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The recent turn toward fiscal austerity in Europe in the wake of the Greek crisis has raised serious concerns that it will threaten economic growth and revive global trade imbalances. While fiscal consolidation is unavoidable for the high-deficit, high-debt countries, the cuts made by Germany, whose government deficit is comparatively moderate, have attracted particular criticism. Conflict over macroeconomic policy is a recurring feature of international monetary relations, but the present episode is particularly illuminating. It highlights a little-noticed but fundamental consequence of the creation of the euro in 1999—loss of the ability on the part of the United States to press the European country with the largest current account surplus, Germany, to adopt expansionary policies.1
The basic case for coordinating macroeconomic policy, fiscal policy in particular, stems from the externalities, or "spillover effects," in the presence of globalized markets for goods and capital. An increase in the budget deficit can stimulate a nation's economy in a recession, such as the recent one. However, much of that stimulus leaks abroad to the benefit of others, while the cost of servicing the extra debt remains the responsibility of the initiator. To prevent governments from delaying or under-providing stimulus, in the expectation that others will act, the G-20 endorsed coordination at the Washington summit in November 2008 and London summit in April 2009.
A similar dilemma of collective action (or "free rider problem") applies on the upside, once the recovery begins: The pain of withdrawal of the stimulus in one country is ameliorated by shifts in trade and capital account balances, spreading part of the sacrifice abroad. This gives each country an incentive to withdraw earlier than its neighbors. Because growth for the group as a whole weakens with the number of countries consolidating, the first mover consolidates with considerably greater ease than the last. This dilemma or problem confronts us now and is recognized by the G-20 ministers' recent prescription, when interpreted carefully, that fiscal consolidation be administered selectively with the most vulnerable countries proceeding before the less vulnerable.2 The current problem, according to the critics of Chancellor Merkel's government, is that Germany, in consolidating now, has jumped in front of other countries that are more deserving of an early exit from stimulus.3
The United States and European countries have, on average, a significant conflict over macroeconomic policy about once a decade. The current conflict may thus be overdue. The recent recession and present recovery is the first major test of transatlantic cooperation since the euro was created in 1999. This time, the argument plays out against an international monetary system whose structure changed fundamentally as a consequence of Economic and Monetary Union (EMU). To understand exactly how, consider the pre-euro history.
During the late 1970s, the United States pressed Germany for a fiscal stimulus, which Germany administered as part of a multi-issue bargain involving the other members of the G-7 at the Bonn summit of 1978. During the mid-1980s, the Reagan administration pressed the government of Chancellor Helmut Kohl for a similar stimulus, which was provided as part of the Plaza-Louvre process. (During the early 1990s, the principal dispute was over monetary policy, with the Bush administration pressing the German Bundesbank to limit interest rate increases in the wake of German unification.) Let us set aside arguments over the economic merits of these debates to concentrate on the effect that European monetary integration has had on the dynamics of transatlantic conflict.
During the 1970s and the 1980s, a time of recurring US current account deficits and German surpluses, the mark would rise against the dollar when the gap became substantial and transatlantic arguments became vociferous. The appreciation of the mark greatly reinforced the moral suasion and political pressure applied by US policymakers. By making German exports more expensive, the mark's rise threatened German trade competitiveness and reduced German inflation, strengthening arguments within the country for fiscal stimulus—a source of leverage for US officials that I have called the "exchange rate weapon."4
When German Chancellor Helmut Schmidt and French President Valéry Giscard d'Estaing launched the European Monetary System in 1979, Chancellor Schmidt was reacting to the "locomotive theory," the idea that surplus countries should help to pull the rest of the world out of recession, and the Bonn summit. Schmidt was explicit about the benefits of creating an island of monetary stability in a global sea of flexible exchange rates: the benefits included spreading the effects of currency appreciation over a larger monetary area and shielding Germany from political pressure from the United States for policy change.
The formation of the euro area—the culmination of the launch of the European Monetary System (EMS)—fundamentally changed the terrain over which these battles are fought. Rather than facing the United States and the rest of the world alone, Germany is now embedded in the euro area and shares the currency with partners that run current account deficits. As a result, though Germany's surplus is very large—second in absolute magnitude only to China's—the euro area's current account has been very nearly balanced.
As Greece encountered its crisis and other Southern European countries were threatened with contagion from Greece, furthermore, the euro weakened dramatically against the dollar. Although Germany is losing exports to Southern Europe it will, on balance, benefit greatly from rising exports to the rest of the world, expanding a surplus that is already 5.5 percent of GDP. Rather than providing fiscal stimulus to offset appreciation, as Germany did in previous conflicts, the Merkel government is consolidating the fiscal balance in the knowledge that growth will be supported by euro depreciation. Chancellor Schmidt's strategy has been a resounding success!
Given the fragile state of the economic recovery, however, this "success" is problematic for the rest of the world. To be fair, German fiscal policy has boosted growth by about 1-3/4 percent during 2010, without which the country would still be in recession. But Germany is scheduled to reduce these deficits from 5.7 percent of GDP to 5.0 percent in 2011, 4.0 percent in 2012, and 3.0 percent in 2013. The present deficit compares to 6.8 percent for the euro area, 9.5 percent for the G-7, and 6.8 percent for the G-20, which includes many low-deficit emerging markets.5 Given the need for sequential rather than simultaneous exit from the stimulus, Germany's below-average ranking on these measures should place it toward the end of the line rather than with Greece, Spain, and Portugal. Successful resolution of Greece's debt problems hinges substantially on sustaining growth in Europe. Sequential consolidation would also contribute to global current account rebalancing, whereas simultaneous consolidation threatens to undermine it.6
The introduction of the euro has thus created a shield for Germany that protects it from external pressure without providing a replacement for the coercive mechanism—however asymmetrical, variable and controversial it might have been—that facilitated fiscal coordination in the past. The members of the G-20 are engaged in macroeconomic coordination through the "Framework for Strong, Sustainable, and Balanced Growth," facilitated by the IMF and other international bodies. This Framework differentiates the responsibilities of countries running external surpluses, to "strengthen domestic sources of growth," from those running deficits, raising domestic savings, and reducing fiscal deficits.7 President Obama recently reminded his fellow leaders of the policy assignments to which they have agreed.8 Whether the G-20 process leads to meaningful coordination at the Toronto summit during June 26–27 remains to be seen. But the neutralization of exchange rate pressure with respect to Germany augurs poorly for Berlin's contribution.
We can take three conclusions from this analysis. First, the euro area provides Germany with an important strategic advantage in international monetary relations—an incentive to remain committed to the common currency despite misgivings about some European partners. Second, the rest of the world has a vital interest in exactly how the debate over economic governance within the euro area is resolved—that is, whether the euro area propagates deflation or growth. Third, if macroeconomic policy coordination is to succeed, it will probably need stronger mechanisms than the present G-20 process to replace the external pressure on surplus European countries that was lost with EMU.9
Notes
1. See also Henning, C. Randall. 2009. Exchange Rate Policy Arrangements and Experiences: Comparing the US and the Euro Area. Presentation to the European Commission conference, Brussels, April 6.
2. G-20. 2010. Communiqué of the Finance Ministers and Central Bank Governors (June 5). Busan, Korea, paragraph 2.
3. Wolf, Martin. Fear of the Markets Must Not Blind Us to Deflation's Dangers. Financial Times (June 9) and Why Plans for Early Fiscal Tightening Carry Global Risks. Financial Times (June 16).
4. Henning, C. Randall. 2006. The Exchange Rate Weapon and Macroeconomic Conflict. In International Monetary Power, ed. David M. Andrews. Ithaca: Cornell University Press: 117–138.
5. The figures are projections for 2010. IMF. 2010. World Economic Outlook (April). Table A8: 169 and IMF. 2010. Fiscal Monitor (May 14) Table 1: 80.
6. Bergsten, C. Fred. 2010. New Imbalances Will Threaten Global Recovery. Financial Times (June 10).
7. G-20 Leaders Statement, Pittsburgh, September 24-25, 2009, p. 22, paragraph 2.
8. Obama, Barack. 2010. Letter to G-20 Colleagues, Washington (June 16).
9. On surplus countries outside of EMU, see Williamson, John. 2010 (forthcoming). Encouraging Adjustment by Surplus Countries. Washington: Peterson Institute for International Economics.