A bargain, forged in the fires of 2012's economic emergency, has defined the European Union for the past two years. It was an agreement made between two sides that can be defined in several terms - the center and the periphery, the north and the south, the producers and the consumers - but essentially one side, led by Germany, provided finance, while the other, fronted by Spain, Portugal, Ireland and Greece, promised change. In order to gauge this arrangement's chances of ultimately succeeding, it is important to understand what Germany was hoping to achieve with its conditional financing. The answer to that question lies in Germany's own history.
Last week, the Governing Council of the European Central Bank's monthly meeting left financial markets feeling frustrated. Instead of announcing the beginning of a highly anticipated bond-buying program known as quantitative easing, the European Central Bank, or ECB, only slightly changed the vocabulary it used to describe its plans: "We expect" became "we intend." Pulses did not race with excitement.
In fact, the most interesting news of the day was that seven of the 22 members of the council apparently voted against the change in vocabulary. Those opposed included four governors of national central banks and three of the EU executive board's six members, who, in theory, are responsible for shaping ECB policy. This ongoing debate over finances is deeply important to Europe's future because it touches on a key question at the heart of the European project: Is Germany willing to underwrite the whole venture? Germany gave a partial answer to this question in 2012 when it financed the EU rescues of several member states, but the conditions it attached have since created more problems.
The trouble began with 2008's economic crash and peaked four years later with a sovereign bond crisis. Germany reacted by creating various mechanisms and funds to bail out stricken countries, including Outright Monetary Transactions to safeguard sovereign bond prices. In return, the bailed-out nations had to enact painful changes to increase their competitiveness - at a lifestyle cost to their citizens. The rest of the union had to commit to financial reform by signing the European Fiscal Compact. With these conditions, Berlin hoped to bring the rest of Europe through a process Germany had already undergone.
The Makings of an Economic Miracle
After the Second World War, Germany found itself occupied and split in two. It was positioned in the middle of a continent that feared it, and its economy had been wrecked by 30 years of war and turmoil. Militarism had failed repeatedly and spectacularly. Germany needed a new ethos, so it returned to its roots.
Before the German unification of 1871 set the new nation on a course to its own demise, the great behemoth known as the Holy Roman Empire had stretched across Central Europe for over a thousand years, from 800 to 1806. It was a patchwork of states varying in size. Some were ruled by princes while some were independent cities, but all owed ultimate allegiance to the Holy Roman Emperor, whose real power over his vassals was paltry in comparison to that of the French kings or Russian tsars at his flanks. The Holy Roman Empire was a network of Germanic peoples, where no unit was powerful enough to militarily dominate its neighbors or to truly unify the region into a single state. The result was a competitive market where each princedom, duchy and city's survival was largely based on its own efficiency and resources, along with those of any peers with which alliances were formed. Local resources were leveraged, and skilled craftspeople trained through lengthy apprenticeships, forming guilds that created products recognized for their excellence across the Continent.
In the 13th century, a group of these states came together to create a trading federation centered on the northern cities of Lubeck and Hamburg. This federation, which originated in modern Germany and expanded to cities on the coasts of what is today Latvia, Estonia, Poland, Sweden and the Netherlands, came to be known as the Hanseatic League. The league dominated the North and Baltic seas in a manner reminiscent of the Romans in the Mediterranean a millennium before, but Hanseatic power was very much based on trade rather than force. The league's gigantic ships brought raw materials, including timber and grain, from its eastern members to ports in England and carried shipments of cloth and manufactured wool to Novgorod, Russia, on return voyages.
Meanwhile, German industry grew in the center of the web. Family connections and close relationships were used to create a reliable and efficient network that lowered transaction costs to great effect. "Made in Germany" became a trademark that carried great weight in 16th-century London. But ultimately, the discovery of the New World proved to be the Hanseatic League's death knell because the resulting shift in trade routes made having an Atlantic coast a requirement for success. The final meeting of the league took place in 1669.
Prussia rose in prominence during the industrialization period that followed the end of the Holy Roman Empire. The strong Prussian bureaucracy and its military power combined with the diplomatic genius of Otto von Bismarck to finally bring about a unified German state. But the economic strength of the new country and its precarious position on the North European Plain made war inevitable. The next 70 years saw this play out with great destruction.
When West Germany turned to competitiveness, trade and exports as the solutions to its woes in 1948, it was returning to ancient strengths. That year, future German Chancellor Ludwig Erhard led the drive to introduce a new currency because he felt there were far too many reichsmarks in the system and that this was harming the economy. He proposed the deutsche mark, a new currency that ultimately reduced the money supply by 93 percent. The deutsche mark propelled the economy forward and provided an early boost to exports, but the switch also caused a substantial reduction in the net wealth of many people.
The next thing Germany needed was a stable market, and in 1951, the European Coal and Steel Community - the European Union's predecessor - was formed. For France, Germany's primary partner in this venture, the attraction was obvious. By joining the European project, France, which had been invaded by Germany three times in 70 years, could shield itself from German attacks and position itself to take a leading role in Europe's development. Germany, meanwhile, obtained a tariff-free market for its products, and the close alliance with France allowed it an influential, yet less menacing voice. The new arrangement had immediate results. German exports as a percentage of output rose from 8.5 percent in 1950 to 14.6 percent in 1960 and even higher to 27.6 percent in 1985. If services are taken into account, exports today make up 50 percent of Germany's gross domestic product, one of the highest such percentages in the world. Moreover, German excellence in mechanical, electrical and chemical engineering, in addition to a strong automotive sector, turned the country into a trade juggernaut. Just as the Hanseatic League did, Germany found a target market in the rest of Europe and proceeded to outcompete it, becoming even more powerful after reunification in 1990.
The Euro Shakes Things Up
For a long time, Germany functioned well in its role, but trouble emerged with the creation of the euro in 2000. A common currency removed the only real defense the other European countries had against the German trade machine: the ability to devalue. Plus, the euro was cheaper than the deutsche mark had been, making German exports even more competitive on the global stage and contributing to further efficiency gains. The extent to which Germany outcompeted its neighbors in this period is reflected by current account balances - by 2008, Germany had a surplus of 5.8 percent of GDP while Ireland, Portugal and Spain had deficits of 9.4 percent, 12.1 percent and 9.6 percent, respectively. When periphery countries were forced to reconcile these current account deficits with the post-2008 economic realities, it led to debt explosions that contributed to the 2012 euro crisis.
Germany found itself in danger of being pulled under by its own market. Its response was simple and predictable: It would put its peers through the same process it had undergone. All of Europe would be reformed and brought into a modern day Hanseatic League, ready to export their products competitively, just as Germany did. It is no coincidence that around this time, talks began on a new trade agreement with the United States known as the Transatlantic Trade and Investment Partnership. A larger league would need a substantial external market with which to trade.
But the power that allowed Germany to impose these reforms was fleeting. Only the countries that had asked for bailout money - Portugal, Spain, Ireland and Greece - could be forced to take the medicine. France and Italy faced less pressure to reform because they had avoided bailouts, and they were harder to bully because of their relative size and importance.
Now, two years after the crisis, the divergent results are beginning to show. The bailout countries have suffered greatly from the austerity measures, but there are signs that wage decreases and spending cuts are increasing their competitiveness and beginning to turn them around. Spain celebrated a record month for employment gains in November (though with unemployment at 24 percent, there is clearly still a long way to go), and Ireland is forecast to grow by 3.6 percent next year, making it the fastest-growing country in Europe. France and Italy, by contrast, have not reformed, and their economies have stagnated as a result. Furthermore, the European Commission's failed attempts to enforce the Fiscal Compact and change French and Italian behavior have exposed the weaknesses in Europe's institutions.
Germany Cannot Do it Alone
In particular, France's shift from central power to problem case presents a huge issue for Europe. In a continent with a long history of central powers attempting total domination, there is a deep mistrust of allowing a single player too much control over the rest. The Franco-German alliance mitigated this danger, allowing their joint pronouncements to represent the voice of Europe in a non-threatening way. But now that France is diverting from the German course, Berlin finds itself having to make difficult decisions alone. The latent fear across the Continent, however, constrains Germany's ability to enforce its decisions.
