The riddle of German self-interest

by Martin Wolf

Financial Times
May 29, 2012

How will the crises inside the eurozone end? Many people have asked me this question in the US in recent weeks. How, in particular, might the eurozone move from crisis into stability? To address this question, we need to distinguish three aspects of the turmoil: where the eurozone is going; where Germany wants the eurozone to go; and where the eurozone needs to go.

The eurozone’s current position seems depressingly clear. A number of member countries, two of them – Italy and Spain – being large, already have, or are on the verge of having, governments unable to manage their public debt unassisted. Much of that debt is held by their banks. Many of these have been damaged, particularly in countries that experienced huge real-estate bubbles, large fiscal deficits or both. Governments with weak creditworthiness feel compelled to rescue fragile banking systems that are, in turn, expected to finance the governments trying to support them: the drunks are seeking to stay upright by leaning on one another.

Governments are also required to attempt fiscal austerity when private sectors are retrenching: between 2007 and 2012, the financial balance of the private sector shifted from deficit towards surplus by 16 per cent of gross domestic product in Spain (see chart). Austerity further weakens both economies and banks. This, in turn, raises unemployment and lowers government revenue, rendering fiscal austerity ineffective. Meanwhile, slack demand in the core reinforces economic weakness in the periphery, rather than offsets it.

With banks impaired, private demand damaged, government demand contracting and external demand weak, the fragile economies are likely to have smaller output and higher unemployment two or three years hence than now. The reward for pain today is pain tomorrow.

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