As was widely expected, Germans voted to keep two-term Chancellor Angela Merkel in the chief’s tent. What was unexpected about last weekend’s national election, though, was the margin of Merkel’s victory: It was a sweeping triumph, unlike anything the country has seen since East and West reunited in 1990.
What does this mean for the eurozone and, by extension, the Canadian economy?
The politics: More of the same
Merkel’s Christian Democratic Union (CDU) and it’s Bavarian sister party, the Christian Social Union, seized about 42 per cent of the vote, coming just five seats shy of an absolute majority in the country’s Bundestag, the lower chamber of the German parliament. That might not seem like a big deal to outsiders, but coming that close to a 50+ parliamentary majority is a fantastic score in Berlin, and a feat few German politicians before Merkel have managed. This is significant, because it amounts to a resounding ratification of Merkel’s policies, including her approach to the eurozone crisis.
The second major development from last night is that the CDU’s junior coalition partner, the Free Democratic Party, failed to win the minimum five per cent of votes that guarantees a sit in Parliament. This means the chancellor will likely have to form a grand coalition with the centre-left Social Democratic Party (SPD), the same setup of the first Merkel government of 2005-2009. German voters seem to like these sort of right-left alliances, but they are awkward political creatures generally unable to pass ambitious reforms. Another reason to expect more of the same from Germany.
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The third major event of note was the swinging performance of Alternative for Germany (AfD), a newborn euro-skeptic party that came surprisingly close — with 4.7 per cent of the vote — to winning a seat in parliament. A single-issue, populist party, the AfD might not last long in the German political landscape. Its meteoric, if possibly short-lived, rise, though, signals that many Germans are quite unhappy with what they see as Berlin-funded bailouts of the eurozone’s big spenders. The AfD’s success might deter the future government from offering more generous assistance to Greece et al.
The economics: Why more of the same is bad
Germans voted to keep things as they are, but a continuation of the status quo could prove problematic for both the eurozone and Germany itself. Here’s why.
Angela Merkel’s approach to the eurozone’s crisis can be summed up in two words: “caution” and “austerity.” Let’s take a look at each one of them.
Caution: From the very onset of the crisis, the chancellor has proceeded, in her own words, “step-by-step,” confronting the various financial and fiscal blowups one at a time, as they emerged. It might sound like a sensible, careful way to do things, but many economists say it amounts to putting out fires one by one instead of coming up with a grand strategy to prevent stuff from going up in flames in the first place. It’s the same piecemeal approach former Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke initially adopted in the U.S., when they tried to tame the crisis by coming to the rescue of one ailing financial institution after another. In the end, it took a system-wide bazooka, the Troubled-Asset Relief Program, to stem the panic.
By contrast, Merkel’s drawn-out, case by case, decision-making arguably strained the nerves of investors who’d sunk their money in places like Greece, Ireland, Spain, Portugal and Italy. Fear-driven creditors would then push up bond yields for these highly indebted countries — understandably demanding higher returns on what suddenly seemed like very risky loans — and ultimately increase the cost of any rescue package. If anyone managed to calm the markets at the height of the crisis and come up with a system-wide response to the mayhem, it was European Central Bank chief Mario Draghi, who famously pledged to do “whatever it takes” to save the euro.
More recently, Germany has embraced a few eurozone-wide initiatives — such as tighter fiscal rules and the creation of a banking union — but several analysts believe the proposals are too timid to truly inoculate the eurozone from another, similar crisis or a new flareup of the current one.
Austerity: The other trademark of the Merkel way was a focus on austerity. Germany interpreted the eurozone meltdown as a fiscal crisis: Greece, Spain, Ireland, Portugal and Italy got in trouble because they spent too much. In fact, the whole mess started because the adoption of a common currency created some very big financial imbalances within the eurozone.
First, with the appearance of the euro, investors started assuming that, say, Greek debt must be as reliable as German debt. As a result, borrowing costs for Greece and the other peripheral economies, dropped significantly. This would have been fine if Greece and the others had found growth-enhancing uses for the money they could suddenly borrow so much more cheaply. But they didn’t. In Greece, these capital inflows ended up feeding an outsized government debt. In Ireland and Spain they inflated massive housing bubbles. In Portugal and Italy they allowed governments to keep limping along with their enormous public debt and uncompetitive economies.
Second, the euro also made German exports cheaper and southern Europe’s stuff more expensive: The common currency was a competitive boost for the first and a hit for the latter. While Germany’s trade balance started accumulating surpluses, its sickly European neighbours were piling up deficits that further added to their — public or privately held — debt.
And here’s the problem. Convinced that the cause of the crisis was fiscal profligacy, Merkel has been preaching restraint and practicing it at home as way of showing the spendthrifts how it’s done. A belt-tightening Germany, though, is no help to the eurozone’s periphery, which, on the contrary, needs Berlin to boost domestic demand. It would be much easier for, say, Italy to cut its public debt if Germans started buying more made-in-Italy. Imagine that: More Italian exports would create more jobs, which, in turn, equals more people working and more people getting a raise, which in turn means more taxes and fewer unemployment benefits, i.e. higher government revenues and lower expenditures.
Instead, Germany’s Finance Minister Wolfgang Schäuble has already tabled a 2014 budget that calls for fiscal restraint and a balanced budget by 2015. The SPD, which might demand Schäuble’s job as a token for participating in a grand coalition, has also publicly espoused the virtues of austerity. While the Social Democrats have at times pleaded for more leniency toward Germany’s debt-ridden neighbours, their recipe for success has so far read as a slightly watered-down version of Merkel’s compound.
But austerity could prove a bad idea for Germany itself. With the economy forecast to grow at a meagre 0.3 per cent this year and only 1.5 per cent in 2014, the country could use a little boost from the policy side. A step in the right direction will be the introduction of a statutory minimum wage, which the SPD campaigned on and Merkel later shrewdly added to her own campaign promises. That should help fatten paycheques for the estimated 22 per cent of employed Germans who toil in low-paid jobs. Still, the minimum wage reform might be not enough to really boost German consumer demand. The country’s inflation-adjusted wages, after all, have been stagnating for over a decade.
Canada: Why more of the same is bad for us too
What this all means for Canada is that a convincing resolution to the eurozone’s problems isn’t in sight. The crisis will likely continue to simmer at low heat until (a) global economic growth picks up or (b) something causes it to flare up again soon. That something could be the Federal Reserve’s tapering, whereby the U.S. central bank will start shrinking the size of its asset purchases and eventually halt them. The process is widely expected to push up long-term interest rates around the world. Europe’s vulnerable economies aren’t yet in good enough shape to be able to face significantly higher government borrowing costs, so it’s anyone’s guess what happens next.
So how would this affect us? Another eurozone downturn would be a threat to the U.S. recovery. That, in turn, could provide the type of sudden economic shock that the Bank of Canada has long been warning could transform our the housing market’s current soft-landing into an outright crash.
This is all hypothetical, of course, but not impossible.