this is what proper austerity looks like: 

Source: Federal Ministry of Finance

Source: Federal Ministry of Finance

Will this affect their GDP growth? Most surely. Growth will remain to be low at around 1 to 2% in the next few years, but just like in 2003, the system needs to be changed. And in this case the system needs a debt decrease. The opportunity cost of a temporary slowdown is low enough to justify the austerity approach applied by the Germans.

Criticism from the EU

However this zero deficit approach generates fierce criticism across the EU. Many have stated that Germany should continue to pile up debt to keep aggregate demand in Europe higher. They blame Germany on "holding Europe ransom" by forcing them into austerity without providing any relief. Germany should, according to the critics, provide more fiscal stimuli into Europe (indirectly of course) to help the rest recover as quickly as Germany did. However the German logic makes more sense. Germany is not in a recession (contraction) so it sees no point in applying the classical counter-cyclical solutions such as large spending hikes. Instead they opt for encouraging private investments instead of large public investments. This is best done with measures such as capital gains tax write-offs, lower corporate taxes, lower income taxes and other regulatory and non-regulatory (legal) measures aimed at helping businesses grow (see here a short guide for attracting foreign investments). Attracting private investments is the right approach, everything else in a state of unsustainable debt is wrong. FYI, private investments in Germany consist of 17% of its GDP, whereas public ones consists of only 1.8%. 

Germany has its own problems it needs to take care of. As mentioned, with an ageing population large public debt becomes a big problem. Not now, but in the near future. And Germany wants to address this issue immediately, not wait until it's too late. 

Furthermore the rest of Europe isn't far away from the German problem. They too are overburdened with debt, and Europe in general is ageing. Demanding large stimuli and further indebtedness is self-defeating, particularly in the long run, which isn't so far away. Even in the short run it won't cause the effect it is supposed to. Why? Because the private sector deleveraging in Europe as well. Two IMF economists show why this is a drag on growth particularly if all three major sectors of the economy (government, households and corporates) have high debt levels:

Source: VoxEU

The other reason is lack of lending. Banks are safe (according to the latest ECB stress test), but still unwilling to lend. And then we reach monetary policy. Critics of the ECB (and hence the Bundesbank) call for looser monetary policy, i.e. for a more expansionary approach. According to this argument it would be best to simultaneously apply both expansionary monetary policy and an expansionary fiscal policy to raise European aggregate demand. And then do the reforms, which everyone agrees are necessary. 

Where have I seen this approach fail most recently? Oh, that's right, Abenomics, the policy package of Japanese PM Shinzo Abe aimed at finally pulling Japan out of a 20-year-long stagnation. It's not so wise however to use the same policies that have failed consistently for 20 years and then hoping that suddenly they will make a difference. Even if applied simultaneously. 

Europe tries to do the same thing. Avoid a painful solution and provide persistent short-term stimuli, hoping that at one point they will make it. Economics doesn't work that way unfortunately. Not when there's so many structural unbalances as they are today in Europe (and Japan). Which is why, in my honest opinion, Germany holds the key to Europe's success. Leading by example in balancing their budget, while forcing structural reforms upon other nations is the only way to go for Europe. Everything else leaves them in a state of Japanese-style decades-long stagnation.

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Addendum: One of the most commendable things about Germany's economic policies is the continued increase of investment in education. Despite the crisis and the (brief) recovery period, Germany increased spending on education from 3% to GDP before the crisis to almost 5% to GDP in 2014. This will be increasing even more, as the Germans have recognized where the foundations for long-run growth lie in (see here for greater detail). 

Source: Federal Ministry of Finance