“One of the Fingers on the Button Will be German”: German Economic Preferences over EU Institutions and the Irish Economic Crisis

Most of the contributions to this seminar begin with Germany’s internal politics and work outwards. This short piece instead emphasizes the external consequences, asking what they mean for European Union politics, taking Ireland as a test case. Ireland is the only ‘Anglo-Saxon’ member of an economic and monetary union which was built largely in order to match German preferences. Both its current crisis, and the ways in which Germany (and other EU member states) are seeking to respond to it, provide evidence about German preferences, and their intellectual and material limitations when they become generalized as policy prescriptions at the European level. Because Economic and Monetary Union only provides fiscal restraints, and no very useful means of intervening in private markets, Germany and other member states face stark limits in their ability to prevent, and even to respond to crises that originate in the private sector. Moreover, when they do, they are likely to find their interventions politicized, and strongly resented by the populations of the countries that are intervened in.

_The EMU and Ireland: External Consequences of German Preferences_

The story of the battle between Germany and France over the institutions governing Economic and Monetary Union is well known in outline. Although France had some nominal success in labeling the accompanying institutional bargain the “Stability and Growth Pact” rather than merely the “Stability Pact,” this victory was one on paper only. The European Central Bank pursued a policy that adhered quite closely to German preferences for low inflation, paying no serious attention to growth promotion. Although the Stability and Growth Pact mandated serious limits on deficit spending, it proved incapable of restraining the major states – Germany and France – when they found its strictures temporarily inconvenient.

Economists’ doubts about the sustainability of EMU returned to the fore when the crisis got into full swing last spring. It became clear that Greece had systematically lied in its statistical reports, and had in fact been building up an ever larger deficit that became completely unsustainable in the wake of the crisis. Economists and other commentators paid much less attention to the incompleteness of the European institutional bargain, which imposed half – but only half – of the German domestic economic model on other EMU member states. The Stability and Growth Pact – even when it worked – was intended to prevent governments from building up large deficits. There was no accompanying set of institutions that were intended to impose German style regulations so as to prevent private sector crises from emerging.

These problems are cast into sharp relief by the recent economic crisis in Ireland, in part because Ireland represents a very different economic model to the German one that EMU was intended to propagate. In order to create economic growth, Ireland lowered taxes (with particular attention to effective corporate taxation rates) and sought to attract investment from abroad. Towards the same end, it built an International Financial Services Center which combined taxation benefits with minimal regulation laxly enforced, so as to attract financial services firms both from London and elsewhere. Several German banks and reinsurers set up boutique subdivisions in the Center, with quite unfortunate consequences. Finally, lack of a strong system of banking regulation and minimal supervision, together with a close political relationship between Ireland’s dominant political party and land developers helped inflate a property bubble which had dire consequences for both Irish fiscal stability and the Irish banking system when the bubble popped.

Ireland’s Anglo-Saxon growth model, far from being restrained by EMU membership, was facilitated by it. Ireland’s decision to join EMU, rather than to stay outside with the United Kingdom (with which Ireland had strong economic ties) was fundamentally a political rather than an economic choice. EMU membership was expected to lower interest rates and the cost of capital for Irish firms.

EMU membership provided these benefits in the short term. As anticipated, it led to lower interest rates and yields for Irish government debt. However, it also obscured the fundamental trade-offs faced by small open economies such as Ireland in ways that had pernicious long term consequences. As “Avellaneda and Hardiman suggest”:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1642791, EMU systematically helped promote pro-cyclical fiscal policies in member states.

This had particularly damaging consequences for Ireland. Although Ireland achieved surpluses during most of the period in question, this was accidental rather than deliberate, and a consequence of higher-than-expected economic growth rather than careful government policy. Contrary to what US commentators like Christopher Caldwell have suggested, the Irish government were very far indeed from being “model fiscal stewards”:http://www.weeklystandard.com/articles/euro-trashed_522123.html?nopager=1. There was little effort to plan spending responsibly, as suggested by Finance Minister Charlie McCreevey’s publicly stated dictum of “When I have it, I spend it.”

Public profligacy went hand-in-hand with private sector exposure. High growth rates in Ireland attracted money from Germany, France and the United Kingdom. A combination of extraordinarily high growth rates (which initially were a product of catch-up, then of an over-inflated property market), together with cheap borrowing via EMU supported policies that were insupportable in the long run.

When the crash came, it hurt very badly. GDP fell by an estimated 7.25 percent in 2009, while unemployment rose to over 13%. House prices have plummeted 30 percent since their peak, and may fall much further.

In short – even if the Stability and Growth Pact instilled German preferences over economic stability as the baseline for EMU governance, it did not lead to a cloning of the German model across EMU members, nor even (as expected) a greater attention to the merits of fiscal caution. Not only did Southern European countries fail to reform their domestic economic institutions as economists had hoped but Ireland – which embraced an economic model that was in many respects antithetical to Germany’s – found that EMU reinforced its institutional path of development in malign ways. EMU arguably made it easier for Ireland to maintain a feckless economic policy than it would have otherwise, through lowering interest rates. In contrast to EMU’s fiscal policy strictures, there was no European structures to actively promote a social market economy approach, or even to monitor effectively for problems within EMU’s private sector.

German preferences for an economic and monetary union based on low inflation and simple external rules on budget deficits would have proved insufficient even if Germany and France had not weakened EMU. Ireland’s twin crises of fiscal importunity and property market instability not only went hand-in-hand, but were effectively invisible under EMU’s strictures. Economic and Monetary Union’s rules provided no very obvious way to investigate or forestall behavior that was manifestly fiscally irresponsible in the long run, but did not lead to budget deficits over the shorter term.

_Responding to the Crisis: The Contradictions of the German-led Policy Response_

If Ireland’s initial economic difficulties were in part the result of a half-baked attempt to instill German policy preferences at the heart of an EMU composed of countries which did not resemble Germany, current efforts to extricate Ireland illustrate the problems of a more whole-hearted approach to change.

Ireland’s current crisis was not caused by Germany, as some Irish commentators like to pretend. Better information about the true extent of Ireland’s problems emerged last year, with two consequences. First – it meant that Irish banks had to rely ever more on the European Central Bank’s emergency liquidity support system to raise any money at all – by the end of October, Irish banks held almost a quarter of total ECB loans. This generated increasing unhappiness within the ECB, which started to make public noises about the need to find an exit strategy. Second, the spread between German and Irish government bond rates began to widen ever more as lenders priced in the cost to the government of dealing with losses.

While the Irish government hoped to bluff it out until after the next election, markets took fright when Angela Merkel suggested that any permanent EU crisis resolution mechanism would involve haircuts for holders of senior debt. This led to an accelerating spread, and enormous pressure from Germany and other EU member states on Ireland to apply for a bailout, in the hope that this would prevent financial uncertainties from infecting the eurozone as a whole. The result – agreed on November 22 2010 – was a package of loans administered by the EU (through EMU-focused emergency mechanisms and bilateral loans from non-EMU members the UK and Sweden) and the IMF of approximately 85 billion euro. Of this sum, 50 billion will support government spending as it seeks to reduce its deficit (on the assumption that the Irish government will have extreme difficulty in raising money on international markets) and 35 billion to allow the Irish government to further support the Irish banking system through effective nationalizations, majority shares, and the allocation of bad debts to a `bad bank’ arrangement (NAMA).

This package did not calm markets. This is at least in part because it is riddled with contradictions, which are in large part consequences of difficulties in extending the German model. If Germany is not responsible for lowering the boom on Ireland, it has much to do with the obvious inadequacies of the purported approach to getting Ireland out of trouble.

Germany’s strong preferences for austerity have reshaped European economic policy since mid-2010. The package agreed by the IMF and EU includes a bridging loan, which is however conditional on continued sweeping budget cuts. Yet this is obviously likely further to depress domestic demand, and spur renewed emigration. At the very least, German and ECB suggestions that austerity would calm market expectations and lead to a swift return to growth appear likely to be falsified in Ireland. Although Ireland would have little choice but some form of austerity, it appears that ECB preferences (which likely reflect thinking in the Bundesbank and Germany) would have been to impose an even larger set of cuts than the euro 15 billion cutbacks mandated in the final package. Rather unusually, it was the IMF that pressed for more generous terms for Ireland.

More importantly, the specific form of the rescue package has been dictated by German beliefs and domestic imperatives. Karlsruhe looms large — the continued desire to avoid a Constitutional Court veto of any European rescue arrangements mean that the European Union is again lending above the market rates that Ireland and other EMU members once enjoyed. This means that Ireland will have extreme difficulty in escaping its debt burden in the future, except under extraordinarily optimistic assumptions about future growth. As Willem Buiter and his colleagues “put it”:http://www.scribd.com/doc/46575893/Citi-Economics-Debt-of-Nations recently:

bq. Ireland provides a microcosm of the challenges facing the [euro area]. Accessing the official external sources of funds that have been made available will likely not mark the end of Ireland’s troubles. The reason is that, in our view, the consolidated Irish sovereign and Irish domestic financial system is insolvent – the Irish banks are `too big to save’ for the Irish sovereign. The Irish sovereign cannot `bail out’ the banks from its own resources and make its own creditors – the owners of Irish sovereign debt – whole. In addition, a bail-out (permanent fiscal transfer) from EA/EU partners or the ECB on a scale sufficient to fill the solvency gap is most unlikely. Therefore, either the unsecured and non-sovereign-guaranteed creditors of the banks, or the creditors of the sovereign (including holders of sovereign-guaranteed bank debt), or both, will likely eventually have to accept sovereign debt

Despite statements from Angela Merkel and the Bundesbank that private bondholders should share the pain of future banking bailouts, there is some evidence that the failure to impose a haircut on holders of senior Irish debt reflects the preferences of France, Germany and the UK as well as those of the European Central Bank. An interview with Irish Central Bank governor Patrick Honahan suggests that Ireland’s decision not to pursue these bondholders was a “quid pro quo” for continued ECB support and that there had been “no enthusiasm” in European capitals for forced writedowns. This reluctance is plausibly motivated in part by the fear of contagion spreading to other Eurozone members. However, it also possibly reflects the fact that prominent and influential French, German and UK banks are among those debt holders. The perception, whether justified or otherwise, that Irish taxpayers will have to repay enormous sums which are being lent to them for the primary purpose of protecting the interests of foreign banks has done little to endear the bailout to Irish taxpayers. Nor, for that matter has the requirement that the Irish government invest pension funds that were previously firewalled off in banks which are widely perceived as worthless.

_Conclusions_

The crisis in Ireland and other peripheral Eurozone members was in large part (although certainly not entirely) the product of institutions that were intended by Germany to enforce fiscal rectitude on EMU participants. Not only did they fail to do this in Ireland and Greece, but they plausibly provided positive incentives for imprudent behavior. The Stability and Growth Pact served not as a spur towards scrupulous fiscal policy, but as a replacement for it. Because eurozone governments were perceived as safe borrowers, they could maintain levels of borrowing that would otherwise have been unachievable. Rigid and simple rules on government spending proved completely inadequate to guarantee domestic fiscal sustainability in the absence of any mechanisms for monitoring private activities and stringent financial regulations. A stripped down version of _Modell Deutschland_ proved a poor basis for regulating a monetary union made up of diverse economies. German institutional preferences proved an inadequate basis for securing German policy goals.

The contradictions in Germany’s stance towards bailing out other European economies are even more apparent. German-imposed preferences for austerity, as mediated through the ECB, appear far more likely to hurt recovery than to help it. German’s domestic policy constraints prevent the EU from offering loans at rates that would allow states in trouble to recover credibility on markets, let alone to recover properly.

This is arguably less the product of conscious state strategy on Germany’s part, than the playing out of domestic politics in a situation where Germany is uniquely powerful and where the definition of Germany’s international interests is still quite malleable. Even so, Germany’s new role is generating much resentment. Irish political commentators such as the prominent economist Morgan Kelly argue that ECB policy has been dominated by the “overriding concern” of ensuring the solvency of French and German banks and “complain”:http://www.irishtimes.com/newspaper/opinion/2010/1108/1224282865400.html that:

bq. Since September, a permanent team of ECB “observers” has taken up residence in the Department of Finance. Although of many nationalities, they are known there, dismayingly but inevitably, as “The Germans.”

Ireland’s Finance spokesman for the main opposition party (and probable senior figure in the next Irish government), Michael Noonan “suggested”:http://debates.oireachtas.ie/dail/2010/11/25/member821.asp in the Dáil (the Irish Parliament) that Germany had directly profited from the crisis.

bq. It is probably not known in this country that Germany has gained a lot from the crisis. German bonds are a safe haven for the savings of Europeans, particularly in peripheral countries. A reasonable calculation would suggest that German debt servicing has gone down by between euro 15 billion and euro 20 billion since the start of this crisis because of the inflow of funds from elsewhere. This pitch is very uneven at present and I am growing increasingly concerned about the weight of what is being imposed on Ireland and the lack of understanding, in particular, on the part of the European institutions although the IMF, which has experience in this area, seems to be taking a more tolerant view.

The long term consequences of Germany’s successful push towards austerity have yet to play out. However, initial results from the Irish case would suggest two lessons. The first is that the contradictions within Germany’s policy towards Europe are leading to bad policy. The second is that as a result, Germany is likely to receive the political blame in target countries both for the economic pain that its mandated measures are causing, and for many of the adjustment pains that they would surely have suffered in any event. Germany’s asymmetric power is reshaping European economic politics in a direct, and arguably even a brutal fashion. It is not clear that German politicians and economic policy makers have any appreciation of the resentment and hostility that they are likely to incur as a result.