Europe waits for Germany to come to the rescue

From The TimesOnline
May 18, 2009

Anatole Kaletsky: Economic view

Last Friday the European Commission published what were arguably the most catastrophic economic statistics produced by any official institution in the capitalist world since 1945. These figures showed that Germany has suffered the steepest economic collapse ever recorded in a major industrialised country; and that several of the countries in Central Europe and on the periphery of the eurozone are now in a state of economic and financial meltdown comparable with Argentina, Indonesia and Russia in the 1990s or with Iceland last year.
The 3.8 per cent decline in Germany's first-quarter GDP reported on Friday translates into an annualised rate of 16 per cent. That was almost three times the rate of decline in the United States and Britain and steeper than most estimates of the economic collapse during the worst years of the Great Depression. And this was not just some temporary fluke or statistical exaggeration.
The German economy has now been falling at a rapid and accelerating rate for four consecutive quarters, resulting in a year-on-year decline of 6.9 per cent. The comparable figures for the US and Britain are 2.6 per cent and 4.2 per cent. More important than comparisons with other countries is the contrast between the present disaster and the recessions that Germany has suffered in the past. Before the present 6.9 per cent slump, the worst year-on-year decline that Germany had recorded was 2.7 per cent in 1975. What these statistics confirmed is that the credit crunch has been a far greater disaster for Germany and most of continental Europe than for the US and Britain. In fact, it is Europe that faces a genuinely unprecedented economic crisis, whereas the recessions in America and Britain are broadly similar in scale to the ones of the past three decades (see charts).
That continental Europe — and Germany, in particular — has suffered far worse from the credit crunch than the US or Britain should come as no surprise. I have described repeatedly the three interacting elements now hitting Europe in a “perfect storm”.
The first element is Germany's dependence on exports, especially of capital goods, cars and other consumer durables. The vaunted strength of Germany's export industries has turned out to be its Achilles' heel, at a time of contracting global demand. To make matters worse, the mercantilist assumption in Germany that exports are somehow more virtuous than housebuilding or domestic consumption has left it entirely dependent on cycles of consumption and housing in other countries, while making German politicians unwilling to stimulate their own domestic demand.
The second element of the perfect storm has been the reckless lending to Central Europe and the Baltic States, especially by banks based in Austria, Sweden, Greece and Italy, which in turn have been large borrowers from German investors and banks. Countries such as Latvia, Estonia, Hungary and Romania have been borrowing between 10 and 20per cent of their national incomes each year — largely in euros and Swiss francs, rather than their local currencies. As a result, their businesses and homeowners will suffer a tsunami of bankruptcies if their currencies ever fall. Eastern European governments are, therefore, desperate to avoid devaluations. But the actions they take to “protect” their currencies — for example, cutting public sector wages — only deepen their recessions and magnify the mortgage defaults.
The third component of the economic hurricane is the euro itself. In its first decade of existence, the euro contributed to continental Europe's growth by allowing Spain, Greece, Portugal, Ireland and Denmark to run enormous current account deficits and enjoy housing and mortgage booms far more extreme than anything seen in Britain or the US. These booms provided markets for Germany's production of cars and other consumer goods. In the past few months, however, the single currency has changed from a stabilising factor into a new source of vulnerability for members of the eurozone. The reason is that eurozone governments are no longer risk-free “sovereign credits”, like the governments of the US or Britain, or smaller countries, such as Switzerland, Australia or New Zealand. A government that borrows in its own currency will never default because, in extremis, it can always instruct its central bank to print money to pay its debts. But governments in the eurozone cannot do this. They are in the same position as US state governments or as Argentina, Indonesia and Russia when they borrowed in dollars.
The default risks are particularly serious for governments that are deeply embroiled in the banking crisis. In Ireland, Greece and Spain, governments have been forced to guarantee banks whose liabilities are greater than the entire state budget. In Austria, Greece and Italy, financial risks have been magnified by bank exposure to Central Europe, which in the case of Austria is equivalent to 70 per cent of GDP.
Now consider how the three elements of this perfect storm have begun to converge. The plunge in the German economy has devastated the manufacturing industries and wage remittances in Central Europe, with output in several countries falling at annualised rates of up to 40per cent, never before witnessed in any capitalist economy.
The economic collapse in Central Europe almost surely implies a tidal wave of loan defaults. These, in turn, will wreak havoc in the European banking system and could raise the possibility of sovereign defaults in Greece, Austria, Ireland and other eurozone countries. Finally, efforts by governments to maintain their credit ratings and to control deficits by slashing wages and imposing other deflationary measures will push down house prices and the ability of local borrowers to service their debts, a process that is already alarmingly visible in Ireland. The ultimate result is that the European economy will be caught in a 1930s-style deflationary spiral of deteriorating credit, deflationary government policies, falling wages and even further declines in credit.
The most plausible way for Europe to escape from this vicious circle will be for Germany to abandon its age-old philosophy of fiscal rigour, to embark on a large-scale fiscal stimulus and to guarantee the debts of all its partners in the eurozone. The present assumption in the financial markets is that, if conditions in Europe continue to deteriorate, the German Government will do exactly this.
To offer unlimited pan-European bailouts and guarantees, regardless of potential costs to German taxpayers, might, indeed, be a rational policy for Germany to pursue in its own interests, given the scale of the economic and financial threat. But then the rational policy of the US Government last September was to prevent the collapse of Lehman, regardless of the potential cost to taxpayers. But then governments do not always act rationally — especially in a financial crisis that has to be resolved over a weekend. That, surely, is a lesson we should all have learnt from the past 12 months.

Copyright 2009 Times Newspapers Ltd.