Global economy supplement: the eurozone—still likely to crack

The German economy has transformed itself through economic reforms. Mario Draghi, President of the European Central Bank, ended the eurozone crisis with a promise to support the euro in all circumstances. Spain goes through a miraculous economic recovery. The threat of a breakdown of the eurozone is averted.

We can tell ourselves these and similar stories over and over again. Most people believe them. They have become part of the standard narrative. But as plausible as each one of those statements may seem, they are all wrong.

The real story is that the eurozone fell into a recession in the fourth quarter of 2008, and has been stuck there, more or less, ever since. When recessions last that long, they do real, lasting damage. Many of the young people who have not worked in the last six years, may not work in six years’ time either, if ever. The recession has permanently reduced the productive capacity of the economy. Investment rates have fallen, as member states are struggling to meet the fiscal rules of the monetary union. A fall in investment today means lower growth tomorrow. And lower growth tomorrow traps the public sector in Greece and Italy and the private sector in Spain and Portugal in a debt trap. The eurozone’s existential crisis is economic. It is not just financial. What is widely known as the eurozone crisis of 2010-12 was only the financial crisis. Investors pulled out of bond markets, drove bond prices lower and interest rates higher. That specific crisis ended with the lender-of-last resort guarantee by Draghi in 2012. That guarantee encouraged banks and global investors to come back, thus stabilising the sovereign debt markets.

By 2013 the world had already moved on. At the annual meetings of the World Bank and the International Monetary Fund in October 2013, the eurozone had ceased to be the central topic of conversation. Everybody talked about China, and about how the United States will normalise economic policy, by ending its programme of quantitative easing. A year later, in October 2014, the situation reversed. The eurozone was back in the dock.

The trigger was the 4 per cent decline in German industrial production during the month of August. It was one of the biggest falls ever recorded in modern German history, and brought back the fear of a renewed recession. Those of us who read the economic data month by month have learned from experience to be cautious with any set of numbers. German statisticians have great difficulties accounting for the various seasonal and calendar effects. Germany has many bank holidays that do not always fall into the same month each year. The 16 German Länder, the federal states, operate a complex rotation system for their summer holidays. The combination of these effects produces some freak data. But there is no question that the German economy has been slowing down markedly. The mood among German industrialists changed from euphoric during the first quarter, to pessimistic by September.

The German economy is in reasonable shape, but not nearly as robust as is widely believed. Over the previous years, Germany benefitted from a serious of fortuitous circumstances, which have changed since the beginning of this year. The investment booms in China and Russia, as well as in many emerging markets, greatly benefited German industry. For a country its size, German industry is unusually specialised. Its main area of excellence is high-end engineering, mechanical, electrical and chemical. German companies sell high-tech plant and machinery, power plants and gas turbines, to foreign states or utility companies.

Germany has been the great beneficiary of global imbalances. One of those was the clearly unsustainable investment boom in China, where investments make up more than 40 per cent of GDP, about twice as high as investment in other advanced countries. The issue for Germany is not whether China can grow by 7 or 7.5 per cent, but how much of this is accounted for by investment spending.

China is now doing the inevitable: rebalancing towards consumer spending. China does not have to fall into a recession for Germany to feel the pinch—China just needs to revert to a more sustainable position. The success of the German economy was based to a large extent on unsustainable investment booms elsewhere.

Germany does not have a particularly strong entrepreneurial culture. It used to, in the 19th and early 20th centuries, and then again after the war. But this is no longer the case. There has been not a single globally successful information technology start-up in Germany since SAP, the software company, in the 1970s. Germany is not a leading player in the biotech sector either. The services sector remains largely unreformed. The professions and trades are protected. There are still a few successful upmarket consumer durable goods producers, but these serve comparatively small markets. The legends of companies like Porsche or Leica are much greater than their contribution to Gross Domestic Product. They are not insignificant, but Germany is a country with 80m people and a GDP of €2.5 trillion (about £2 trillion). The bread and butter comes from highly specialised pieces of metal.

The other market that has broken away is Russia. The impact of Vladimir Putin’s aggression against Ukraine has been widely underestimated because economists focused only on the direct trade links, which would not have suggested such a big impact. But in an age of just-in-time production, and global distribution networks, small shocks can have a big impact. If you feel that Putin’s actions destabilise not only Ukraine, but also other parts of central and eastern Europe, you are more likely to hold back any investment projects in the entire region. When companies do not invest, they save more. And since the German government, too, saves more because it has tied its own hands with a constitutional balanced-budget rule, there is nothing that could offset the shock from the export markets.

The same happens to an even greater extent elsewhere in the eurozone. Austerity is not something they did for a year or two. It has become a way of life. Add to this the process of deleveraging in the private sector, and you have the ingredients for a self-reinforcing slump. It does not feel as bad as the 1930s because modern welfare systems buffer the worst parts of the shock. What is particularly disturbing is that the public, by and large, endorses austerity. In Germany, austerity wins you elections. Only the Left Party, the descendants of the old communists of East Germany, supports fiscal expansion right now. If you advocate a Keynesian fiscal response in Germany, I am afraid your only friends are communists.

For now, the prevailing narrative dominates: Germany is doing better than the rest because it reformed its labour market, while France, Spain and Italy did not. Germany pursued a more conservative fiscal policy while the others were running large deficits. According to this narrative, the threat of a crisis will vanish once everybody becomes like Germany, when everybody moderates their wages like the Germans, saves like the Germans, and exports like the Germans.

The logical flaw in this proposition is obvious to anybody who knows that, on a global level, trade surpluses and deficits must all add up to zero. One country can be more competitive than another, but the world cannot increase its competitiveness as a whole. Of course, we can all become more productive, but that is a different concept from competitiveness.

When in October the news of the fall in German industrial output came out, commentators and politicians predictably demanded that the solution to this problem is for Germany to improve its competitiveness further. Yet the issue is not a lack of competitiveness, but a lack of global demand, China’s rebalancing and Putin’s aggression. Even now, Germany is still running massive trade surpluses. So is the eurozone as a whole. A lack of competitiveness can hardly be the problem.

The real problem is rather different. It is a lack of aggregate demand, and specifically a lack of investment. The situation is particularly extreme in Germany. The Bundeswehr, the armed forces, is essentially dysfunctional because its equipment is in an extraordinary state of ill-repair. Many bridges and roads have turned into public safety hazards. The country is not spending enough on education either. We know that low levels of investments induce lower growth in the long run, and this, in turn, will reduce future tax revenues, laying the ground for more austerity, and even less investment. Germany would be saving itself towards a slow death, were it not for the dissaving in other parts of the world.

As the reality and narratives about Germany are beginning to diverge, the eurozone narrative must change as well. The establishment’s view of crisis resolution has been that Germany provides interim support to the entire system, while everybody else reforms their economies and becomes like Germany, balancing the budget each year, running current account surpluses, and keeping wage growth moderate for the sake of competitiveness. But if this strategy does not even work for Germany itself, it cannot work for the eurozone. As we are seeing in France and Italy, there is a lot of political opposition to the reforms. With global demand not supporting an export-led strategy, the economy remains weak until domestic or global demand pick up. The domestic economy is relatively stable, and feathers the fall in global demand a little. But it is hardly buoyant. And once the global economy recovers, which it will eventually, it is not clear that it will benefit German manufacturers in the way it did in the past.

With a weakened Germany, the whole edifice of our optimistic post-crisis narrative crumbles. France and Italy will not be following the German model. Italy had 15 years of stagnating productivity growth. One reason clearly is the high level of debt—now over 130 per cent of GDP. It is hard to see how it can return to positive growth rates in a eurozone with tight fiscal constraints. Unlike Germany, Italy did not manage to preserve a large exporting sector, having come under competitive pressures from emerging markets in the early 2000s. This has something to do with the nature of Italian products—less high tech, more replicable—but also with the lack of wage restraint. Italian industry is not a position to generate growth even if global demand were to pick up. A debt restructuring will not bring any relief either, since most of the debt is held domestically by banks. The only imaginable relief could be through transfers from other eurozone countries, some form of debt mutualisation, for example, through the conversion of Italian debt into eurozone debt, or ultimately through an Italian withdrawal from the eurozone.

If Italy’s economic situation does not improve until the next elections, scheduled for 2017, there is a big risk that the anti-euro Five Star Movement could win that election. The party is promising a referendum on the euro. The outcome of such a referendum would be wide open. Should Italy leave the eurozone, the future of the whole project is in danger. Do we know whether France will want to plough on in the role of Germany’s permanent junior partner? If the Italian economy were to recover after a euro exit, would this not encourage other countries to do the same? If the eurozone were to shrink to a small core group of countries around Germany, would the resulting euro not be a super-strong currency that would kill off the export industries of those countries as well? It is impossible to predict whether and how the eurozone will unravel, but the situation is unstable, and any unstable situation will lead to some kind of resolution, one way or the other. Unlike a generalised run on the bond markets of 2010-12, this is a type of instability that the central bank will find harder to bring under control. If people were to conclude that the monetary union itself is responsible for their loss of wealth and income, they might vote for parties that promise an exit from the regime. So far, the majority of Europeans have not blamed the currency regime. They still believe in the narrative that labour market reforms will do the trick. But when they find out that this is not so, will they continue to support the euro? I have my doubts, although I cannot predict when this will happen.

In the case of Germany, labour market reforms were followed by a period of higher growth, but the reforms were hardly the reason. The reason was a long period of wage moderation over many years, a process that started well before the reforms in the late 1990s. The reforms did, however, have an important effect. They brought about a fall in the structural rate of unemployment and produced more low-wage jobs. That is a perfectly desirable outcome in its own right, but it has not made the German economy any stronger. On the contrary, the lack of investment, which was needed to support the austerity policies, has weakened the country in the long run.

The same goes for the eurozone at large. The current policy of forbearance and austerity may have stabilised the situation in the short run, but has done so at the expense of more instability tomorrow. My reading of the situation is that Germany will stick to its policies to the bitter end. It will not accept a fiscal union, mutualised debt, or fiscal transfers. This is why I believe the probability of an eventual break-up of the eurozone is higher now than it was two years ago when Draghi promised to do “whatever it takes.”