U.S. Markets close in 4 hrs 22 mins

Germany’s 5 Awkward Economic Truths

Yahoo! Finance
The Exchange

By Desmond Lachman

An unfortunate characteristic of modern day electoral campaigns is that they rarely provide the electorate with a frank discussion of the major policy issues. Sadly, this could not be truer of the German campaign now in full swing ahead of the general election scheduled there for September 22. For rather than leveling with the German people about the country’s very difficult policy choices with respect to the ongoing European economic crisis, Chancellor Angela Merkel chooses to underplay Europe’s economic and political difficulties. She also chooses disingenuously to insist that her European strategy is working and that it only needs perseverance before it bears fruit.

Mrs. Merkel’s electoral strategy will not provide her with the political mandate to do the difficult things that she will need to do after the election if the euro is to survive over the longer haul. However, her strategy makes perfect sense if her goal is simply to get re-elected. For if she were to be honest with the German people, she would be obliged to tell it the following five unpleasant truths that the electorate might prefer not to hear.

Budget austerity is not working

While the strategy of budget austerity and deep structural reforms might have worked well for Germany following unification, it is simply not working in the European periphery. Indeed, in the context of domestic credit crunches and a weak external economic environment, applying budget austerity within a euro straitjacket is producing deep economic recessions, intolerably high unemployment, and a great degree of political stress across the European economic periphery.

The overall European economy has now been in recession for almost two years, while output in major European countries like Italy and Spain is now some eight percent below its 2008 peak. At the same time, there appears to be little prospect for meaningful economic growth in the European periphery any time soon if we continue to apply the same policy mix of budget austerity and economic reform that contributed so importantly to the recession in the first instance.

A disturbing outcome of our insistence on severe budget austerity across the European periphery is that it is failing to repair their public finances due to the deep economic recessions that austerity has produced. Indeed, despite a major debt restructuring, Greece’s public debt now stands at 160 percent of GDP while the public debt levels in Italy, Ireland, and Portugal have all risen to around 130 percent of GDP. After the election, we will have little option but to ease up further on the austerity policies that we have been imposing on our European partners to date and we will all too likely have to entertain the idea of public debt restructuring in those countries.

Germany is financing a bottomless pit

When over the past two years Germany went along with the IMF bailouts for Cyprus, Greece, Ireland, and Portugal it did so in the hope that those countries would use the breathing space provided to mend their public finances with a view to re-accessing soon the global international capital markets. However, given the lack of budget progress that these countries have made and given the fragility of their ruling coalitions, it is all too clear that these countries will need yet another round of official bailout assistance. Worse still, there is every prospect that the larger countries like Italy and Spain will soon also need IMF-EU bailouts as they struggle to borrow money in the markets. If we want to keep the Euro together, we will have to get used to the idea of writing more bailout checks to Southern Europe.

A few sacred German economic cows must be sacrificed

Germany has long placed a premium on budget discipline and low inflation as guiding principles for its domestic economic policy. While these principles have served us well, it is questionable whether they are appropriate now at a time that our European partners are very much in need of buoyant external markets and improved competitiveness to get their depressed economies moving again. After the elections we will need to give serious thought to following more expansive policies in Germany in order to facilitate the process of economic adjustment that is so necessary for the rest of Europe and that is in our own interest. We might also need to tolerate a higher domestic inflation rate than that to which we are accustomed in an effort to make the rest of Europe more competitive.

A banking and fiscal union is unavoidable

Germany has long insisted that prior conditions must first be met before Europe moves towards a full-fledged banking and fiscal union if moral hazard is to be avoided. However, given the serious strains that are now all too apparent in the Euro area, we might have to soften our stance on these issues if we are to save the euro. For without the early prospect of banking and fiscal unions, markets are likely to increasingly question our commitment to keep Europe together.

The European Central Bank (ECB) must be given more support

When Germany gave up its Bundesbank in favor of establishing the ECB, it did so on the understanding that the ECB would continue with the Bundesbank’s hard money policy. However, circumstances have changed in the sense that a deepening European economic recession is now raising the specter of deflation at the same time that a strengthening Euro is harming our competitiveness. After the election, it might be appropriate for us to lend the ECB the political support it needs to pursue a very much more aggressive monetary policy along the lines of that being pursued by the United States and Japan.

One should not hold one’s breath to hear Mrs. Merkel engage in such truth telling before the election since she knows full well that such frankness would cost her that election. Sadly, this makes it all too likely that after the election Mrs. Merkel will continue along the same policy path for Europe as before. It also makes it all too likely that she will stumble from crisis to crisis as before with no clear vision as to how to extricate Europe from its present economic and political malaise.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.