Germany’s Dilemma and the Future of European Integration

IMGXYZ4241IMGZYXThe 2009 sovereign debt crisis left Europe in a financial bind. With Greece stuck in political deadlock and Spain shackled by austerity, an economically assertive Germany has taken the lead in mobilizing Europe’s economy. Germany’s actions will significantly impact the future of the region’s monetary union as well as trade relations with China, the EU’s largest trading partner.

Carnegie-Tsinghua’s Shi Zhiqin moderated a roundtable discussion with Luigi Bonatti, a professor of economics at the University of Trento in Italy. The event focused on the implications for China of Germany’s leadership in Europe’s economy.

Understanding the Context of Europe’s Financial Crisis

• Process of Monetary Integration: Bonatti explained that economic concerns were the primary motivation behind the process of monetary integration in Europe. The core countries, especially Germany, sought to eliminate the possibility of competitive devaluations by Europe’s peripheral countries. These countries needed external constraints to gain credibility and deflate their economies while providing structure to price and wage behavior. Bonatti added that the introduction of the euro allowed the nominal exchange rates of the peripheral and core countries to converge.
   
• Root of the Financial Crisis: The origin of the financial crisis was the belief that real convergence could happen between the periphery and core countries, Bonatti said. Instead of these periphery countries establishing uniform price and wage dynamics with the rest of the eurozone, the opportunity to borrow at low interest rates generated real estate bubbles in countries like Ireland and Spain and postponed necessary structural reforms in countries like Greece and Italy. Bonatti explained that financial markets ignored this growing imbalance for years and that EU institutions could not regulate the private sector’s over-borrowing or mitigate the resulting instability. 
   
• Crisis Erupts in Europe: The global financial crisis and the Greek misreporting of budgetary data, Bonatti explained, exposed the weaknesses in the core-periphery country gap in Europe.  He recommended that the only long-term solution for Europe was rebalancing and real convergence between the core and periphery countries. However, Bonatti added, the core countries were unwilling to accept higher inflation, larger fiscal expenditures, or set up the transfers union that would be necessary to help peripheral countries adjust to the economies of core countries.

Where Europe Is Now:

• Problems of Highlo Debt and Slow Growth: The periphery remains highly vulnerable because these high debt and slow growth are closely intertwined, Bonatti said. High government debt is due to large public deficits (in Italy and Greece) or the need to bail out banks that lent heavily to the private sector (in Ireland and Spain). Slow growth resulted from the low productivity, high labor costs, and overall inefficiency that lowered the competitiveness of these countries. 
   
• Regaining Competitiveness: Bonatti recommended that the periphery can regain competitiveness through a process of internal devaluation. However, he stipulated that an internal devaluation in Southern European countries could only result from a prolonged recession and high unemployment.
   
• Role of Chinese Investment: Several Chinese scholars stated that China was investing more resources in Europe and already pledged to buy more European bonds in an attempt to solve the fiscal crises. Shi said that the EU was China’s largest trading partner, while China was the second-largest trading partner of Europe. However, Bonatti questioned whether Europe would continue to remain committed to free trade, free competition, and free enterprise when faced with increasing anti-market and protectionist sentiments. A Chinese scholar raised questions about Germany’s determination to stay in the EU and whether Germany could continue to bail out Europe at the cost of its own domestic economic competitiveness. A German diplomat responded that Germany was committed to continuing investments in Europe, driving down inflation, and further integrating Europe.
   
• What’s Next for Europe: Bonatti stated that the fiscal austerity implemented in most European countries would ultimately be self-defeating. He explained that the political system had low legitimacy and traditional political parties had lost credibility due to the growing populist and anti-European forces. As a result, these countries will not escape the recession anytime soon, leaving the future of the euro at risk. He concluded that the most important priority is to reduce this risk and focus on recovery in the periphery. China, Bonatti added, could help by rebalancing its own economy toward domestic consumption and Germany could help by letting wages rise faster. A French diplomat highlighted that Europe needed to focus on politics first in order for Europe to overcome the crisis.