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Germany's New Role in Europe

Daniela Schwarzer Tuesday, Feb. 7, 2012

Both the Lisbon Treaty, which entered into force on Dec. 1, 2009, and the effects of the sovereign debt crisis that has ravaged the European Union for the past two years have considerably changed the union’s functioning. The Lisbon Treaty created the position of a permanent president of the European Council, tasked with preparing and chairing the council’s meetings and shepherding working committees between summits. As expected, this helped the summits of EU heads of state and government gain steering capacity and political importance in the decision-making system of the EU. But the sovereign debt crisis further established the European Council as the center of both crisis management and governance reform of the EU to a degree that took many by surprise. The European Council’s appropriation of longer-term policy planning and strategic reflection has in particular challenged the European Commission’s role and called into question its capacity to act as an agenda-setter. Essentially, the European Union has become more intergovernmental, with some even observing a move toward renationalization.

The winners of this evolution are above all the large member states that can considerably influence the agenda of the European Council and the direction of its debates. Meanwhile, in the discussions over the future shape of the monetary union, power has also clearly shifted to those member states that are on the donor side of the rescue mechanisms set up to help out the crisis-stricken member states. Germany qualifies on both counts. German Chancellor Angela Merkel probably has the most-direct access to European Council President Herman Van Rompuy, in particular in the debate over governance reform of the euro area. And with the strongest-performing economy of the eurozone over the past two years, Germany currently guarantees 27 percent of the European Financial Stability Facility (EFSF), amounting to €211 billion ($276 billion). Simply put, Germany is today the most influential member state of the European Union.

As a result, Germany now finds itself at the center of the debate over the shifting power relationships in the EU. Many observers still tend to see Germany as the reluctant giant at the center of the eurozone, hesitating to save the single currency. Does Germany still want the EU? How far does Germany’s European commitment go? These questions are among those most often heard when it comes to the changing politics of European integration.

Sovereign Debt Crisis Management and German Reservations

Criticism of Germany’s handling of the sovereign debt crisis goes back to 2010, with observers initially blaming the German government for the deterioration of the situation in Greece. An informal European Council meeting on Feb. 11, 2010, had promised to help member governments having trouble refinancing their debt. But in the eyes of many, Germany did not show a convincing commitment to this decision and hence increased nervousness in the financial markets. There are at least four reasons why decision-makers in Berlin did not act more swiftly to rescue Athens at the time. Understanding this reasoning also helps to grasp the German position in the debate over economic governance reform that has evolved since.

The first major concern was to exert as much public pressure on the Greek government as possible in order to push and support then-Prime Minister George Papandreou’s reform agenda. The assumption among German policymakers was that rescue packages create moral-hazard problems, which is one of the reasons why the German government requested strict conditionality and high interest rates for credit given to Greece and other highly indebted countries. Second, there is a strong principled belief among German policymakers that the eurozone should function according to the rules embedded, at Germany’s insistence, in the Maastricht Treaty -- that is, as a monetary union founded on monetary stability, sound public finances and a no-bailout clause. Many consider that sacrificing these principles, even in times of crisis, is a major mistake. The third concern was over developments in German public opinion, which showed, if not signs of outright euro-skepticism, then an unwillingness to cover the tab for other countries’ debt problems. Solidarity was seen more through the prism of respecting the rules than of bailing out those who hadn’t, and given regional elections and discouraging poll numbers for Merkel’s governing coalition, the two ruling parties did little to convince the public of Germany’s self-interest in supporting Greece. The fourth and strongest concern was that German participation in a rescue package could be challenged before the German Constitutional Court. Policymakers felt the need to be able to justify rescue packages with the argument that the stability of the euro was at stake.

These elements taken together explain why the German government insisted that help should not be granted too early without ensuring that the recipient government would embark on an ambitious reform process and implement budgetary austerity. The German thinking was very much driven by its own recent experience of structural reforms and cutbacks in public spending in the middle of the past decade. In combination with wage restraint, this had allowed Germany to pull out of the decade-long economic slump that had followed German reunification and re-emerge as a strong and competitive economy. If emergency aid was granted to a fellow eurozone member state, the thinking went, it should be done in exchange for hard conditionality and punitive interest rates in order to keep member states without a real need from asking for credit from the new rescue mechanisms.

German Views on Economic Governance Reforms

The debate over and process of economic governance reform in the eurozone began as early as spring 2010, and the German government has been strongly engaged in both since the start. The German approach can be summed up as an effort to draw lessons from the current crisis in order to bring the eurozone back to the monetary union that Germany thought it had joined in 1999.

However, two years of the ongoing sovereign debt crisis have left some German assumptions about the eurozone’s functioning deeply shattered. The European Central Bank (ECB) is now buying the sovereign debt of highly indebted member states on the secondary bond market in such large quantities that commentators have dubbed it Europe’s largest bad bank. It has flooded the banking sector with so much liquidity that some see a form of quantitative easing. It furthermore plays a strong role, alongside the EU and the International Monetary Fund, in the so-called Troika vis-à-vis the debt-stricken member states and, with Italy, has put policy pressure directly on a member government, which adds to doubts about its political independence.

Next page: A de facto fiscal transfer union . . .

Meanwhile, the fiscal rules laid down in the Stability and Growth Pact have continued to lose credibility, even though the framework has just been reformed and complemented by the so-called Fiscal Compact. In Greece, for instance, the situation has deteriorated to such a degree that few doubt any longer that the country is insolvent. But providing liquidity to an insolvent member state is incompatible with the no-bailout clause, leading most people to conclude that this clause has been abandoned in practice, if not in principle. This has left the widespread perception in Germany that the framework of the Maastricht Treaty has been undermined, and that a de facto “fiscal transfer union” has been installed.

For the German government, agreeing to the Greek rescue package and the creation of the EFSF in April and May 2010 was only acceptable if credible measures were taken in parallel to prevent a similar situation of sovereign indebtedness in the future. Unsurprisingly, Germany advocated for a stronger, rule-based approach involving nominal targets and automatic sanctioning mechanisms, a low degree of risk-sharing and very little room for political discretion. These positions are consistent with Germany’s ideas about the “proper” functioning of the eurozone, which date back to when the Maastricht Treaty was negotiated back in the early 1990s. The aim was and is to prevent unsound fiscal policies from undermining monetary stability, as the positions presented by the German government to the EU working group tasked with sketching out reforms of the eurozone shows. The German proposal to withdraw voting rights from member states that break the rules of the Stability and Growth Pact, as well as the principles that ultimately informed the Euro-Plus Pact, agreed to in March 2011, and the Fiscal Compact, agreed to at the European Council meeting on Jan. 30, 2012, all represent German initiatives to ensure sound public finances.

On the question of institutionalizing top-level cooperation in the euro area, Germany was at first reluctant to agree to the creation of a regular eurozone summit, as French President Nicolas Sarkozy had repeatedly suggested since coming into office in 2007. Berlin’s concern was that such an institution, and closer coordination among the eurozone governments in general, could lead to an increase in discretionary policies, which would undermine Germany’s stability concerns and possibly also the ECB’s independence. Despite the pressing problems unique to the eurozone, Germany initially wanted to improve fiscal and economic governance among all 27 EU members. It altered its stance only under the severe pressure of the sovereign debt crisis in 2011, which forced Berlin to accept the idea of a eurozone summit. But Germany swiftly tried to occupy the meeting’s policy agenda with the Euro-Plus Pact, which was ultimately signed by 24 EU member governments. The new understanding in Berlin is now that top-level involvement in the coordination of budgetary and economic policy is necessary in order to strengthen the rules-based approach and to ensure budgetary austerity and structural reforms in fellow eurozone member states.

Furthermore, the assumption is widespread in Germany that private-sector involvement in the case of highly indebted member states should be institutionalized under the future permanent crisis-management mechanism, the European Stability Mechanism (ESM), and should occur at an early stage of crisis management in order to prevent moral hazard. But the worsening of the sovereign debt crisis, which has been attributed in part to Germany’s insistence on private-sector involvement, has recently made decision-makers more cautious on this issue.

Germany and the European Central Bank

A continuous matter of debate in Germany is the role of the European Central Bank in the management of the sovereign debt crisis and its implications both for the ECB’s independence and for potential inflationary pressures, in particular since summer 2011. With market tensions spreading to Italy and Spain, the ECB first injected liquidity into money markets and then resumed its Securities Markets Program, making significant purchases of Italian and Spanish bonds on the secondary bond market for the first time in a bid to lower yields. A major concern in Germany is the potential difficulties of “sterilizing” large bond purchases, as well as the impact on the ECB’s balance sheet of any future sovereign debt restructuring.

Though the German government has backed the European Central Bank’s secondary market purchases, the program has been openly criticized by prominent German economists, such as Jens Weidmann, Merkel’s former adviser and now the Bundesbank president, as well as Axel Weber, Weidmann’s predecessor who resigned as president of the Bundesbank in protest against the ECB’s role in managing the sovereign debt crisis. The departure of Jürgen Stark on Sept. 9, 2011, from his position as ECB chief economist and one of six ECB board members, also in protest over the bond purchases, marked an important point in the German debate. The original conception of the eurozone built around Germany’s preference for stability and in the style of the old Bundesbank currency union is now perceived as coming to an end.

External Imbalances: Germany Under Pressure

Another sensitive topic in the debate over reform of the eurozone is how to address growing economic imbalances as a result of diverging degrees of competitiveness among eurozone and EU member states. These imbalances have been identified as one of the root causes of the current crisis in the eurozone. There is a broad European consensus that countries with large external deficits need to implement far-reaching structural reforms in order to improve their competitiveness. However, in March 2010, the Eurogroup acknowledged for the first time that surpluses also need to be critically reviewed. This is a very sensitive point for Germany, which has repeatedly been criticized for relying too much on exports and too little on domestic demand as engines of growth.

Some critics argue that Germany has pursued competitive real devaluation as unit labor costs have stagnated and reductions of the financial burden on the corporate sector have improved its competitiveness. Meanwhile, the increase of the value-added tax to 19 percent weighs on domestic consumption. Germans react strongly to such criticism, because many interpret it as a request by Germany’s partners for the country to “do worse.” In general, the debate in Germany on export competitiveness is often much more focused on global markets than on the eurozone or the EU common market, which may explain why economic policymakers in Germany tend not to understand their European partners’ concerns over Germany’s real devaluations.

Nevertheless, the question of whether Germany needs to do more for domestic demand is nowadays regularly raised in political debates in Berlin, and it will be raised even more often if export-driven growth decelerates in the years to come. There is a rising concern -- for instance among some Social Democrat and Green politicians in the German parliament -- that Germany will have to do more for domestic demand, for two major reasons. First, Germany has a clear interest in seeing the eurozone return to robust growth and sustainable public finances, for which a strongly growing German economy is a prerequisite. Second, if the eurozone partners substantively increase their competitiveness, Germany will as a consequence lose market share in certain segments, and will therefore need to rely more on domestic demand.

Next page: Germany, France and governance reform . . .

Germany and the Franco-German Partnership

Since the sovereign debt crisis broke out, Germany and France have joined forces to launch a number of crucial initiatives. The so-called Deauville compromise of early October 2010 foreshadowed the later decision to reform budgetary and economic policy surveillance. A Franco-German compromise was subsequently the decisive step toward the Euro-Plus Pact, which aimed at improving the competitiveness of eurozone countries. The same was true for the Fiscal Compact, an intergovernmental agreement agreed to in January that forces member states to adopt national fiscal rules and engage in budgetary austerity.

Nevertheless, in the course of the recent crisis, the balance of power in the Franco-German partnership has clearly shifted toward Berlin. On key elements, such as tougher budgetary rules and sanctions, the inclusion of rules for private-sector involvement in the permanent post-2013 debt-crisis mechanism, a treaty change to enshrine fiscal discipline in European law and a less-rapid enlargement of the bailout fund, Merkel has imposed her views on Sarkozy. Meanwhile, there is little trace of French handwriting in either the handling of the debt crisis or in the governance reform process.

The main factor behind this shift is related to economic developments and, more recently, the growing pressure on France’s budgetary situation, in particular since it lost its AAA credit rating. In the immediate aftermath of the economic crisis that hit Europe in 2009, France initially emerged more strongly than Germany, as the French welfare system continued to support traditionally strong domestic demand, while the government quickly stimulated the economy. But things changed in 2010, when Germany’s economy was driven by an export-led surge that pushed GDP growth to 3.7 percent, against only 1.6 percent in France. Germany was reaping the benefits of years of wage moderation and labor-market reforms that had improved its competitiveness. German unemployment hit record lows, while other member states continued to record extremely high rates. Meanwhile, after 28 years of running deficits, France’s budgetary situation became a pressing issue in 2011. Debates began to be heard about whether France was actually part of the sovereign debt crisis problem, rather than part of the solution.

Nevertheless, the power shift should not imply that Germany could somehow do without France. First, France remains Germany’s biggest trading partner. Second, both countries together guarantee almost half of the rescue mechanisms in the eurozone. It is in Germany’s absolute self-interest that the situation in France does not deteriorate further. Also, in policy areas other than economics, France is a key German partner, often more active, if not more relevant, on the global scene. It has a permanent United Nations Security Council seat, stronger defense capabilities and traditionally engages more actively in the Arab world and in Africa.

Yet, the post-war Franco-German partnership, by which Germany put its economy and its money at Europe’s disposal, while France provided Germany with political legitimacy, clearly no longer holds. The challenge for both countries as they prepare the future of their partnership is to come to grips with Germany’s economic supremacy as well as its willingness to pursue its national interests more vocally than it used to.

Conclusions

Rather involuntarily, Germany has slipped into a new leadership role in the eurozone: It has shaped the governance-reform debate, and it continues to set the pace for other member states through its ambitious consolidation agenda. With markets quicker to sanction domestic developments since the sovereign debt crisis, eurozone members, including France, feel considerable pressure to follow Berlin’s policy choices. This explains why Germany has managed to impose a significant number of its initiatives to reshape economic governance on its eurozone partners.

However, the question remains how politically sustainable the current shift will be in the long run, in particular since the parallel strategy of implementing budgetary austerity and structural reforms has driven several member states into recession and is provoking social unrest. Germany is increasingly confronted with a new debate on its responsibility for the economic development of the eurozone. This will not be an easy discussion, because it is becoming increasingly clear that the eurozone’s internal divergences may not be solved simply by forcing others to “do their homework, too.” Rather, it will require sensitive and far-sighted debates between Germany and its eurozone partners.

While the German government has appeared to reflexively rule out many proposals for further integration of the eurozone -- such as introducing eurobonds or creating cross-border bank rescue funds -- this does not mean that German political leaders are reluctant to “think big” on its political future. Quite the opposite is true: Since summer 2011, a domestic debate on “fiscal union” or “political union” has emerged, which clearly shows that German decision-makers are willing to consider substantial steps of further integration that could even entail transfers of sovereignty to the EU level, provided that the steps of integration are compatible with the German Basic Law.

But what has become equally clear is the price that Germany will demand from its partners: a basic consent to exporting Germany’s “economic model” to the eurozone. Unless this is ensured, it is unlikely that the German government will embark on steps of cooperation or integration that would substantially increase the sharing of risks and burdens in the currency union.

Daniela Schwarzer heads the research division on European integration at the German Institute for International and Security Affairs (SWP), an independent think tank advising the German government and Parliament. She is also an adviser to the Centre d'Analyse Stratégique of the French prime minister. Previously, she worked with the Financial Times Deutschland as a feature writer and France correspondent.


Photo: German Chancellor Angela Merkel, January 2007 (WEF photo by Severin Nowacky).