Don't Blame Germany

style="float: right; margin-bottom: 10px; font-weight: 600;"Mon 4th Aug, 2014

After attending an academic conference in 2011, I and my friend were on vacation in Miami, Florida. One evening we drove to one of the interior parts of Miami known as 'little Havanna' where we met group of immigrants from Cuba and other Latin American countries who have settled there for over two decades or more. They quickly recognised that I am from India, as we delved into the discussion on the financial crisis. One of the folks attracted my attention when I told him that I was pursuing my PhD in Germany. He then started to murmur, 'ah...Germans....', putting his index finger on his forehead pointing out to me that Germans are very ingenious, hardworking and are basically a rules-based society, which according to him is what distinguishes it from the rest of Europe.

I picked up similar such sentiments about Germany when I was holidaying in Spain in late 2012 and in early 2013. During my interactions with young and old Spaniards who were quite disillusioned not only by high rates of unemployment but also the grisly corruption scandals involving successive governments. They were parroting me not only what was their belief but what a lot of us in Europe came to believe - the rise of Germany as an economic power engine of Europe. As an immigrant living in Europe which is going through an insurmountable crisis, indeed I could not imagine what would happen without Germany to the European Union, which is on a cusp of a breakout. Not surprisingly though, almost all the European countries, especially those in crises, blame Germany for imposing 'austerity' programs on them. It has indeed become a conventional wisdom in the last three years or so, to constantly attack Germany for prescribing 'austerity' to treat Euro zone's problems. The recent revelations in the 'replication-gaffe', wherein the empirical results from a 2010 paper by Carmen Reinhart and Kenneth Rogoff which argues in favor of 'austerity' could not be replicated because of a data coding error in Microsoft Excel, further added fuel to the fire. However, the conundrum which I never understood is that all the member countries in Europe want Germany to lead the economic recovery but without themselves undertaking any measure of tough economic reforms. This is in my view simply preposterous to say the least. I also believe that the mounting criticism heaped on Germany's proposed 'austerity' measures as a panacea is also vastly overstated.

Instead of blaming Germany, countries in Europe should actually turn the crisis into an opportunity to reform. In that sense there are many parallels to what happened to the East Asian countries during the Asian crisis in 1997-98 and what is happening to Europe today. In fact, Ruchir Sharma, Head of Emerging Markets Equities and Global Macro at Morgan Stanley, points out as to how Asian tigers, namely South Korea, Taiwan, Indonesia, among others, who had a very hard landing in 1997-98 actually converted the crisis into an opportunity to reform and clean up their desks. During those years, the International Monetary Fund (IMF) was loathed in East Asia and criticized globally for imposing 'austerity' in return for bailouts. Since then, these countries have undergone many painful reforms in which the entire banking system was wiped off, currencies were significantly devalued, businesses suffered losses, experienced massive capital outflows, faced colossal levels of unemployment, economies contracted by over 8% resulting in dramatic loss in income levels during that period. But, that really set the stage for a very strong economic growth for the next 10 to 15 years. The countries which were in the abyss and suffered the most, namely South Korea, Taiwan and Indonesia emerged very strong out of the crisis because of the bold structural reforms and continue to exhibit a very strong momentum even today. South Korea and Taiwan have become the darlings of global investors like Ruchir Sharma who identify them as the 'gold medallists of growth and austerity', while Indonesia is seen as the next big emerging market on the rise. Within Europe, Sweden and Finland too have carried out large scale reforms in the banking sector in the aftermath of their banking crisis in the early 1990s. The bottom line is no one wants austerity for the sake of austerity. 

Historically, it has been observed that countries carry out economic reforms only when they have their backs against the wall. Vadlamannati and de Soysa (2013) in their empirical work including 116 countries during a 30-year period (1980-2010) find that countries reform when they are faced with severe economic crisis. Interestingly, we also find that full-fledged economic reforms increases the survival rate of the incumbent leaders, while half-hearted reforms pave way for crony capitalism leading to a backlash against reforms. The German Chancellor Angela Merkel seems to be well aware of this fact. This is precisely the reason why the German government signalled that it is willing to bail weak Euro zone countries out in return for reforms that would deregulate labor markets and improve their economic competitiveness. Ironically though, the German government faces resistance in its own backyard. Most Germans are opposed to the idea of bailing out countries like Greece who, according to them, must be responsible for their own actions of financial mismanagement, fraud, and poor competitiveness. As a neutral non-European observer, I understand the concerns of German citizens whose taxes will be used to bail out a country like Greece which is accused of economic mismanagement. Despite this, the German government appears to be willing to support weak Euro zone countries that are willing to commit themselves to reform. 

During the last three years though there has been a significant backlash against the 'austerity' program, which is perceived by the people in crisis-ridden countries as imposed on them by the German government. Thus, it is not surprising to hear that the people in these countries regard Germans as ungenerous, neurotic and dogmatic, who believe in the doctrine of 'austerity' as a palliative to the ills confronting Europe today. On the contrary, as an outsider, I consider German government's remedy of 'austerity' to be more pragmatic. If a country, operating in a democratic framework, is asked to use its tax payers' money to bail out the ill-doings of another country, then surely it has every right to demand structural reforms in return for the money released in trenches from its wallet. 

Let us for a moment concede that indeed Germany is dominating terms in Europe, but the larger question which remains unanswered is what other options these countries have on the table at the moment? The only other option, which has of late set the debate going, is exiting from the European Union. However, what is not really understood is that if countries like Greece do go down this path, then they would certainly find that financial markets, banks and the international financial institutions such as IMF would simply refuse to lend money at reasonable rates unless these countries convince them by undertaking pretty much the same set of reforms measures which Germany is asking them to carry out anyway! In fact, life would be much tougher for countries like Greece without Germany than with the German prescription of 'austerity'. This is one good reason for countries like Greece to be thankful to the German government, embrace the 'austerity' program, and use it as a means to clean up their balance sheets.

After all, the Germans have undergone their own version of 'austerity' in the early 2000s, when Germany was often referred to as the 'sick man of Europe'. Under the leadership of Gerhard Schröder, Germany in 2003 embarked upon a tough journey that took their economy, which was almost in the state of moribund, to being the economic powerhouse of Europe today. Gerhard Schröder also exemplifies the decisive political leadership which is desperately lacking in the crisis prone Euro zone countries. Schröder had the audacity to undertake some of the tough economic reform decisions which were the need of the hour in 2003 knowing fully well that it could mark the end of his political career thereafter. In fact, he did put his future political career prospects at stake to pull Germany out of the rut. Some of the tough economic reform decisions by Schröder including sweeping tax reforms, slashing welfare benefits (remember Angela Merkel's 50% - 25% - 7% argument on welfare spending), business and labor market deregulation, just a year before the elections demonstrated that German leadership was willing to sacrifice short term political gains for the larger interest of long term economic gains for the country. Indeed, he and his centre-left SPD party, whose cadres resisted reforms, paid a heavy price with an electoral defeat in the 2005 federal elections. Though his party lost considerable support among its supporters thereafter, the country gained in the long run. Germany's current economic strength can be traced back to some of the tough economic reform measures adopted a decade ago. Surely, countries like Greece can take a leaf out of the German system which puts country first over party politics. 

As Germany went to the polls on the 22nd Sept 2013, a thumping electoral victory for German Chancellor Angela Merkel, touted in the media as Europe's most impressive politician, should set the stage for bold reforms both at home and elsewhere in Europe. Many argue that Germany should then assume the mantle of leading Europe from the front. Whatever may be the argument over the leadership issue, the fact remains that Germany needs Europe, given its poor demographics, as much as Europe needs Germany. The fates of the two are therefore intertwined. While Germany pushing for 'austerity' could accommodate some of the concerns of countries seeking bailouts, weak Euro zone countries on the other hand should also come out of denial, tighten their belts, and start implementing many of the structural reforms which they badly need.

Reinhart, Carmen M. and Kenneth S. Rogoff (2010) Growth in a Time of Debt, American Economic Review, 100(2), 573-78
Sharma, Ruchir (2012) The Breakout Nations: In Pursuit of the Next Economic Miracles, Penguin Books: London.
Vadlamannati, Krishna Chaitanya and Indra de Soysa (2013) Damned if You Do! Free-Market Reforms and Leadership Tenure, 1980-2010, ISS working paper, NTNU: Trondheim.

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