Germany is reshaping the European economy in its own image. It is using its position as the largest economy and dominant creditor country to turn members of the euro zone into small replicas of itself – and the euro zone as a whole into a bigger one. This strategy will fail.
The Berlin consensus is in favor of stability-oriented policies: monetary policy should aim at price stability in the medium term; fiscal policy should aim at a balanced budget and low public debt. No whiff of Keynesian macroeconomic stabilization should be admitted: that is the way to perdition.
To make this approach work, Germany has used shifts in its external balance to stabilize the economy: a rising surplus when domestic demand is weak, and the reverse. Germany's economy may seem too big to rely on a mechanism characteristic of small and open economies. It has managed to do so, however, by relying upon its superb export-oriented manufacturing and ability to curb real wages. In the 2000s, this combination allowed the country to regenerate the current account surplus lost during the post-unification boom of the 1990s. This, in turn, helped bring modest growth, despite feeble domestic demand.
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For this approach to stabilization to work well, a large export-oriented economy also needs buoyant external markets. The financial bubbles of the 2000s helped deliver this. Between 2000 and 2007, Germany's current account balance moved from a deficit of 1.7 percent of gross domestic product to a surplus of 7.5 percent. Meanwhile, offsetting deficits emerged elsewhere in the euro zone. By 2007, the current account deficit was 15 percent of GDP in Greece, 10 percent in Portugal and Spain, and 5 percent in Ireland.
The domestic-demand counterparts of the huge external deficits run in these countries were mostly credit-fueled private spending. Then came the global financial crisis. Capital inflows halted and private spending collapsed, creating huge fiscal deficits. Harvard's Carmen Reinhart and Kenneth Rogoff have shown that this was predictable. Between 2007 and 2009, the fiscal balance shifted from a surplus of 1.9 percent of GDP to a deficit of 11.2 percent in Spain, from a surplus of 0.1 percent to a deficit of 13.9 percent in Ireland, from a deficit of 3.2 percent to one of 10.2 percent in Portugal and from a deficit of 6.8 percent to one of 15.6 percent in Greece.
The mistaken consensus swiftly emerged, notably in Berlin, that this was a fiscal crisis. But that was to confuse symptoms with causes, except in the case of Greece. Yet, being deprived of access to the bond market or close to that plight, crisis-hit countries had to tighten, despite their deep recessions. Tighten they did. Between 2009 and 2012, according to the International Monetary Fund, the structural fiscal deficit shifted by 15.4 percent of potential GDP in Greece, 5.1 percent in Portugal, 4.4 percent in Ireland, 3.8 percent in Spain and 2.8 per cent in Italy. This combination of financial crises with fiscal tightening caused deep slumps: between the first quarter of 2008 and the fourth quarter of 2012, GDP fell 8.2 percent in Portugal, 8.1 percent in Italy, 6.5 percent in Spain and 6.2 percent in Ireland. So far, so grim.