Why This Time Germany Is Right (Part 1)

Attacks on Germany have gotten more venomous and personal this week. Its leaders stand accused of being “in denial”, “timid”, “obstinate”, “relentlessly negative”, “ignoring the lessons of the 1930s” and the reasons for “the breakdown of democracy”, undermining “trust” within Europe, giving swimming lessons to drowning people, and leading us toward "the end of the world as we know it". 

Since the beginning of the Euro crisis hostile academics and journalists and desperate politicians wanting German savers to set the world to rights ridiculed Germany with infantile jibes about its obsessive “housewifely” economics and puritanical zeal for pain, punishment, discipline, and sacrifice. It is a welcome relief, then, that two very smart journalists -- Simon Nixon (WSJ) and Gideon Rachman (FT) -- this week wrote knowledgeable analyses of the German position for the benefit of English readers.

Germany has perhaps not been good at public relations during the Euro crisis. It does not help that none of the major German dailies has a foreign language edition. Germans will learn the hard way that great powers must win the hearts and minds of the world. I think Germany is nevertheless doing gratifyingly well as an international leader. I want to explain this in terms of the vital "law sequence" of political economy, which has been universal in European economic history, and which Germany has quietly, politely, and determinedly pursued.

What are the immediate problems in Europe today?

The noise: Most vocal and strident modern economists hold to a quaint mid-twentieth century belief in centralized capacity to solve major economic problems by engineering monetary aggregates. The impression is created that the crisis requires government debt and spending to promote growth. The complaint is that Germany is holding back solutions by recommending retrenchment and refusing to open its hands with economic charity.

The action: Right now, however, investors and savers are fleeing the southern European periphery *not* because of periodic everyday uncertainty about the size and timing of the next European monetary easing, sovereign bailout, bank rescue, liquidity injection, or public infrastructure investment. Rather they are fleeing because of permanent and deep uncertainty about future rules governing coordinated European monetary and fiscal union, which in the short and medium term means rules for managing debt.

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The context: Before this crisis it was reasonable to argue that while monetary union and common currency was convenient and deepened markets, it did not require coordinated fiscal policies. Centralized fiscal policy risked reducing flexibility by feeding the existing EU dirigiste tendencies, and might encourage false accounting by deficit countries.

Economic crises have a way of revealing the problems that only institutions can solve.

Thus the need for fiscal coordination within the Eurozone was revealed by the task of coping with the various symptoms of debt overhang which the crisis has brought to light.

The sticking point is resistance to rules:

Polarization in Europe stems from the fact that some countries (inside and outside the Eurozone) pressured by fiscal constraints seek immediate unconditional Europe-wide monetary easing, bank bailouts, public works, and -- above all -- debt mutualization via Eurobonds. They want Rescue-First. Reforms are to be left until the dust settles.

It has become even clearer this week that the legitimate German position is Rules-First or Rules-For-Rescue. As the major contributor to any rescue Germany finds unacceptable the risk of damaging its future by taking on primary responsibility for ad hoc and potentially endless transfers to poorly governed economies. It wants aid recipients to face conditions for structural reform, and to cede some sovereignty to a central fiscal authority.

Germany seeks a formal predictable framework to regulate joint-liability.

Once the rules for fiscal coordination are agreed and signed, the policy options are relatively open. German officials have made it clear that they would consider some pooling of debts with joint guarantees or euro bonds if basic elements of fiscal union are in place.

The reforms on the table are as follows (WSJ):
1. Oversight of national budgets by European institutions (the condition for Eurobonds).
2. Structural reforms to boost competitiveness and growth including stalled privatizations.
3. A banking watchdog and depository insurance.
4. Coordinated tax and finance policies including budgets for stabilization measures.

The new intergovernmental treaty or fiscal pact agreed December 2011 and signed March 2012 requires ratification by the parliaments of at least 12 of the member countries before taking effect. That is the most visible ‘formal’ sticking point. It is outside my area of expertise. Apparently once it is ratified the new bailout mechanism -- European Stability Mechanism -- can come into effect. However, reports suggest the ESM could be up and running next month even though only a small number of countries have ratified the Treaty.

Pressure on Germany is relentless. Hardly a day passes without someone trying to slip in new schemes to circumvent Rules-First. Yesterday the Bundesbank said a Banking Union “would be joint sovereign liability through the back door – without the possibilities for intervention and control, i.e. protection, of a fiscal union.”

Any measure to circumvent that imperative would effectively be propping up a failed discretionary system and preparing the ground for a succession of ever larger short and medium term crises. The rules being suggested are hardly unreasonable. If this really is an emergency, and if there is agreement on preserving the Eurozone as a market economy area, the onus is on those who require rescue to agree to simple conditions conforming to EU tradition irrespective of national pride and localized political cycles. If, in contrast, the underlying disagreement is an older ideological one -- between forms of discretionary dirigisme and impersonal market regulation -- there is less room for compromise.

The point of looking at economic history:

Before being provoked into defence of Germany I had intended this week to write about the eternal universal sequence of economic history in which economic change inescapably drives changes in law without which further economic development becomes impossible.

It has always been this way. After a time, informal agreements among economic players are not sufficient. Free riders are discovered. Arbitrary and discretionary interventions are resented. Rule-followers sense they are being systematically gamed by rule-breakers. There emerges the demand for enforceable formal rules, i.e. the laws of a political community, to substitute for the hitherto informal norms.

Frustrating as the technicalities of Rules-First fiscal-monetary union may appear, they represent the human and institutional face of the historical imperative that has governed affairs between and within modern economies ever since the origins of capitalism.

In the troubled southern European countries, the root reason for the acute intensity of today’s financial crisis is preexisting weakness of their economies. Northern European countries were generally better prepared for crisis, which is why they are now suffering the brunt of the clamour to save the unprepared. There are two main dimensions. The first is the level of public and private debt, and their eliding during crisis if sovereigns choose to absorb household and bank debt. The second is the progress made in structural reform.

The principles embodied in Keynesian macroeconomics of demand management are a major reason for fiscal imbalances that left Europe disproportionately vulnerable to large impacts from perfectly foreseeable Schumpeterian capitalist crises. The politician who said the modern state superseded the boom-bust cycle should have been debarred from office lest he continued to sign-off government spending as cure for every problem.

Underlying weaknesses that now must be urgently tackled as a precondition both for renewed growth and rescues are the same structural supply side deficiencies (markets for labour, goods, services) that existed in much of southern Europe for decades.

These supply-side issues were elegantly explained in a book dedicated to Rudi Dornbusch -- The Future of Europe: Reform or Decline -- published 2006 by two Italian economists Alberto Alesina and Francesco Giavazzi. The chapter titles say it: 2. Handling Multiethnic Society; 3. Americans at Work, Europeans on Holiday; 4. Job Security, Job Regulations, Fourteen Million Unemployed; 5. Technology, Research, Universities; 6. Competition, Innovation, The Myth of National Champions; 7. Interest Groups Against Liberalization; 8. Cost of Doing Business; 9. Conflicts of Interest in Financial Markets; 10. United Europe?; 11. Rhetoric of Dirigisme and Coordination; 12. The Euro; 13. Budget Fixes…

This short though occasionally flawed (e.g. criticism of efforts to coordinate fiscal policies) book was prescient and now deserves rereading. I will quote some sentences:

“The relevant conflict in Europe is not between the federalists and intergovernmentalists. The real cleavage is different. On the one side are the French dirigiste and protectionist economic terms… On the other is a vision of Europe as a free market…”

“The sluggish pace of supply-side reforms is the reason for the current economic difficulties of Europe, not the Euro.”

“Rather than attacking the entrenched political power of various insiders -- labour unions, monopolistic firms, inside traders in financial markets -- that prevent adoption of reforms, European politicians often attack the European Central Bank.”

“The impending decline of Europe is not a short-run problem; there is nothing monetary policy can do to prevent it… The current problems do not stem from the euro but from the lack of those accompanying supply-side and competition measures that would have permitted the euro to display fully its beneficial effects.”

This crisis is a natural experiment. The early result is the finding that delays in structural reform cost countries catastrophically by making them excessively vulnerable to history’s recurrent large-impact events. But we knew this already! The twentieth century spawned three great theory-shaping economists. Only one of them - Keynes - thought the fire of large-impact events could and should be doused with showers of state money.

The modern Draghi-version of the classical sequence:

People rightly complain about the “uncertainty” for businesses and financiers. A simplistic populist response is offered in this week’s Economist: “Throughout this crisis, Mrs Merkel has refused to come up with a plan bold enough to stun the markets into submission”.

Investment in enterprise is risky. To make long term financial commitments in market-operating organizations investors at least want relative predictability in the political and legal environment. A few hundred years of European history demonstrate that rulers cannot buy certainty and predictability with money. Aggregate demand management and discretionary bailouts at best buy temporary respite from symptoms. In the current context they would clearly prop up a unsustainable government-business relations in bankrupt and overburdened welfare states. The route to relative certainty lies not in any combination of ad hoc risk-and-burden sharing. Predictability will be assured only by laws that clarify the procedural routines and harmonize rescue measures with permanent solutions.

Mario Draghi -- head of the European Central Bank -- explained to European parliamentarians in December 2011 that legal agreement on a fiscal compact is the precondition for restoring the credibility of governments and market stability. “Sequencing matters”, he stated. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds

Fiscal union is the only thing that could “frame the expectations” of investors. “It is time”, underlined Mr Draghi, “to adapt the euro area design with a set of institutions, rules and processes that is commensurate with the requirements of monetary union.”

It is implicit in Mr Draghi’s statement that crisis is driving the process by which monetary union will be combined with fiscal union. In Part 2 I will examine parallels with the process in European economic history through which the expansion of market communities drove design of relevant law. Max Weber, German economist-sociologist described it:

“Formal legal equality has been achieved by two great rationalizing forces: first, the extension of the market economy; second, bureaucratization of the organs of consensual groups.”

Germany is relentlessly leading the diplomatic charge of the law brigade and receiving little thanks for its effort. Germany undertook tough structural adjustments during and after unification. Many Germans expect indebted Eurozone countries to grow by lowering their business costs, enabling private enterprise, and introducing more budget discipline. With its combined institutional solidity and entrepreneurial drive Germany is today probably the world’s strongest and most competitive economy. It is by no means a perfect paragon of virtue. Ongoing vestiges of state corporatism may be a weakness rather than strength of the system. Nevertheless there is something in that country worth emulating.

Yet there is always a bottom line. I suspect Germany may not tolerate the abuse for ever. At some stage the northern European AAAs might just up and leave. There is a silly cartoon in The Economist this week. Angela Merkel stands on a pier teaching fit-looking young men to swim. Only inches away from the posts of the pier the non-swimmers could easily reach over and climb to safety. Instead they panic and cry in anguish. My reason for mentioning this? The cartoonist has not incorporated the lesson swim instructors learn about life saving -- don’t risk yourself by being dragged down with panicky drowning people. 

Back to history:

The ideas of Keynes never had such a large following in Germany. The weight of opinion among German economists is on the side of supply side measures to stimulate growth rather than on pumping up aggregate demand. Continental economics has always been more concerned with the institutional and political rather than the quantitative dimensions of economic analysis. In his book The State Tradition in Western Europe, Kenneth Dyson characterizes post-1945 German principles of social market economy as follows:

“The state’s purpose was to provide the basic economic order and the moral framework of economic policy with which the economic process could unfold automatically. Its functions were maintenance of the competitive order and economic stability… A strong independent state able to resist sectional interests was a prerequisite of a neo-liberal economic system.”

This contrasts with Britain where “fiscal fine tuning predominated over the attempt to make explicit and to order basic principles”. If one then looks back at the distinctive philosophical principles of Germany’s Rechtsstaat legal and institutional development in the nineteenth century and post-1945 the emphasis is found on Max Weber’s characterization of modern authority: 

“Today the most common form of legitimacy is the belief in legality, compliance with enactments which are formally correct and imposed by accepted procedure”.

Today we see that the economic debate is more fundamental than the one between Keynesian and market approaches.

The key point: Irrespective of particular policies, the issue (for Germany) is the *sequence* of policies. In its insistence, Germany stands on the right side of history.

I am not an ardent believer in the Euro. A common currency with adequate supporting structures is a convenience not a necessity. The European Union for as long as I can remember was too much a protectionist economic union, too politically correct in its social justice, too expensive in its welfare dictates. But as indicated in an earlier post I like the Kantian cosmopolitan ideal of global federal governance with market freedom under international rule of law. It was the crisis and the German response that changed my mind. Potentially we have a watershed moment when the Kantian ideal could be advanced a few stages. 

On the right rechts terms, legal institutionalization of European union might be a peace-and-prosperity model to spread. Policy hero of the moment? Angela Merkel. 

But if she fails it won’t be the end of the world. We just go back to petty national politics.