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European austerity was a failure but what comes next may be even worse

Even Angela Merkel now seems to agree that austerity has run its course. When Italy’s prime minister, Matteo Renzi, together with other European leaders, led a fresh charge against the ill-fated policy…

Renzi replaying the past. Angelo Carconi/EPA

Even Angela Merkel now seems to agree that austerity has run its course. When Italy’s prime minister, Matteo Renzi, together with other European leaders, led a fresh charge against the ill-fated policy after the European elections, Berlin caved in surprisingly quickly.

The details remain to be worked out but it seems certain that the conditions of the stability pact will be softened. Most likely a deal will be cut by which investment expenditure for structural reform will not count anymore towards the restrictions imposed by the agreement. This would give crisis countries substantial leeway to increase government spending and stimulate their economies.

Should critics of austerity feel vindicated? There can be no doubt that this represents an important policy change but it may be too early to celebrate. After bungling austerity, European leaders now seem poised to make a mess of its end.

Less than 24 hours after Merkel’s spokesman had made the German green light public, Renzi delivered a major policy speech outlining his vision for the upcoming Italian presidency of the EU. Most importantly, he asked for more financial flexibility and announced a series of structural reforms, including changes to labour market regulations. In the speech he explicitly cited Gerhard Schröder’s reforms as a model for Italy and others: “Germany has been able to face today’s crisis better and more successfully than any other country because of the extraordinary reforms initiated by Schröder.” This was not merely a gesture of courtesy to Berlin. Renzi’s plans resemble Schröder’s 2003 agenda in important respects.

Surplus requirements

The German chancellor had used a two-pronged approach. His government increased public spending and the resulting economic upswing gave him leeway to go ahead with structural reforms. New legislation deregulated parts of the labour market and put pressure on the unemployed by reducing benefits and introducing penalties for those refusing to accept jobs that were offered to them. The reforms allegedly helped to keep German industry competitive and made possible the substantial export surpluses that drive German growth.

Renzi and others believe that the way out of the crisis is for European countries to have their own “Schröder-moments”. However, quite apart from the simple mathematical fact that not all countries can run trade surplus at the same time, there are also important flaws in the underlying analysis of Germany’s economic experience. It is true that real wages slightly declined in Germany between 2000 and 2008 and that this was in part a result of Schröder’s reforms. However, the main reason for the growing gap in costs between Germany and other Euro countries were the increasing costs in the periphery – where economies were booming at the time. Declining wages in Germany played a minor role in this development.

Moreover, it remains questionable whether in the German case there exists a causal relationship between low labour costs and growing exports. Most of the recent growth of German exports comes from sales to emerging economies and not to European partners. This includes countries such as China that have extremely low labour costs. Together with the types of products exported by Germany this suggests that exports are not driven by low costs but by high quality. The secret of Germany’s economic success story are not frugal workers at home but growing demand for high-quality consumer and investment goods in emerging economies.

Debt and competitiveness

The version of Germany’s success story that Renzi is trying to emulate is largely a mirage. It is therefore unlikely that he will solve Italy’s economic woes. Still worse, similar plans are bound to aggravate two structural problems that threaten the survival of the Euro: the high levels of public debt in the crisis countries, and their lack of competitiveness compared with Germany and other advanced Euro countries.

Austerity was not successful in reducing debt levels in the crisis countries. But increasing deficit spending in Italy and other crisis countries will raise debt levels, making the aim of debt reduction even more elusive. Once again the confidence of financial markets and the ECB’s commitment to do “whatever it takes” to avoid financial meltdown will be tested. If the ECB fails to put its money where its mouth is, the Euro will collapse for financial reasons. If the central bank honours its commitment and bails out Italy or another crisis country after austerity rules have been relaxed, then the Euro may come to an end as a result of the political backlash in Germany and other parts of the eurozone.

The deregulation of the labour market, the second leg of Renzi’s reforms, is designed to close the gap in competitiveness with other Euro countries. This is urgently necessary because the imbalances in the balance of trade and hence in the current accounts of Euro countries are one of the main structural problems of the currency. However, it is doubtful that Renzi’s reforms can depress wages sufficiently to close the competitiveness gap. Even after Schröder’s large-scale reforms, real wages dropped only marginally – and it is far from certain that Renzi will be able to implement changes on a similar scale.

Spending review

What choices is Europe left with? Austerity failed but it seems that if crisis countries are given more rope they will only hang themselves. The answer to this dilemma may lie in geography. Austerity has to end where it began not where its consequences are felt most harshly. If public and private spending is increased in Germany and other booming Euro countries this would lead to increasing wages and higher costs there. This is a way to reduce differences in competitiveness without having to severely depress wages in the crisis countries. In addition, additional demand from the booming centre of Europe would provide the peripheral crisis countries with an outlet for exports and help to stimulate growth there without adding to the debt burden.

It is unlikely that Germany will decide to go on a spending spree just to help out its European neighbours. But there are several areas in which boosting expenditure would make sense also from a perspective of narrow national interests. German infrastructures are in dire need of an upgrade. A renovation of internet infrastructure is much debated and if the end of nuclear energy and the substitution with green energies is to become a reality, major investments in energy production and distribution facilities will be necessary.

Education is another area where Germany needs to spend more. Already now, schools and universities are falling behind. If Germany wants to remain a world leader in research and development it needs to invest to make sure school leavers and university graduates remain among the best in the world.

Finally, there is the large and growing sector of working poor in Germany. The introduction of a minimum wage was a step in the right direction but much more needs to be done to raise wages and hence consumption in these parts of population. Taken together, similar measure could help to kick-start the Eurozone economy and give stability to the Euro, while laying the foundations for Germany to go from strength to strength over the next decades.

What Europe needs is another round of reforms in Germany, not European leaders imitating German reformers of ten years ago. As Marx once pointed out historical figures tend to appear twice. First as tragedies then as farces. Certainly when Italians imitate Germans it tends to get particularly farcical. But this time may be different. The true tragedy may be still to come.

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