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Forget Greece: Europe's real problem is Germany

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By Steven Pearlstein
Friday, May 21, 2010

Ground zero of Europe's debt-currency-banking crisis isn't in Greece, or Portugal, or Ireland or even Spain. It's in Germany.

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So says Martin Wolf, the estimable economics columnist of the Financial Times, who this week offered this wonderfully concise, if somewhat mischievous, description of how the vaunted German economic machine really works:

At one end is a powerful and highly efficient industrial export engine that generates a large trade surplus with the rest of the world, including most other countries in the eurozone. Instead of spending this new export wealth on a higher standard of living, however, parsimonious Germans prefer to save it, handing it over to thinly capitalized German banks that have proved equally efficient in destroying said wealth by investing it in risky securities issued, not coincidentally, by trading partners that need the capital to finance their trade deficits with Germany. To prevent the collapse of those banks, German taxpayers are dragooned into using what remains of their hard-earned savings either to bail out their hapless banks or their profligate trading partners.

We Americans, of course, know all about this rather perverse form of economic recycling. It describes what happened in the 1980s with Japan and more recently with China. And to a lesser degree, it describes our economic relationship with Germany, whose banks and insurance companies were big buyers of American subprime mortgage securities and commercial property. It's what inevitably happens when a large, productive country tries to run a "mercantilist" economic policy predicated on running large and persistent trade surpluses.

Normally, what should happen to such a country is that, as a result of its trade surplus, wages rise, along with the value of its currency, to reflect its new wealth and productivity. That has the effect of making those exports less competitive while encouraging workers to spend their increased income on cheaper imports. And in that way, the system brings imports and exports more into balance.

That rebalancing, however, hasn't happened in Germany. It hasn't happened because much of Germany's trade surplus is with other European countries with which it shares a common currency, so the currency can't adjust. It hasn't happened because Germans, by their nature, are eager to save and reluctant to spend their newfound wealth on imported goods and services. And it hasn't happened because the European Central Bank, driven largely by German economic rectitude and fear of inflation, has followed a tight monetary policy that has reduced growth and discouraged domestic consumption and investment.

But that's not how most Germans see things. They look at the current crisis and blame their spendthrift Mediterranean neighbors for using the cover of the euro to rack up public and private debts that they now cannot support. They blame hedge funds and other speculators for making a bad situation worse and profiting from other people's misery. And they are furious that they are being told by their leaders that they have no choice but to bail everyone out.

What Germans won't accept is that they wouldn't have been able to sell all those beautifully designed cars and well-engineered machine tools if Greeks and Spaniards and Americans hadn't been willing to buy those goods and German banks hadn't been so willing to lend them the money to do so. Nor will they accept that German industry was able to thrive over the past decade because of a common currency and a common monetary policy that, over time, rendered industry in some neighboring countries uncompetitive while generating huge real estate bubbles in others.

The danger of Germans misunderstanding the causes of the current crisis is that it leads them, and the rest of Europe, to the wrong solutions.

While European governments surely have long-term structural budget problems, the immediate fiscal challenge comes from the decline in tax revenues and the increase in transfer payments that result from slow growth and high unemployment. The right policy response to that -- along with the very real threat of price deflation in Europe -- isn't to put the entire continent in a fiscal straitjacket that makes the recession even worse. The immediate need is for the European Central Bank to deliver additional monetary stimulus in the form of lower interest rates and direct purchases of government bonds. The reality is that the price of avoiding a dangerous deflationary spiral in Greece and Spain is allowing inflation in Germany to rise to 3 or 4 percent.

It's also time to give up the fiction that Greece can avoid a default. It can't -- nor should taxpayer money be used to prevent banks and other private-sector bondholders from suffering losses on their unwise investments. If public money is used, it should be as a sweetener for a "voluntary" restructuring in which bondholders are invited to swap old bonds for new ones that have a lower face value but are insured against default by the European Union. The same tack could be used with the bonds of other countries facing insolvency.

Such a restructuring not only reduces the problem of moral hazard, but it also avoids forcing countries into the kind of grinding depression and deflation that, as with Greece, would inevitably result in a default. And if it turns out that losses from the restructuring threaten the solvency of some European banks, as is feared, then the E.U. could use proceeds from its new bank tax to inject fresh capital into failing banks in way that dilutes existing shareholders and gives taxpayers the chance to earn a profit if and when the banks recover. That strategy worked in the United States, and there's no reason it can't work in Europe.

In the long run, the eurozone won't be fixed until Germany figures out how to generate growth and wealth without beggaring its neighbors and its trading partners. As Finance Minister Wolfgang Schauble acknowledged this week in an interview with the Financial Times, Germany has become so prosperous "because it has more advantages from European integration than any other country." Unless Germans can find a way to share that prosperity, other countries may conclude that the price of membership to its club is just too high.


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