Coming out of the pandemic crisis will be a difficult political and economic balancing act for the Eurozone. And Germany stands to topple, says Dirk Ehnts.

The Eurozone is a monetary union with 19 members. The institutions of its biggest member, Germany, make it into an exporting juggernaut which has led to more industrial (high-paid) jobs in Germany and fewer elsewhere. As a result the Eurozone has come under strain since the beginning of the pandemic.

“The obvious solution is to increase government spending. There is just no other source of demand left.”

German households and firms are net savers at a combined 7-8% of Gross Domestic Product (GDP). This goes hand-in-hand with trade account surpluses of the same size, as its government aims for a balanced budget. This means that the German economy depends heavily on foreigners buying German exports. Hence other Eurozone countries have to deal with losing a part of their demand from driving their economy to paying for German exports on a permanent basis. Imbalances in the trade account are then a feature, and not a bug, of the Eurozone.

Spending to support future growth can only come from three sources: the private sector (households and firms), the public sector (government) or the rest of the world (through exports). Increasing exports is not a realistic option since the European Central Bank (ECB) does not set the exchange rate of the Euro. Firms and households are hardly likely to react to unemployment and slower wage growth in a post-pandemic recession by spending more. So, the obvious solution is to increase government spending. There is just no other source of demand left.

While larger discretionary increases in government spending are usually not permitted, in mid-March 2020 the European institutions removed all the roadblocks. First, the ECB introduced its Pandemic Emergency Purchase Programme (PEPP) effectively ending financial markets’ grip on the public finances of national governments in the Eurozone. By offering to buy up basically all sovereign bonds for the time of the crisis, it removed any problems national governments might have in selling their bonds to finance expenditure.

“Given its dependence on exports, it is clearly in Germany’s own interest that the Eurozone’s economy does not collapse during the Corvid-19 crisis.”

Then, the European Commission stated that the general escape clause would be activated, thus freeing national governments from the fear of being persecuted for running “excessive” deficits. Given its dependence on exports, it is clearly in Germany’s own interest that the Eurozone’s economy does not collapse during the Corvid-19 crisis. But other Eurozone countries have to continue to deal with demand being lost to Germany. They do that either by replacing the lost demand through a corresponding increase in government spending, or refusing to grant Germany access to their markets, as French president Macron recently threatened. So the Eurozone might be transformed substantially – or falter completely. What then are the options for the Eurozone’s governments? The past is unlikely to provide the answers.

During the crisis in 2008/09, German policy makers propped up domestic demand by short-term work schemes whereby companies kept workers on the payroll instead of firing them. When the financial wobbles were over, this helped the German economy to return to normal with an increase in the rate of unemployment that was less than 1%. The ECB’s zero interest rate policy reduced the exchange rate of the Euro and helped German exporters.

“The Eurozone might be transformed substantially – or falter completely.”

The German government then increased federal government spending in the 2010s. It went from €490bn in 2009 to about €700bn in 2019. This was possible because investors saw German government bonds as a safe haven. Demand was high and interest rates were low. This was a direct result of the capital flight that took place during the crisis, as perceived risks of default on other Eurozone countries’ government bonds increased.

Other countries were not able to increase government spending in the same way since they didn’t have the same capacity to repay. Back then, the ECB did not help out by buying government bonds and Greece showed that a Eurozone government can indeed run out of money.

The current situation is totally different.

This time, Eurozone member states have been given unlimited fiscal firepower. As a result, in late April, the Italian parliament decided to increase government spending by €55bn. Since then, Italian government bond prices have gone up and their yields down (which is good). The ECB’s PEPP, which was expanded in early June, is clearly working as investors perceive Italian government bonds as risk-free assets.

On the European level, a €1.5 trillion recovery fund is in the making. Nevertheless, it seems that the European Union, which has no control over national health care systems, will not be the solution to the Eurozone’s woes. Italy, for example, is to receive only €81.8 billion. And the recovery fund is unlikely to be operative before the autumn and some compromises will certainly be added to it. It will not be enough to get Italy out of its depression. So, every country is supposed to spend itself out of the crisis solely by increasing government spending.

“The current situation is totally different.”

For the German economy, it is crucial now that the other Eurozone countries use fiscal policy to increase demand and, therefore, production so that German exports can be restarted. The situation is almost comical. The country that imposed austerity on the rest of the Eurozone and declared that public spending, public deficits and public debt are bad, is now forced to rely on its trade partners to adopt those same “bad” practices.

In contrast to 2008/09, the European Commission and ECB have now come out in support of the non-German members of the Eurozone. If their national governments fail to increase government spending, short-term work schemes in Germany will end at some point and unemployment will explode.

This situation makes the German government uncomfortable. It has built prudent budget surpluses over multiple years, claiming that it would add “fiscal space” for times of crisis. Now, it is obvious that its plan was flawed. The ECB, via its PEPP, guarantees that all national governments of the Eurozone are solvent, regardless of the respective level of public debt.

“The governments of France, Spain and Italy are now pushing for reform of the

Eurozone to reduce their dependence on German policy-makers.”

The governments of France, Spain and Italy are now pushing for reform of the Eurozone to reduce their dependence on German policy-makers who seem not to understand basic economics. They would like to see a step towards a fiscal institution that makes sure that pan-European government spending is adequate to provide full employment.

The European Union and Eurozone face an economic maelstrom that might be even bigger than the Great Depression of the 1930s. Having overcome neoliberal dogma, the German government now seems to accept a Keynesian policy response with higher deficits and higher public debt. This is the only thing that could keep the Eurozone together as a project.

It remains to be seen whether other countries will follow Germany’s path of expansionary fiscal policy. Their fear is that the ECB’s support will be dismantled at some point, leaving them no choice but to borrow from the European Stability Mechanism (ESM) and accept austerity once again.

There is a great irony here. The problems arising from Germany’s dependence on exports for its economic growth arose from the Eurozone’s application of neoclassical dogma – that lower wages would create more private sector employment. Yet this has led the continent back towards Keynesian dogma – that more spending leads to more employment and income – and a bigger role for the state.

Dirk Ehnts

Dirk is an economist based in Berlin. He is the speaker of the board of the Pufendorf Society for Political Economy and author of Modern Monetary Theory and European Macroeconomics.

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