Hugo Radice: Germany calls in euro debts despite lessons of history

With the recent signing of a rescue plan for Portugal, the spotlight has now turned back to Greece, which is by all accounts struggling to fulfil the terms of the agreement reached a year ago.

Why is it proving so difficult to come up with a lasting and effective solution to the sovereign debt problem?

The answer to this lies, to a large degree, in Germany.

Germany has by far the largest economy in the eurozone, and a long tradition of big trade surpluses built on the excellence of its manufacturing industries, especially the medium-size firms that make up the Mittelstand.

It is also noted for the modest deficits and debts of its federal government, and for its high rate of domestic savings.

After the fall of the Berlin Wall, Germany had remarkable success in getting its citizens to pay for the costs of post-communist unification: labour market reforms and union co-operation enabled their industries to regain and then increase their competitive advantage internationally.

In addition, the European Central Bank, created to manage the new currency, is based in Frankfurt and largely inherited the highly conservative monetary policies of the old German Bundesbank. Because of its great economic and financial strength, therefore, it seems natural that Germany under Chancellor Angela Merkel should take the lead in resolving the eurozone crisis.

There is, however, another very good reason why Germany needs to take a lead. Precisely because German businesses and households rely on their own resources, rather than on borrowing from banks as we do in Britain, the German banks took to lending money abroad in order to make a decent profit.

With the arrival of the euro, they thought they could more safely lend to peripheral eurozone countries like Greece, rather than to countries outside the zone whose currencies might fall in value; and since they had neither the branch networks nor the local knowledge to lend directly to households and businesses in such countries, they were happy to find that governments and local banks were only too willing to borrow from them instead.

As a result, German banks which have lent abroad are currently owed over 150 per cent of their total equity capital by banks and governments in Portugal, Ireland, Greece and Spain. French banks are second with just under 100 per cent of their equity exposed, banks in the rest of the Eurozone about 50 per cent and UK banks some 45 per cent. Ever since this crisis began, German politicians have therefore been concerned to rescue German banks from their reckless lending to the euro periphery. They have therefore obstinately refused, until now, to consider a restructuring of these debts which would require the banks to write down their value in their accounts – a process known colourfully as a “haircut”.

In the short term, forcing the repayment of debts through savage cuts in public expenditure is having exactly the consequences that Keynesian economics predicts: slashing public sector employment and incomes leads to a worsening of the public sector deficit, as tax revenues fall (from both incomes and consumer spending) and the state welfare bill rises. In the medium term, continuing austerity makes it impossible to undertake the investments, both public and private, that are essential if the indebted countries are to improve their international competitiveness. Sooner or later, sovereign bondholders are going to have to be forced to accept losses, and that means that ultimately banks all across Europe will have to do the same.

The near-certainty of this outcome is today reflected in the greatly-reduced market values of Greek, Irish and Portuguese government bonds, and the high cost of the credit derivatives that insure bondholders against default. Whatever transpires in the coming months, it seems increasingly clear that forcing complete debt repayment on schedule upon Greece, Portugal and Ireland cannot work.

History provides us with a dire warning of what can happen when such pressure is placed upon a debtor country: the great irony is that the debtor country in question was not Portugal, Greece or Ireland, but Germany.

When the victorious allies enforced an impossible burden of war reparation payments upon Germany at Versailles in 1919, the outcome was disastrous, as the young Keynes warned at the time in his famous pamphlet The Economic Consequences of the Peace. To many historians, the imposition of endless austerity upon the Germans created the economic and social conditions that led to the rise of Hitler.

What is more, it was through absorbing the lessons of that disastrous policy that the USA was persuaded, after 1945, to take a completely opposite course of action in the Marshall Aid programme, which enabled the economic reconstruction of Germany and of Western Europe as a whole.

Surely the political and financial élite of Germany today know enough of their own country’s history to appreciate that austerity is not the answer?

Hugo Radice is a Life Fellow in the school of politics and international studies at the University of Leeds.