The German Specter That Is (Not) Haunting Europe

May 03, 2012, Wall Street Journal

(Op-ed by Klaus F. Zimmermann)

[view WSJ online version]

A new specter is haunting Europe, as elusive and illusory as that other, more famous specter of Marxist provenance. If Francois Hollande’s campaign rhetoric can be believed, there is a battle going on in Europe, pitting German-style austerity—a merciless, self-destructive throwback to the 1930s—against the noble cause of European growth by way of public subsidies to infrastructure, education and other worthy causes.

Given this near-absurd juxtaposition, let’s start with some basic economic truths. First off, the German strategy of the past decade has not involved “austerity.” Gerhard Schröder, the Social Democratic Chancellor of Germany between 1998 and 2005, oversaw fiscal consolidation and growth-oriented labor-market reforms as two integral parts of his economic package. Thus spending cuts for their own sake were never the “German style,” as is now widely but falsely surmised.

That's because trimming public budgets, per se, is not a growth strategy—a point on which both Berlin and anti-austerity French Socialists, such as Mr. Hollande, agree. Optimizing the use of public resources makes long-term sense only if it comes with a similar overhaul and optimization of labor-market practices. Both are vital to the economy, which—not unlike the human body—requires constant exercise and regime-monitoring to get and stay in shape.

It is true that these measures take time. In economics, there are no overnight miracles. And given the tendency of politicians everywhere (including Germany) to delay corrective action, it is in any government’s interest to use moments of crisis to break political impasses.

But those who believe there is an easier or faster route to self-improvement have the evidence of economic history stacked against them. The problem is not that European governments have ever been unwilling to take reflationary measures; they have done so repeatedly and reflexively over the decades, even when they were not really needed. It has always made for good short-term politics and, after all, another election at the national, state or regional level, has always been around the corner. Rather, what Western economies—not just in Europe, but also in the U.S.—have to come to terms with is that money does not grow on trees. Politicians who cling to that notion are recklessly exposing their nations to the mercies or furies of financial markets.

But nor does that mean this now isn’t the time for any public investments. Clearly, governments must continue to support areas such as education and infrastructure in order to give their economies a promising path to the future. But financing these investments with public debt is only viable if it comes as a reward for having consolidated budgets and reformed economic structures, such as labor markets. Infrastructure and education investments cannot substitute these necessary overhauls, as the Mr. Hollandes of this world would have it.

So contrary to what we keep hearing—even from otherwise very reasonable economists, such as Italian Prime Minister Mario Monti—there is no rigid either/or choice between budget consolidation and growth. Both will be crucial for Europe’s economic health going forward.

Yet the philosophers of yesterday’s economic strategies constantly underestimate the self-reparative forces of free economies—even Europe’s. For instance, it has always been said that Europe, because of its language barriers, had no natural path toward a truly integrated labor market. Undoubtedly, it will be a long path. But in this time of crisis, the transfer of young and mid-career professionals, such as unemployed Spanish engineers to German Mittelstand firms, is already under way.

Germans are doing something else right now that helps the European cause: As indicated by recent, collectively bargained labor agreements, wages in the country are on their way up—in some cases are rising well above inflation. That will not only strengthen German domestic demand. It will also provide other euro-zone nations with a path to economic adjustment, as the German wage increases provide them with solid catch-up potential on labor costs. That assumes, of course, that enough of Germany’s euro-zone partners resist the old temptations of disastrous Europe-wide “scala mobile,” by which one nation’s workers are deemed entitled to rapid wage increases simply because another country, such as Germany, has experienced them. Wage increases throughout the euro zone must instead be tied to real productivity gains and improved economic performance—as they have been in Germany.

The German approach to wages underscores something fundamental for the rest of Europe: Germans, wiser after 1970s, have not gained prosperity by pre-distributing wage increases they believe will be earned in future. They first generated their economic gains, then paid out the results. That order represents a wide gulf in contrast to what’s happened in the southern half of Europe in the last 10 years.

Behavioral economics tells us that it is always tempting to overspend in order to keep up with the Joneses. But more often than not, both people and economies can only satisfy that impulse by accumulating more debt. That does not make for a viable strategy, either at the household nor the national economic level. If southern Europe really wants to keep up with the Continent’s Joneses—Germany—they’d do better to spend more judiciously while reforming and liberating their economies.

Mr. Zimmermann is director of the Institute for the Study of Labor (IZA) in Bonn, Germany.

German foreign minister Guido Westerwelle argued similarly in the Washington Post: "A growth pact for Europe"

Reprinted with permission.