An alternative perspective

01 November 2010

The return of the Euro: German growth, fiscal discipline and recovery


As the credit crisis fed through into the recession on a scale not seen since the Second World War, Britain and America embarked on massive Keynesian fiscal and monetary interventions. As the private sectors reeled, the public sector stepped in – in both cases with deficit spending of over 10% of GDP and large doses of quantitative easing. Both followed the Keynesian textbook to head off the anticipated 1930s-style depression and the expected deflation.

Over in Euroland, the Keynesians lambasted the straightjacket of a currency union without a fiscal union, with a dominant and ultra cautious Germany at its core. They argued that the Europeans should have gone for a big expansion of state spending and the euro was predicted to fall apart, so that the weaker members would be able to devalue their way out of their uncompetitiveness with Germany.

Yet it has turned out very differently. Germany led the way out of the recession with a stunning bout of economic growth, based not on domestic demand (as the Keynesians advised) but on exports. Its labour hoarding – supported by government measures to encourage part-time working – has paid off. And the widely derided weaker (and very small) economies in the Eurozone have been engaged in the sorts of microeconomic reforms made possible because they could not devalue.

In the Eurozone, pension liabilities have finally begun to be addressed, public expenditure is being pruned back and work incentives confronted. In Greece, people are finding they have to pay their taxes and public sector workers in Ireland are having their wages cut. Across Europe, real wages are being pruned back. There remains a long way to go, but a start has undoubtedly been made.

The euro has clawed its way back and it is the dollar and sterling that have fallen back. The threat of the ‘double dip’ haunts policy makers in Britain and America and both are considering reaching for the printing press again. How has it come to this? How could the conventional Keynesians have got it so wrong?

The explanation is partly a deep misunderstanding of the Eurozone, and Germany in particular, and partly a deeper set of flaws in Keynesian economics.


The standard critique of the euro is that it provides a straightjacket within which countries with very different competitiveness are denied the ability to devalue their way out of their uncompetitiveness. And since they cannot devalue, they cannot overcome their uncompetitiveness and hence they will not grow. Cutting their public expenditure won’t help, because it simply sucks out more demand Default is the inevitable consequence.

The problem with this argument is that it takes the uncompetitiveness for granted. It is a given. It is not possible for Greece or Ireland to make themselves competitive. But why? Is Germany really a supereconomy destined to always out-compete them – both absolutely and relatively?

Germany has few natural resources, it shares the same internal market and it has lots of social costs. The reason it is super-competitive is to be explained in part by what has been going on in German industry since reunification. When it took on the collapsing East Germany, there followed a boom and then a bust. The result of the bust has been a quiet revolution in the corporate sector, especially amongst the family-owned and private small- to medium-sized firms. When the economic crisis hit, they absorbed the shock. They took the pain without the exposure to stock markets and their response was – given their ownership patterns – inevitably more long term. Whereas the Anglo Saxons concentrate on the flexibility of the labour market to hire and fire, the German corporate sector flexes internally with its own private capital market.

So when recession came – especially in China – Germany had quality services and quality products that overseas consumers were prepared to pay the price to get their hands on. Having survived and prospered against a rising exchange rate since 1948, German companies have had to increase productivity faster than the deutsche mark went up to keep competitive. It has always been an export-driven economy at the margin, and hence set itself to deliver to global rather than domestic demand. It has done this by saving, and by turning savings into investment.

The question then is: is this uniquely German or can the others follow? Take Greece. Its uncompetitiveness is to be explained in part by its dysfunctional politics. Having experienced a military dictatorship, its democratic institutions delivered a form of capitalism which encompassed widespread tax evasion by its middle classes, public sector pension arrangements which look absurdly generous now in the harsh spotlight of international scrutiny, and national accounts which stretch the imagination.

What Greece has now had to do is to address the fundamental causes of its uncompetitiveness – rather than simply devalue its way out. It has therefore no choice but to cut its deficit, deal with its pensions, make people pay taxes and produce meaningful accounts. None of this would probably have happened if the drachma could have been devalued. It might yet default but, even if it does, the reforms will have started a process which will have to continue.

The story in Ireland is superficially different. Its crash came from its construction sector through to its banks. But think of its history. Up until the end of the 1970s, the Republic of Ireland was poor – indeed so poor that it was the weaker relation to the more prosperous Northern Ireland. There followed two decades of what was on almost any measure an economic miracle. It confounded its past. Dublin became a location for high tech industries and pharmaceuticals, backed by a high quality education system.

None of this has gone away. Rather the construction boom has brought a severe bust. Had Ireland devalued its way out, the immediate pain would have been much less severe, but it would have lost the basis of its long-term prosperity. Being in the euro, being willing to address its debts – these are essential for international inward investment. And in the process of all this pain, its public sector is being pruned, its pensions are being addressed and the banks are being reformed.


As countries across the Eurozone carry through these painful measures, European competitiveness is improving. Unlike the US and Britain, Europe has a trade surplus. It does not rely on capital inflows. It has begun its monetary exit strategy and the spotlight has shifted to the risks of the Keynesian experiments elsewhere. Faced with the choice of investing international capital flows in dollars or euros, the balance does not now favour the US. The process takes time, especially given the exposure of China to US bond markets, but there is almost an inevitability to the diversification of international portfolios away from the dollar and towards the euro – at least at the margin (which is what matters).

The recovery of the euro brings renewed confidence with it. It becomes easier to finance European debt and bond spreads begin to fall. There will be risks and volatility ahead, but there is also a sense of reality dawning. The euro is not about to collapse and Germany (and France) were never going to let that happen anyway. Greece, Portugal and Ireland are very small components of European GDP. Even a default in Greece is not the end of the euro.

As recovery and confidence return to the Eurozone, the rationale of Germany’s hard line on budgetary discipline is beginning to be more widely recognised. By holding the weaker governments’ feet to the fire and demanding national fiscal reform, it has forced them to confront the new reality. Now Germany wants to cement that discipline in. Contrary to the demands for Germany to write a blank cheque to bail out others who fail to control their budgets, it is gaining support for a much harder constraint. The blank cheque would be like devaluation – a way out of difficulties without forcing reforms. The politics are tough – especially for France – but the direction of travel is not in doubt.


The great economic crisis which erupted in 2007 is like that of the 1930s, a test bed for economic ideas. But though history has its lessons, it rarely repeats. The Keynesians claim they were right about the 1930s and they tend to see the pattern repeated now.

If they are indeed right, Germany should be in deep trouble and the euro should have collapsed. Yet it is Britain and the US which have been in difficulties. Both have enormous fiscal deficits and both have large trade deficits too. Britain has been devaluing since it abandoned the gold standard in the 1930s, and it has not been a notable success. North Sea oil and gas bailed out its trade balance from 1980–2005, but that prop has now gone. Belatedly – but rightly – Britain is now putting the brakes on and attempting a painful rebalancing. It has become almost German in its approach – though it has a long way to go to make up the productivity gap, reform its corporate capital markets and increase its saving. Early signs are that taking a more German line is paying off in better British economic growth. The US has yet to make this transition and it remains to be seen whether it will manage it.


Most of the great advances in Europe have come out of crisis. The shocks of the 1970s led to the painfully slow steps towards currency stability and eventual monetary union. The collapse of the fascist and military governments in Spain, Portugal and Greece presaged enlargement. The collapse of the Soviet Union saw the European Union rise to the challenge and radically expand.

The shock of the economic crisis ranks alongside these past challenges. Out of the crisis have already come major reforms – reforms to its public sectors, the addressing of the pension liabilities and, most of all, deficit reductions. Whilst there are many in the Anglo Saxon economic fraternity who have predicted the death of the euro and sclerosis for the European economy, the euro lives on and Germany leads the economic recovery.

Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

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