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Germany alone can save the European Union, but will it?

Friday, June 8, 2018

Germany alone can save the European Union, but will it?

Andrew Sheng, Distinguished Fellow of Asia Global Institute, says the political problems of debt-laden Italy may well destabilise the entire European project, because they are symptomatic of what really ails the euro-zone family – a refusal of the rich members, led by Germany, to accept that an individual debt is a family debt

Is Europe in an existential crisis? Yes, according to George Soros, who spoke at the European Council on Foreign Relations last week. Five days later, I heard him elaborate on this view at the Trento Festival of Economics in northern Italy. For an Italian city to celebrate economics as a science is remarkable at a time when the economics profession has lost considerable credibility and trust. This was more so when the Italians finally managed to form a government two months after the elections last March. 

The coalition government is an unholy alliance of the populist Eurosceptic Five Star Movement and the right-wing League party that seems to want to set a minimum wage, reduce immigration, cut taxes and boost subsidies all at the same time.

Why is the political fracas in Italy so threatening to the existence of the European Union and the euro zone?

First, Italy is the third-largest economy in Europe, pending the departure of Britainunder Brexit. Second, its debt stock, at roughly 160 per cent of gross domestic product, is the third-largest sovereign debt in the world and Italian banks do have high levels of non-performing loans. Third, even the International Monetary Fund admits that, a decade after the global financial crisis, Italian real per capita GDP is still below the level in 1999, when the euro was launched, 8 per cent lower than in 2007, and falling behind other euro-zone countries.

Italy is growing at 1.6 per cent a year, which is not good enough to address its growing debt, high unemployment and regional and generational inequalities. The electorate understandably rejected the establishment and voted in the populist parties.

Surveys suggest that a third of Italian voters are toying with the idea of exiting the euro zone, the second-highest proportion after Greece. But the Italians and Greeks understand that a divorce from the EU would plunge their country into a deeper debt crisis.

Italy’s problems stem from a combination of internal structural issues and its complex relations within the European family. The good news is Italy does not suffer the property-related credit booms and busts of Greece, Portugal, Spain and Ireland. The government may be in debt, but the people are actually quite wealthy, with a balanced net international investment position.

But its fragmented government (with each administration lasting only a year on average since 1946) has never addressed long-haul labour and productivity reforms, even as Germany and the northern European economies powered ahead.

The heart of Europe’s problem is that it is a family of separate nations with no unified fiscal policy. Nearly two decades after the formation of the euro monetary zone, the banking and capital markets are still fragmented, and Europe cannot agree to mutualise its member-country debts. In plain language, Germany, the largest and richest member of the family, refuses to accept that the individual debt of each member is a family debt.

Basically, it is a family that does not act as a family, with each member forced to cut debt, accept deflation and high unemployment in order to balance the family’s books.

The cumulative result since the 2007 crisis is that the GDP numbers of Europe as a whole look good, but the south is hurting. This is a family that is existentially rich, but unhappy, made worse by the threat of more immigrants from the war-torn Middle East and water-stressed North Africa.

Indeed, geopolitically, Europe has transformed itself from a roughly balanced current account trade zone to the largest trade surplus region in the world, running a €121 billion (US131.7 billion) trade surplus with the United States in 2017. Europe is now holding the largest part of the US trade deficits, replacing China and the oil-producing countries. Since exports make up 43 per cent of the EU’s GDP, Europe is very vulnerable to trade friction with the US and cannot escape collateral damage from growing US protectionism.

The standard Keynesian argument in such a situation is for the winner country (especially Germany) to reflate, spend more and increase aggregate demand so that the southern deficit countries will also reflate. But because the Angela Merkel government is fiscally cautious, this imposes a huge political strain within southern Europe.

The solution to this high-debt situation was first identified by John Maynard Keynes in 1919, when Germany, as the loser of the first world war, was crippled by the high cost of war reparation. This resulted in huge deflation, excessive debt and hyperinflation, which then led to the second world war.

Post-war Europe was reflated by the US Marshall Plan. In the aftermath of the European debt crisis, where is the Marshall Plan for Europe?

The irrationality of rational economics is that what seems reasonable to professional economists is unacceptable to people, as when the debtor countries have to suffer through even higher unemployment and loss of income to repay their debt to the rich. Rational economics leads to irrational populist politics.

Politicians who refuse to accept economic realities – that excessive debt is, in many cases, money already lost and unrecoverable except historically through war or hyperinflation – will be swept away by the tides of change.

From the long lens of history and a distant Asian perspective, the European existential crisis is not whether Europe will survive or not, but whether German leadership will rise above its local perspective to embrace a regional and global statesmanship.

Andrew Sheng writes on global issues from an Asian perspective 

This article first appeared in the South China Morning Post on June 8, 2018. The views expressed in the reports featured are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.


Andrew Sheng

Member, Asia Global Institute

Andrew Sheng


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