Eurozone Imbalances

The eurozone presents an extremely complex economic system whose problems are difficult to explain. It can be hard to understand the reasons for the sometimes great divergences in the reactions of governments to the crisis, particularly between France and Germany. This is often presented as due to ideological differences: Germany “believes” in fiscal discipline and national responsibility, in line with the original “no-bailout” philosophy of the Maastricht Treaty. France in contrast is presented as more statist and fiscally profligate and, as a result, more open to bailouts and solidarity.

This article addresses these issues by visualizing the emergence of eurozone imbalances – of trade, debt, and overall economic performance – as an explanation for the current crisis. It shows that Franco-German differences emerge not primarily due to differing philosophies – in terms of fiscal deficits the two had remarkably similar performances in the 2000s – but because of completely different developments in their economic relations with the outside world between 2000 and 2007. Germany succeeded in massively increasing its exports both in the eurozone and, especially, the wider world. France in contrast let its financial sector become massively and one-sidedly intertwined with those of the peripheral countries (GIIPS – Greece, Italy, Ireland, Portugal, Spain), making the survival of its financial system completely dependent on the survival of the wider eurozone.

These differences largely account for Franco-German divergences between 2010 and today. They also account for the inequality of economic power in Germany’s favor.

[iframe ” <iframe src=”//viz.blogs.bertelsmann-stiftung.de/globaleurope/1848?lang=de” width=”800″ height=”600″ style=”border: 1px solid #eee” mozallowfullscreen=”true” webkitallowfullscreen=”true” allowfullscreen=”true”><a href=”//viz.blogs.bertelsmann-stiftung.de/globaleurope/1848?lang=de” target=”_blank”>GED VIZ Slideshow</a></iframe>”]

The Dawn of the Euro, 2000: A relatively balanced situation

On our first slide, “Performance”, we see that the eurozone’s original imbalances are relatively minor in retrospect.

Germany has an $11 billion trade surplus with the GIIPS and a mere $1.3 billion surplus with France. France in turn has a $5 billion trade surplus with the GIIPS. There is relatively little variation in export dependence: exports make up 31.4% of German GDP and around 25% for France and the GIIPS. Unemployment also differs relatively little among the major economies, going from 7.4% in Germany to 10.7% in Spain. There is significant variation of public debt though, with France, Germany and Spain around 60% of GDP, Ireland and Portugal below 50%, and Greece and Italy above 100%.

On our second slide, “Interdependence”, we see the interdependence of European financial sectors. While German banks have over $200 billion in net lending to their GIIPS counterparts, French banks have only done around $75 billion in net lending.

The Eve of Crisis, 2007: Massive imbalances and interdependence

Fast-forward to 2007 with our third slide, “Interdependence”: we see that a number of dramatic developments have taken place over a mere seven years.

Contrary to popular perception regarding “fiscal responsibility,” average (non-weighted) GIIPS public debt declined significantly from 87.3% in 2000 to 74.8% of GDP in 2007. Greek debt (already high) increased 3 points while Portuguese debt increased 20 points. But this is more than made up for by a 12-point fall in Ireland, a 5-point fall in Italy, and a 33-point fall in Spain. In contrast, public debt increased by 7 points in France and 5 points in Germany. German public debt, on the eve of the crisis, was the highest of all the major European economies except Italy. Unemployment was comparable among major economies, generally around 8%.

German performance then appears unremarkable or even rather mediocre. However, underlying this was an extraordinary expansion in German exports, likely accentuated by the controversial Agenda 2010/Hartz IV reform programs. While the share of exports as a percentage of the GIIPS’s and France’s GDP has increased only slightly, German exports in 2007 made up 47.1% of GDP, an almost 17 point increase.

Finally, and most strikingly, there was a massive increase in financial interdependence between countries as a result of capital liberalization enabled by the Single Market and the euro. There was an explosion in interbank lending: French banks have lent $904 billion to their GIIPS counterparts, while German banks have lent $833.3 billion.

The picture is even more striking if we look at net lending (that is, if we subtract GIIPS banks’ lending to Franco-German banks). French banks’ net lending to the GIIPS has increased almost 900% over seven years, reaching an incredible $743.7 billion. In contrast, German banks’ net lending to the GIIPS had “only” reached $308 billion.

This imbalance helps to explain the appearance of stability prior to the crisis: GIIPS performance in terms of unemployment, public debt and GDP growth was typically passable, satisfactory or even very good, but this was only possible thanks to massive and ultimately speculative capital flows from the core, artificially sustaining public spending, private investment and consumption.

This difference between the French and German financial sectors alone helps to explain the very different attitudes taken by France and Germany in the euro crisis. The French financial sector is over twice as exposed to losses should the GIIPS countries, through public or private defaults, fail to guarantee their banks. This exposure is perhaps three times greater if one considers that the French economy is only about three-quarters the size of the German one. As a result, France favors collective EU bailouts, either financed by the Member States or indirectly by the European Central Bank, in both cases in proportion to GDP. This means the burden and risks of indirectly saving the French financial system are disproportionately borne by the German (and “Core”) taxpayers in general. As economist Hans-Werner Sinn noted after the first Greek bailout in 2010:

France’s implacability, in Germany’s political circles widely perceived as recklessness, can be explained by the fact that its banks were affected particularly strongly by the crisis, since they held a large volume of government securities of troubled countries. […] From a French perspective it was definitely preferable to opt for collective rescue measures, as this implied that some of the over-proportional burden expected for their own banks would have to be shared by other countries, above all Germany.

As calculated by the Bertelsmann Stiftung , losses to Germany from euro-secession of the GIIPS would be significant, and the knock-on economic and political consequences are inherently unpredictable, but they would be far greater for France.

The picture is further nuanced by looking at trade flows on our fourth slide. While German exports and trade imbalances within the eurozone have increased massively, the GIIPS and France represent a declining portion of German exports. In 2000, the GIIPS and France represented respectively 15.8% and 10.1% of German exports. In 2007, the GIIPS represented only 15.2% and France 8.9%. Thus Germany’s extraordinary export boom was not primarily dependent on the eurozone, but on exports to the rest of the world.

These two facts: Germany’s declining dependence on the eurozone for exports and its relatively low exposure to southern banks, explain why Berlin was so reluctant to shoulder the burden of bailouts and was so open to the idea of “Grexit.” Exits and defaults in the periphery are simply far less threatening to the German industrial economy than they are to the French financial system.

In addition, we observe a notable deterioration of France’s trade position: the trade deficit relative to Germany has expanded tenfold over seven years to almost $13 billion.

Euro Crisis, 2010: The bubbles pop

Our fifth slide shows the effects of the 2007-2008 financial crisis on the eurozone economy. Debt in the GIIPS skyrocketed as governments spent money to compensate for the collapse of speculative bubbles and to bailout bankrupt financial sectors. Unemployment in the periphery also increased massively, reaching almost double the German levels. There was also a partial unwinding of financial sector imbalances: net German lending to the GIIPS went down from $308 billion in 2007 to $157 billion in 2010. French lending is down from $744 to a still huge $556 billion.

These factors reveal Germany’s unassailable negotiating position: unemployment is low, exports do not in fact depend on the periphery, and its banks are three times less exposed than French ones. In addition, the dysfunction of the euro means Germany is continuously benefiting from capital flight from the periphery as investors fear money placed in the peripheral nations will be lost if they default and/or leave the eurozone. The question then becomes why should Germany “save” the periphery? At least in terms of short-term rational self-interest, we might say Realpolitik, it can be argued that Germany’s conduct has been optimal.

Germany’s policy today, regularly condemned as “brutal” or “hegemonic,” is the equivalent of President Charles de Gaulle’s “Empty Chair Policy” of 1966. Then, France made any further European integration conditional on special care for French interests, in particular dedicating 80% of the European budget to agriculture, which, if one simplifies a bit, basically meant German industry subsidizing French farmers. Germany accepted because, then, de Gaulle’s France was in an overwhelming position of diplomatic and political strength in the face of a divided Germany, still cowed by postwar guilt.

Today, Germany is a “normal” country, unafraid to assert its interests even if it is condemned as “un-European,” and as such uses its overwhelmingly superior economic position to determine the nature of any and all further European integration and aid necessary to “save” the eurozone and the peripheral economies. France in contrast naturally pushes for “solidarity” but is in a position of economic vulnerability and is as such completely dependent on German goodwill. As such, whatever the verbal preferences or electoral promises of the French government, it quietly accepts German conditions of austerity, the outlawing of significant Keynesian stimulus (Fiskalpakt), and bringing national public spending levels under EU control (Six-Pack, Two-Pack).

It would be wrong to dismiss completely the role of ideology in the euro crisis. Germany clearly has an attachment to hard money and a fear of inflation, most visible in the prestige of the Bundesbank, that simply do not exist in other countries. Britain, France, Japan, the U.S. and other countries, in contrast, are happy to adopt a “flexible,” pragmatic attitude based on which they readily use currency devaluation or central bank financing of the government when it is deemed necessary.

However, Franco-German differences over the bailouts have more to do with different interests than different ideas. These interests emerge from the very diverse reactions of the French and German economies, and political systems, to the creation of the euro. Germany, in the face of a decade of economic underperformance, chose to adopt an aggressive global export-led strategy of growth, even if it should come at a significant cost in terms of reduced wages, higher inequality and indeed heightening eurozone imbalances. France, by contrast, reacted with a massive “financialization” of its economy, its financial sector getting addicted to making staggeringly massive and misguided loans betting on growth in the eurozone periphery. The discord between Paris and Berlin hence emerged primarily from the huge differences in interests and bargaining power that flow from these choices.