Only Germany Can Save Europe
The euro crisis is back with a vengeance -- and only Berlin can pull the continent from its economic doldrums.
The crisis in the eurozone is rearing its ugly head again. European markets tumbled early this week in what one investor called a "perfect storm" of bad economic news, dragging the U.S. stock market down with it. And the fundamentals of many European economies remain weak: Yields on Italian and Spanish 10-year bonds are way above 5 percent — despite a successful Spanish bond auction last week. It’s a far cry from the 3 to 4 percent range that Italy and Spain need for their considerable debt burdens to be sustainable.
The immediate provocation for the flare-up of the crisis seems to have been a bearish note on Spain — and a few dour media appearances — by Citigroup chief economist Willem Buiter. According to Buiter, Spanish Prime Minister Mariano Rajoy’s new government is doing too little too late in terms of fiscal and structural measures to avoid sovereign default. Spain, he believes, therefore looks likely to enter some form of an IMF program this year.
The shifting political landscape in France could also stunt its economic recovery. Socialist Party candidate François Hollande emerged victorious in the first round of the French presidential election on Sunday, April 22, and is in a strong position to win the second round on May 6. The prospect of a Socialist Party takeover does little to reassure financial markets: The economic plans that Hollande has unfolded during the election campaign — lowering the minimum legal retirement age of 62 and raising the top income tax rate to 75 percent — seem utterly untenable in the eyes of many a mainstream economist, let alone global financial markets.
The euro crisis is also having political repercussions beyond the countries that experienced the worst of the downturn. The Dutch coalition government of Mark Rutte collapsed after anti-immigration firebrand Geert Wilders withdrew his support over negotiations on budget cuts needed to bring next year’s budget deficit in line with the 3 percent ceiling required under the EU Stability and Growth Pact. Financial markets have also shown signs of strain, with yields on Dutch government bonds mounting steadily. The Dutch government has championed austerity so vigorously in the past year that there must be a healthy dose of glee in Southern European capitals that it now tripped over its own feet. The Netherlands is up for elections that will be held in September, but financial markets don’t seem overly confident that Rutte’s outgoing government will garner sufficient political support to bring the 2013 budget under control.
Eurozone watchers are no doubt exasperated over this latest set of crises, but there is no reason for despair. Sure, the prospects of a default in Spain — a country that is both too big to fail and too big to rescue — and a Socialist takeover in core European countries are enough to guarantee financial turmoil in the weeks, if not months, to come. Investors, however, are not abandoning the eurozone completely, and Germany still has a unique opportunity to rescue Europe’s faltering economies.
Investors may be fleeing Spain and Italy in droves, but the same is not true for the eurozone as a whole. Witness the overvalued euro, which still stands above $1.30. That’s because investors who flee the eurozone periphery are seeking refuge in German government bonds. As a result, the yield on 10-year German government bonds has dropped to a record low of 1.70 percent, while a yield of 3 percent would have been more appropriate given the European Central Bank’s short-term interest rate of 1 percent. The low yields on German bonds only in part reflect the muted economic growth outlook for Germany and the eurozone as a whole. But the ultralow yields mostly reflect Germany’s status as a relative safe haven.
Economists like Paul Krugman have argued that the reason the yield on 10-year British government bonds is much lower than the yield on 10-year Spanish government bonds, even though the state of Britain’s public finances is direr than Spain’s, is that Britain has its own central bank to act as a lender of last resort. While Spain is dependent on the European Central Bank for its monetary policy, the Bank of England can always print more pounds to prevent Britain from defaulting on its financial obligations. Of course, a country that abuses this privilege runs the risk of resembling Zimbabwe.
A more plausible explanation for the yield gap, however, is the absence of exchange-rate risk between Spain and Germany. It is, after all, only wise to hold investments in the same currency as you have financial obligations. Let’s say you invest your savings in a foreign currency. If that currency depreciates, you run the risk of coming up short when the next mortgage payment comes due. From the perspective of an investor — for example, any eurozone pension fund — German government bonds are a perfect substitute for Spanish government bonds. As soon as doubt arises about whether the Spanish government will be able to service its debt, the money is quickly channeled to Berlin’s coffers, potentially setting off a self-fulfilling default in Madrid. From the perspective of a British pension fund, there is no such substitute for British bonds, and that is what keeps rates low.
Even though German economic growth continues to be modest, the unemployment rate hits new record lows each month — the adjusted rate currently stands at 6.7 percent, a two-decade low. And the squeeze on the labor market is starting to translate into higher wages. Just last month, the country’s 2 million civil servants secured a 6.3 percent pay raise for this year and next, which will most likely serve as the lower bound for private-sector pay raises. German carmakers already dole out cash bonuses of more than $10,000 per employee for the entire workforce. German politicians may wince at the prospect of rising inflation, and the old Bundesbank, Germany’s cautious central bank, surely would have raised interest rates to get it under control. It is the European Central Bank (ECB) that is in the driver’s seat in the new Europe, however, not the Bundesbank, and experts expect the ECB to cut, not raise, the short-term interest rate before the end of 2013.
Even if the ECB were to raise its short-term interest rate, the rate hike would likely fail to raise the yield on longer-term German bonds, which drives investment and consumer demand. Investors would probably see a rate hike as the death knell for Italy’s and Spain’s growth prospects, adding fuel to the debt crisis and causing investors to flock in even greater numbers to the safe haven of German government bonds. That’s at least what happened last year, when the ECB’s rate hike coincided with the earthquake in Japan and the unrest in Libya, and the yield on longer-term German bonds dropped like a brick. It is unclear what caused the euro crisis to flare up then, but it is possible that the ECB’s rate hike did have something to do with it.
Unless the unemployed youths from the eurozone’s outer boroughs flock to the German labor market, there is little the German government can do to halt Germany’s domestic wage growth. And that’s good news: Rising German wages may in turn help to restore the competitiveness of Portugal, Italy, Greece, and Spain (known as the PIGS), which will still have to do their part by implementing fiscal and structural measures to bring labor costs down. The same financial markets that failed to discipline governments in the 2000s for their profligacy will now serve as a powerful stick to bring about the much-needed structural reforms in the eurozone’s southern regions.
Thanks to the ultralow yields on German bonds, the treasury in Berlin each year has a windfall that I have estimated at upwards of $15 billion. Because some of this windfall comes at the expense of the eurozone’s periphery, Germany should consider reinvesting some of these funds in the economically stricken countries surrounding it. They could be used, for example, to fund loans or risk capital for enterprises in Portugal, Italy, Greece, and Spain. With those countries’ banks depleted and probably insolvent due to the debt crisis, business investment in these countries has suffered tremendously. Along with the money — which could also be channeled through the German-led European Investment Bank, as World Bank President Robert Zoellick has suggested — Germany might pass on some good economic advice to the PIGS as well.
The German government, especially Chancellor Angela Merkel, has been vilified in the past two years by fellow Europeans and Americans alike for not moving aggressively enough to resolve the debt crisis. Germany, however, actually does have something to show for its caution: namely, economic success. With few natural resources and no tourism industry to speak of, there has been no easy way for the German economy to generate growth. But through innovation, moderation, and sheer hard work, Germany turned itself from the sick man of Europe at the end of the 1990s into one of the few Western economies that seems truly globalization-proof. Now Berlin has an opportunity to use its newfound economic leadership to rescue its neighbors from the worst of the euro crisis.