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German Economy Bounces Back

A strong rebound in the German economy is giving Berlin new clout to demand fiscal restraint in Europe and resist U.S. calls for more stimulus.

In the depths of the Great Recession, economists and policymakers in the U.S. and Europe actively debated the shape of the expected recovery. Some forecast a “U”-shaped cycle, with a long period of subdued economic activity before a recovery could take hold. Others warned of a dreaded “W,” with an initial upturn quickly fizzling into a double-dip recession before a lasting recovery would get under way. Few were optimistic enough to bet on a classic “V” — a hard downturn followed by a robust recovery. Except, that is, policymakers in Germany.

In Berlin, Chancellor Angela Merkel huddled with her ministers and advisers and concluded that the violent downturn that followed the collapse of Lehman Brothers Holdings in late 2008 would give way to a conventional, vigorous recovery. They bet that strong demand from emerging markets in Asia, Eastern Europe and Latin America would pull German industry out of recession before long. The government could limit itself to short-term stimulus measures; all policymakers had to do was build a bridge to get from one side of the “V” to the other without “falling into the abyss halfway,” as one senior government official put it.

Today, Merkel and her team are feeling no small amount of vindication. While many of its European Union partners are worrying about the fallout from the region’s debt crisis and U.S. officials grow concerned about the risk of a renewed recession, Germany’s economy has come roaring back to life. Output grew by 2.2 percent between the first and second quarters of this year, a 9 percent annualized rate that makes traditionally stodgy Germany look like an emerging economy itself.

Even more important, by convincing Berlin’s policymakers that their diagnosis of the crisis was correct, the country’s strong rebound has emboldened the Merkel government to push its forward-looking policy prescriptions with renewed force, even at the risk of growing friction with Brussels and Washington. Merkel and her Finance minister, Wolfgang Schäuble, contend that governments should now focus on reducing the massive deficits built up during the crisis and putting their finances on a sustainable footing for the long term. To that end, Germany is pressing for the 16-nation euro zone to adopt tough new rules limiting budget deficits and national debts, backed by quasi-automatic sanctions for violators. The proposed rules aim to ensure that the €110 billion ($147 billion) bailout for Greece, which Germany supported earlier this year despite intense political opposition at home, is never repeated. Berlin has also used its weight to push the Group of 20 to emphasize the need for budgetary consolidation, and in the process has rebuffed calls from the U.S. and France for Germany to do more to stimulate its economy.

“The fears that I heard expressed just a few months ago — that we would damage the European or even the global economy with our moderate budget consolidation — have been disproved by the actual numbers,” Schäuble tells Institutional Investor in an interview at his office in Berlin. “Few people ask me anymore if it is possible to reduce the deficit and still create the conditions to promote economic growth. We are proving that it can be done.”

Germany didn’t exactly eschew stimulus, although it did act later than the U.S. and several other countries. It spent some 3.4 percent of GDP on measures designed to boost demand in 2009 and 2010, compared with stimulus spending of 4.8 percent of GDP by the U.S. government between 2008 and 2010, according to the International Monetary Fund. The German government budget, which was balanced in 2008 according to EU definitions, deteriorated to show a deficit of 3.3 percent of GDP in 2009 and is projected to hit 4.5 percent, or €60 billion, this year — above the 3 percent rule for euro zone countries but well below the estimated levels of 8 to 12 percent for Greece, Ireland and Spain.

With the economy recovering, Merkel and Schäuble are determined to begin pruning the budget. They plan to start next year by slashing €8 billion from the defense budget and cutting civil servants’ pay by 2.5 percent. In future years they intend to generate an additional €38.4 billion in tax revenues through faster growth and new levies on items such as airline tickets and nuclear fuel rods. The cutbacks aim to bring the deficit within the Maastricht Treaty’s 3 percent ceiling by 2012 and to virtually eliminate it by 2016, the target date under a recent balanced-budget constitutional amendment.

Germany’s stunning economic turnaround this year is no accident. For decades the country has been building an export-driven economy that has kept manufacturing jobs at home while countries like the U.S. outsourced millions of theirs.

After World War II the former West Germany built up an industrial capacity larger than the needs of its domestic economy, believing that exports of German goods would create jobs at home. By 1960, West Germany’s share of global trade was about 8.8 percent, while the U.S.’s share had slipped to 16 percent from 20 percent in 1949, according to data from the World Trade Organization. By 1990 the newly unified Germany had overtaken the U.S. as the world’s leading exporting nation. Manufacturing exports accounted for 22.4 percent of total economic output in 1991.

The country then faced several economic shocks. A postunification boom quickly turned to bust as overbuilding and inflation led to higher interest rates and recession. The government deficit grew to pay for welfare spending and modernization in the former East Germany. Currency crises within Europe drove the Deutsche mark higher, undermining competitiveness at home even as they fueled political support within Europe for a single currency to contain German might. By 1999, when Europe introduced the euro, many economists wondered whether Germany had condemned itself to decline by locking itself into an uncompetitively high cost base under the single currency. The country would soon become known as “the sick man of Europe,” with growth averaging just over 0.5 percent a year between 2001 and 2005.

Far from knuckling under, however, German companies and workers rolled up their sleeves and redoubled their efforts, just as their predecessors had during the Wirtschaftswunder that saw the country rebuild after the war. Thanks to wage restraint and strong investment, Germany did more than any of its major trading partners to improve its competitiveness over the past decade. In real terms, average unit labor costs fell by 0.5 percent from 2000 to 2008, according to the Organization for Economic Co-operation and Development. Meanwhile, German companies, ranging from global giants like electrical engineering conglomerate Siemens and luxury automaker Daimler to the host of smaller, specialized companies that make up the vaunted Mittelstand, increasingly targeted global markets in their search for growth. The results are striking. Manufacturing exports totaled $1.4 trillion in 2008, or nearly 40 percent of GDP. The current-account balance, which was in deficit as recently as 2000, surged to a peak of 7.6 percent of GDP in 2007, nearly double the level of Japan’s and exceeded only by China’s 11 percent surplus that year.

Germany’s export orientation has brought about another change. In addition to improving their competitiveness, German companies have positioned themselves as key suppliers of products and services to emerging markets in Eastern Europe, Asia and Latin America. Although the U.S. recession was mainly a structural crisis caused by debt deleveraging, in Germany the downturn was largely cyclical. Orders to German factories plunged 14.2 percent last year as the global recession caused demand to plummet; GDP contracted by 4.9 percent, more than double the 2.4 percent drop in U.S. output. The economy has come charging back, however, as emerging markets have picked up again. Germany was able to bridge the recession with measures such as subsidies for companies keeping excess staff on their payrolls on shortened hours and a cash-for-clunkers program that spurred new-car purchases. The short-time work program, which supported 1.5 million workers at its peak, prevented unemployment from surging — it currently stands at 7.6 percent of the workforce, compared with 9.6 percent in the U.S. — and enabled German companies to ramp up production quickly when world trade began rebounding last year.

“German exports to Asia are now twice as high as to the U.S.,” says Thomas Mayer, chief economist at Deutsche Bank. “The shift to emerging markets is the biggest trend in the German economy. But it also means that Germany is dependent on world trade.”

Critics warn that the lopsided structure of the German economy, with its reliance on exports, bears considerable risks. There is a danger that Berlin’s deficit-cutting plans will curtail growth and forestall a rebound in domestic consumption — presenting a risk not only to Germany but to other European economies. DIW, a Berlin-based economics institute, has thrown its weight behind union demands for significant wage increases in upcoming negotiations as a way of boosting domestic consumption.

“Unless Germany does more to stimulate demand, there is a danger of seeing the kind of deflation in the euro zone that existed in Japan,” Peter Bofinger, an economist and member of the government’s independent panel of economic advisers, told reporters in August. He added that Germany was profiting from the stimulus programs of other countries. “Germany is not at all the locomotive. In fact, it is being pulled along by others. The current recovery is proof that Keynesian policies work,” Bofinger said.

Joseph Stiglitz, former chief economist at the World Bank and a leading advocate of more stimulus, has warned that Germany’s budget cutting could have dire effects on the rest of Europe. As the focus of market concern switched from Greece to countries like Spain and Ireland (which some economists warn could be the next bailout candidate), Stiglitz argued that austerity measures across Europe would depress growth and make it harder for countries to get their debts under control. “Obviously, Ireland by itself is too small to determine what happens to Europe as a whole,” Stiglitz said in a recent French radio interview. “But if Germany, the U.K. and other major countries follow this excessive austerity approach, Ireland will suffer.”

The German government has turned a deaf ear to calls for renewed stimulus, though. Senior officials in Berlin make it clear that they are determined to fulfill the demands of a constitutional amendment adopted last year that requires the government to reduce its structural deficit — the part that doesn’t reflect swings in the business cycle — to no more than 0.35 percent of GDP by 2016 from a projected 3.6 percent this year. The measure also requires German states, or Länder, to balance their budgets.

Economists like Bofinger and Stiglitz say the “debt brake,” as the measure is called, ties the hands of politicians. But one senior German official in Berlin contends that the country’s strong recovery demolishes the arguments of the stimulus camp. “We’ve cut taxes, we’ve created stimulus, and our economy is growing,” says the official, who spoke on condition of anonymity. “The constitution requires us to balance the budget. Should we change the constitution?” The official says that despite all the sound and fury in Washington and Paris, most conversations that start out with allies attempting to bully Berlin into doing more to foster demand usually end up with everyone agreeing that Germany is pulling its weight.

Germany’s response to the Great Recession has also had a major impact on its handling of the euro crisis. The fact that the economy has resumed growing so strongly reinforces the belief among Berlin officials that economic problems in the EU can only be solved if other member states emulate the German model.

“We were right,” says one senior official. “It is unfair of weaker countries to demand that we should move slower so that the others can run faster. We are very happy in Europe, but are concerned that Europe is becoming a transfer union. That is something which we don’t want to happen.”

Such comments reflect changing German attitudes about Europe. In the 1990s, Helmut Kohl was able to win elections as the chancellor who was anchoring Germany within a broader European Union. Merkel, however, has little to gain from playing the Europe card. Most Germans today were born long after World War II and do not feel the same attachment to the EU as a guarantor of peace and stability that Kohl’s generation does. The recent debt crisis has further undermined support for the EU. Germans were promised when the euro was created that there would be no government bailouts in the single-currency area and that the European Central Bank would be every bit as rigorous as the Bundesbank in defending the currency. Many see the recent bailout of Greece and the ECB’s decision to buy bonds of heavily indebted governments as betrayals.

“Germans are disillusioned with Europe,” says Gerd Langguth, a political scientist at the University of Bonn who has written a biography of Merkel. “Many no longer see the euro as a stable currency, and Merkel’s declining support in the polls has a lot to do with public attitudes toward Europe.”

To some extent, German frustration with Brussels and the EU is similar to the popular American pastime of blaming all one’s troubles on Washington. But there is a difference: The EU member states are sovereign nations. Kohl’s generation was willing to sacrifice a degree of independence to keep Germany restrained in the EU straitjacket, but younger parliamentarians today are more likely to want to limit the reach of Brussels bureaucrats. Björn Sänger, a 35-year-old member of Parliament and a finance expert for the Free Democratic Party, is a good example of the change in attitude toward Europe among younger politicians. Like many of his peers, he takes it for granted that Germany is rooted firmly in Europe, and he does not want that to change. But Sänger complains that German tax money and European rules are being used to help foreign companies set up shop in neighboring countries to compete with German businesses at the expense of German jobs. Facing complaints from mayors in his constituency in the central German state of Hesse, Sänger, a member of Parliament’s influential Financial Affairs Committee, has taken to telling local politicians to ignore directives from Brussels that “don’t make sense” and just cost local governments money. “There is no reason that we have to implement every nonsense that comes out of Brussels,” he says. “What are they going to do, send in troops?”

The German public was never keen to give up the strong Deutsche mark for the euro. In the wake of the Greek crisis, some former euro advocates are calling for Germany to revert to its old currency. Hans-Olaf Henkel, a former IBM Corp. executive and onetime president of the Federation of German Industries, is currently writing a book with the working title Let’s Reestablish the D-Mark.

Henkel tells Institutional Investor how in the 1990s he had to fight within Germany’s huge, influential industry association to convince members that the euro would be good for business. His main argument was that the Stability and Growth Pact — the EU rules limiting government deficits — was watertight and very German. Today he complains that the Greek rescue violated the euro area’s no-bailout rule. “We have moved from a monetary union to a transfer union” in which stronger euro zone members subsidize weaker members, he says. “That’s exactly what we didn’t want.” Henkel argues that the costs of rescuing Greece and the potential costs of future bailouts could easily wipe out any advantages of a common currency. Germany, he says, would be better off going back to the days of exchange rate competition within Europe than having to repeatedly foot the bill to bail out other euro zone countries. “The constant valuation of the D-mark caused German industry to be better and more productive than the competition,” he says. “Introduction of the euro took the pressure off.”

Schäuble is old-school when it comes to Europe, a committed integrationist like Kohl. A trained lawyer who joined the conservative Christian Democratic Union party in 1965 and was first elected to Parliament in 1972, Schäuble rose up the party’s ranks as Kohl’s protégé. As Interior minister, he negotiated the 1990 treaty that unified East and West Germany. Later that year he was shot by a deranged man at a campaign event and left paralyzed. Subsequent complications have affected his health. He was hospitalized in Brussels for several weeks at the height of the EU debt crisis in May after having a bad reaction to medication in the midst of an EU ministerial meeting. He returned to the hospital again late last month because of inflammation from a surgical implant he received in February.

Although his EU convictions are strong, Schäuble knows that in the mind of the German public, the European project is at a crossroads. Like Kohl, he believes that the Maastricht Treaty, which established monetary union, is incomplete without a corresponding political union. But Kohl was unable to convince his French counterpart, François Mitterrand, of the need for greater political unity. To fill the gap, EU leaders came up with the Stability and Growth Pact, which former Finance minister Theo Waigel devised to enforce budgetary restraint among euro-area members. As Germans see it, the euro and the ECB were supposed to transfer Germany’s financial culture to the rest of Europe. But the pact turned out to lack teeth. Merkel’s predecessor Gerhard Schröder and former French president Jacques Chirac effectively discarded the pact earlier this decade when their deficits exceeded the ceiling of 3 percent of GDP. By weakening discipline, many observers contend, Germany and France set the stage for others, like Greece, to follow suit. “Schäuble now sees it as his mission to complete what Waigel left unfinished. He wants to complete the Stability and Growth Pact,” says political scientist Langguth.

The point that Schäuble repeatedly makes is that European politics cannot function without the support of the citizens in the member states. There has never been a German popular majority in favor of the euro. Opponents call it the teuro — a play on the German word teuer, which means “expensive” — because of the widespread impression that the conversion of deutsche marks to euros was used secretly to inflate prices. If the German public was growing weary of the European project, the euro crisis seemed to confirm its worst fears, that politicians had traded the beloved deutsche mark for a political football of a currency. German popular frustration turned to anger, and for the first time, Merkel’s otherwise stellar approval ratings, the best of any German chancellor, fell below 50 percent.

As Schäuble engages in negotiations with his European counterparts, he is intent on not just reestablishing the status quo but on creating a new, tougher regime for members of the euro zone. Germany has believed from the beginning of the crisis that Greece’s problems are not the result of a liquidity crisis but of real structural issues that need to be resolved. Germans know better than anyone what must be done. In the 20 years since unification, German politicians have been forcing citizens to accept belt-tightening and structural change that has led to less security than Germans were used to.

“It took Germany the biblical seven lean years to work its problems out,” says Deutsche Bank’s Mayer. “Now the others have to go through the lean years.”

In April and May, when Greece was close to meltdown and Merkel seemed undecided as to whether Germany would participate in a rescue, it appeared that Germany was still uncertain about its role in Europe, unwilling to take on the responsibility of leadership that its sheer size and the power of its economy have bestowed upon its leaders. Tommaso Padoa-Schioppa, the former Italian board member of the ECB, was quoted in German business daily Handelsblatt imploring Germany to accept its responsibility. “German leadership of Europe is a fact,” he said. “Ignoring this would be the wrong way for Berlin to exercise its leadership.”

German officials are uncomfortable speaking about their role in such terms. In conversations in the chancellery and in government ministries, however, officials say Merkel saw opportunity in the crisis. The debt problem gave Europe a chance to apply pressure on Greece and make clear to any other euro member what the consequences of lax fiscal discipline will be. “We wanted to make sure that Greece’s commitments to reduce its deficits, which were the cause of the crisis, were so serious that they would be adequate to relieve the problem,” says Schäuble. “Otherwise, every act of solidarity would just extend the problem but not resolve it. It was about ensuring Greece had to meet strict commitments, and Chancellor Merkel succeeded very well.”

Germany has always been destined to be not just another European country. Too large to become isolationist and too small to dominate the Continent — as history has repeatedly, tragically proved — Germany remains a reluctant leader. Yet from outside, Berlin is clearly seen as the place with that famous phone number that Henry Kissinger once wanted to contact Europe. It was Merkel whom U.S. President Barack Obama repeatedly called back in early May to make sure that Europe would come to Greece’s aid and prevent another meltdown in global financial markets.

A newly confident Germany is determined to flex its muscles in other areas as well. The government is pushing within the G-20 for a global tax on financial transactions, to reduce market speculation. Berlin is also campaigning to obtain a seat on an expanded United Nations Security Council. Government officials note that Germany is one of the biggest contributors to the U.N. budget and has troops stationed in Afghanistan, Kosovo and the Horn of Africa to support international security missions. “We in Germany have a massive interest that we are not only seen as a strong economic nation in the world, but rather that we naturally also exert our influence in questions from climate protection to disarmament,” Foreign Minister Guido Westerwelle said in an interview on German radio in September.

During the euro crisis it briefly seemed that Germany had forgotten its pivotal role in Europe. Schäuble says opting out is not a possibility for Germany, but he insists that the country will stick to its principles as it bears its European responsibilities. German leaders sold economic and monetary union to the German public in the belief that they were getting a larger deutsche mark and that Europe had finally come around to accept Germany’s hard-currency culture. Now Berlin is discovering that the euro zone is not quite the monetary union it had envisioned. Over the next few months, as the debate over strengthening the Stability and Growth Pact continues, Berlin will have to walk a fine line between defending the euro and appeasing public opinion at home. Schäuble knows that he has to find a compromise between the German monetary culture and those European leaders who want to assert political influence over the single currency. Europe’s challenge remains trying to bring together diverse financial cultures. And although Schäuble insists that Germany has no desire to dominate Europe, to keep German citizens happy he must achieve a result that puts their country’s stamp even more firmly on the European project than before.

“We aren’t the teacher or headmaster for the other European states. But we are fulfilling our responsibilities,” he says. “And we understand that it is also our responsibility to help Europe make the right decisions. But we have to win over others to do so.”

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