From 2000 to 2008, Europe was a microcosm of the global economy. On the global scale, China was the engine driving the machine, its vast population of low-wage workers producing huge quantities of exports for consumption by developed Western economies that had access to soaring levels of credit. A similar model existed in Europe, with Germany churning out manufactured goods that were then consumed by credit-fueled economies on the Continent's periphery. Low public spending and low wages attracted capital to Germany, with surpluses in the German current account (roughly speaking, the difference between its exports and its imports) consistently hovering around 7 percent. (By comparison, China's surplus peaked at 10 percent in 2008.) When the bust finally came, debt-laden Western countries suffered dramatic collapses. Both China and Germany found that their export markets had shrunk considerably.
At this stage, the Chinese and German models diverged. China's primary concern was to maintain the breakneck pace of growth to which its population had become accustomed, so it began to create a credit boom of its own, its external debt doubling since the end of 2009. Germany, meanwhile, began suffering seller's remorse. Unlike China, it found its fate linked to its formerly free-spending customers and thus forced to share in their pain as they undertook severe debt reduction measures. Peripheral countries had become addicted to the credit that fueled their large deficits, while lending from their banks increased rapidly as consumers and corporations benefited from the spending glut.
These banks were at the epicenter of the crisis that followed the collapse, as government after government in Europe was forced to either bail out or nationalize its financial institutions. This process partly shifted the debt from peripheral banks to their governments, creating a new wave of problems related to public debt. Markets no longer believed peripheral countries would be able to pay back the vast debts they had accumulated in the process of salvaging their banking systems. Sovereign bond yields shot through the roof, and nobody knew what would happen if a large eurozone country like Italy or Spain defaulted.
Germany's Austerity Strategy
So Berlin had a problem. The system that had worked for the previous decade could no longer function, and Germany's eurozone partners were on their last legs. In search of a new strategy to sustain the periphery, Berlin decided to expand its own blueprint for success: It would try to turn the eurozone essentially into one big Germany. This meant implementing the strong working culture and Teutonic thriftiness that had characterized the German success story, particularly since reunification in 1990.
Austerity became the buzzword as the German-dominated European Commission created stringent targets designed to return the straying countries to a sustainable model of living within their means. Bailouts were arranged for Europe's worst-off economies, contingent on stiff reforms designed to drive down wages and increase competitiveness. In the meantime, a bandage was needed to halt the sovereign bond crisis racking the economies of the peripheral states. In mid-2012, German Prime Minister Angela Merkel and Finance Minister Wolfgang Schaeuble were integral in the creation of the European Central Bank's bond-buying scheme, known as Outright Monetary Transactions, a weapon with which the bank could bluff out bond traders that had been driving the peripheral European yields skyward.
This solution has proved partially successful. Of the countries forced to take on the reforms attached to the bailouts, Spain, Portugal, Ireland and Greece have shown remarkable fiscal improvement. (Cyprus, the other bailout country, is not as far along the path to recovery, though it has shown improved signs of late.) Each has returned to growth — except Greece, which is close behind — and each has a markedly positive budget.
That said, each country continues to experience the severe pain of austerity. For example, unemployment in Spain is at 24 percent, with the International Monetary Fund predicting that joblessness will still be as high as 19 percent in 2019. Meanwhile, a visit to Portugal shows that there are a particularly high number of beggars on the streets and that many of the country's younger workers have left in search of employment in Angola, Mozambique and Northern Europe. Low inflation is particularly problematic in these countries, since it inhibits their ability to combat high debt levels, while outright deflation would further the debt crisis.
France and Italy Push Back
The main problem now lies with France and Italy, neither of which received a bailout (and thus the strong requirements to reform), but both of which have stagnated in the two years since the crisis. France's new budget postpones its adherence to fiscal deficit targets by two years until 2017. Italy's debt-to-GDP ratio is now more than double the European target of 60 percent, and it continues to rise. Economic stagnation is also preventing Italy from simply growing out of its debt. The country is not issuing more debt than in the past, but its lack of growth keeps the debt-to-GDP ratio high.
The Outright Monetary Transactions scheme, which ended the bond crisis, is facing a hearing in the European Court of Justice, putting its effectiveness in doubt. In addition to chafing against the bonds of austerity, France and Italy have also been suggesting that greater stimulus measures are needed for growth. They assert that Europe's problems — far from being rooted in high debt, the diminution of which has been Germany's priority — stem from a lack of demand, with the unwillingness or inability to spend afflicting both the private and public sectors.
Meanwhile, leaders of both countries are constrained by the surge in popularity of Euroskeptical parties. A major shift took place in August, when European Central Bank President Mario Draghi appeared to move from supporting the austerity side of the argument to the demand side. Draghi still insisted that structural reforms are needed in certain countries (in other words, Italy and France), but he also stated that fiscal stimulus would be needed from those who could afford it (Germany).
The Austerity vs. Demand Debate Intensifies
Since then, the stimulus bandwagon has gathered pace, with the European Central Bank and the International Monetary Fund, followed by the United States, taking turns to criticize German policies and urging it to spend more, both within its own borders and across the eurozone. Germany, which has just unveiled the ultimate austerity budget, breaking even for the first time in 45 years, is now seeing this achievement criticized as a vanity project.
The conservative government in Berlin has based its policies on fiscal responsibility, and the roots of German economic reserve stretch back to at least 1923, when hyperinflation left a deep scar in the collective memory. Indeed, Chancellor Angela Merkel has crafted a successful political career as the "Heidelberg Housewife," comparing national economies to households in which one cannot live beyond their means. The austerity versus demand tug-of-war, which austerity had been winning comfortably, has experienced a strong jerk toward demand, with influential players switching sides. Think tanks are now releasing studies that appear to place at least part of the blame for the Continent's low growth and low inflation on austerity. Meanwhile, Germany's economy has begun exhibiting signs that it might be entering a recession. Blue-chip companies such as BMW and Siemens recently issued sales warnings, and August's industrial production and export numbers were dire (although there are some calendar effects at play on the latter factor, with unusual holiday patterns leading to simultaneous shutdowns at various car plants).
Austerity economics is thus taking blows from all sides. The ethos of balancing the books and living within one's means is losing supporters by the week. Such a buffeting might have cowed most countries into submission by now, but Germany's attachment to its economic model runs deep. Despite the international pressure, the German mantra remains that increased competitiveness is the solution to most economic problems, and German policymakers will not change course — at least not in the short term. For Europe, Germany's strict position creates new problems. As France and Italy feel more vindicated in their resistance to austerity, they will feel more confident pushing back against the European Commission's demands to undertake spending cuts and reforms.
Elsewhere in Europe, the reformed periphery countries have become austerity's strongest supporters because they believe that it would be unfair if France and Italy were allowed to avoid the pain the periphery has had to suffer. British Chancellor George Osbourne has also been notably critical of French laxity recently — perhaps unsurprisingly, since he had linked his political reputation to austerity early on in his chancellorship (the United Kingdom's early undertaking of quantitative easing might explain its current economic strength relative to the rest of Europe). On the other side, incoming European Commission President Jean-Claude Juncker and the Polish government have separately proposed plans to raise an investment fund in Europe that could be used to stimulate demand. Both plans met resistance from Germany.
In short, Europe's battleground is set. Even if a compromise is reached this year as expected and France and Italy's budgets are ultimately accepted, the anti-austerity side has the momentum. Over time, as production figures continue to disappoint and inflation remains low, Germany will ultimately decide that spending money at home, specifically by improving the country's creaking infrastructure, is an acceptable evil, eroding the German fundamentalist position. But these changes will happen at a glacial pace. In the meantime, Germany will need to become accustomed to being berated on the world stage for its perceived intransigence.