Countries around the world fear that Europe's handling of the eurozone crisis will cause a global slump. But in Germany, the currency union's biggest economy, there is a curious sense of invulnerability. For many Germans, including many senior policy-makers, the crisis seems to be someone else's problem. Indeed, some even believe that Germany would be better off without the euro. Merkel's obduracy is widely credited with striking a blow for Germany's national interests. The German government and media portray demands that Germany accept debt mutualisation or a banking sector union as a call for German charity or benevolence. Such reforms are rarely, if ever, seen as being in Germany's self-interest, but rather an imposition on the country. This is puzzling, because Germany is much more vulnerable than German policy-makers appear to believe. And Germany’s strategy for dealing with the crisis is maximising, not minimising, the risks to the country’s economic and political interests.
What explains this sense of invulnerability? Is the German economy really so strong that it can sail through an EU slump and a renewed global crisis? The German economy has certainly bounced back stronger than most of the rest of the Europe. Over the four years to the first quarter of 2012, the economy grew by 1 per cent. This hardly qualifies as the Wirtschaftswunder it is sometimes portrayed as in Germany (and is a worse performance than the US), but is considerably better than the EU or eurozone average. Germany's labour market has also performed strongly. Unemployment has fallen steadily, contrasting sharply with surging joblessness in France, Italy and Spain. German youth unemployment is at a 20 year low. This partly reflects demographics – the number of Germans coming of working age each year has fallen steeply due to the country’s persistently low birth-rate. But demand for labour has also held up well.
However, Germany's export dependence remains as pronounced as ever. The country's current account surplus has fallen but not significantly so: after peaking at 7.4 per cent of GDP in 2007 it was still equal to 5.7 per cent in 2011. Over the four years to the first quarter of 2012, domestic demand rose by 2 per cent, and hence outpaced growth in overall GDP. However, this was largely down to a steep fall in exports in 2009. Since then the contribution of net exports (exports minus imports) to economic growth has been positive: growth in domestic demand has lagged that of the economy as a whole. Moreover, stripping out government consumption – which has risen relatively strongly – domestic demand increased by just 1 per cent over the last four years. And growth in government consumption has now slowed sharply.
But what of the argument that Germany is no longer so dependent on the eurozone because of growing trade with the rest of the world? The eurozone accounted for 39 per cent of German exports in 2011, down from 43 per cent in 2007; the EU's share fell from 63 per cent to 59 per cent over this period. Put another way, exports to the EU are still equivalent to over 25 per cent of German GDP. And Germany exported 10 times as much to the EU in 2011 as it did to China. What of the country's trade surplus with the rest of EU? The surpluses with the EU have fallen from the highs reached in 2007. In 2007, trade with the rest of the eurozone accounted for 60 per cent of Germany's overall trade surplus and the EU for over 80 per cent. By 2011 these proportions had fallen to 40 per cent and 55 per cent respectively.
Germany has not rebalanced decisively towards domestic demand and remains highly dependent on trade with the rest of Europe. What of Germany's foreign investments? Almost two-thirds of Germany's total foreign assets (equivalent to around 200 per cent of GDP) are denominated in euro. Two-thirds of the country's stock of foreign direct investment (FDI) is in eurozone countries. The value of these assets is already being depressed by the crisis and would fall dramatically if the currency union collapses. And then there is the Bundesbank's exposure to other eurozone central banks. As capital flight from the struggling member-states has got underway, banks in these economies have become dependent on funds from their central banks, which have turned to the Bundesbank for financing. At the end of 2006 the difference between the Bundesbank's claims on other eurozone central banks and the latter's claims on the German central bank was negligible, but by May 2012 stood at €700bn. This will not pose problems so long as the euro system holds together, but it is far from clear what would happen if it falls apart.
Record low government borrowing costs have fuelled Germany's sense of invulnerability. Investors have pulled out of struggling eurozone economies in favour of German bunds, pushing yields down to unprecedentedly low levels. But there are signs that this is now changing as Germany's burgeoning exposure to the rest of the eurozone raises fears for the country's own fiscal stability. A declining group of countries are being called upon to underwrite ever larger sums of money, eroding their own creditworthiness. For example, a full bail-out of Spain would further erode confidence in Italy which would have to underwrite 23 per cent of the funds or around €100bn (on the assumption that a Spanish bail-out totalled around €400bn). This, in turn, would increase the likelihood of Italy itself needing a bail-out. At this point, only Germany, France, the Benelux, Austria and Finland would be in a position to underwrite bail-out funds. As a result, France's share of a bail-out of Italy would be around 35 per cent of the total, and would inevitably prompt a steep rise in French borrowing costs. Indeed, there is real risk that France would not be able to underwrite its share, leaving German (and a group of small economies) back-stopping the whole edifice. With each new country forced to seek a bail-out from the EU's rescue funds, the more vulnerable Germany becomes.
The current strategy for dealing with the eurozone crisis is largely a German one. But far from limiting the risks to Germany, it is maximising them. The German economy is not immune to the economic slump enveloping a growing swathe of Europe. One country after another will need bailing out, with Germany ultimately providing the back-stop. Much of this debt will not be repaid, leading to a dramatic rise in Germany's public indebtedness. Without a mutualisation of risk, the euro will collapse, with devastating implications for German exports (to EU and non-EU markets alike as a euro collapse would hit the global economy hard), the value of Germany's foreign investments, and the stability of its banking sector. These are just some of the direct economic costs; the political fall-out would be grave for Germany. Isolated and blamed for the collapse, it would be poorly placed to pursue its interests through whatever is left of the EU.
By contrast, the reforms needed to stabilise the eurozone pose far fewer risks to Germany. Debt mutualisation need not be open-ended, so moral hazard could be limited. And it is far from clear that mutualising debt would boost Germany's borrowing costs compared to the current approach, which threatens to undermine the country's creditworthiness without doing anything to address the underlying reasons for the eurozone crisis. The arguments for a banking union are equally compelling. If the eurozone banking crisis is left to fester, banks will collapse, which in turn will hit German banks (and hence German taxpayers) very hard. In return for agreeing to mutualise debt and to introduce a eurozone back-stop to the economy's banking sector, Germany could demand a host of concessions. The political union needed to give legitimacy to these institutional reforms would be cast in Germany's image. Berlin would cement its influence over Europe's economy and its politics but in a benign and hence sustainable fashion.
Five years ago Germany was plagued by self-doubt and even self-flagellation. Now the political debate, media coverage and national mood generally are marked by hubris and self-righteousness. Germany's strength is exaggerated and its weaknesses downplayed. The German authorities are underestimating how much they have to lose from the eurozone crisis and the damage it is inflicting on the European economy as a whole. Germany should agree to big institutional reforms of the currency union, not out of charity, but as a way of containing the risks to itself. A deepening crisis, culminating in defaults, a rupturing of the eurozone and most probably the single market are all but inevitable under the current strategy. This will not only do huge economic damage to Germany but leave the country isolated and mistrusted by a region from which it derives its strength. With the German economy slowing rapidly and investors starting to question the safety of German debt, it is possible the country will change course. But at present it appears that Germany is not for turning.
This article was first published on the Centre for European Reform website on Friday, June 22, 2012