Why Germany is the Eurozone’s biggest free rider by Pavlos Eleftheriadis @FortuneMagazine October 22, 2014, 11:41 AM EST E-mail Tweet Facebook Google Plus Linkedin Share icons As worries rise that the eurozone is slipping into recession, it’s clear Germany is doing way better than its neighbors. Today, the country has low unemployment, very low inflation, a large trade surplus and a balanced budget. By contrast, most members of the Eurozone are stagnating, while some are going through a catastrophic recession and suffering from debilitating unemployment. The German government says that its own success and its neighbors’ failures are unrelated; that poor performance is due to poor decisions. Yet, even though the policy failures are real enough, this analysis is false. Germany has for many years pursued a policy of wage suppression, which many economists have described as a competitive devaluation or ‘beggar thy neighbor’ policy. Germany’s gains in competitiveness were immediately translated to gains in trade, since the freedom of goods, services, persons and capital allowed German products to circulate freely and quickly throughout the European Union. These are the fundamental freedoms of EU law and are vigorously protected by the European Court of Justice. German policy would not have been successful without them Germany has also benefited from the fixed exchange rate that the Euro effectively secures between itself and its major European markets. This means that its export boom was not offset by a rise in its own currency. If Germany had been outside the Euro, currency appreciation would have hurt Germany’s gains. Not so in the Eurozone. While Germany has benefited so much from the Eurozone, its less successful partners are left to fend for themselves. The Eurozone lacks the automatic stabilizers that other currency unions apply among the various regions — namely, fiscal transfers such as unemployment and housing benefits, shared health care costs, or the pooling of bank risks and deposit insurance. The Eurozone also lacks the large movement of workers across state borders enjoyed by the United States, mostly due to language and regulatory barriers. These institutional features of the Eurozone have created a highly unfair economic union, which magnifies disproportionately the consequences of failure. Germany might respond, ‘Tough, the others ought to have seen it coming.” All members of the Eurozone are subject to the same competitive environment. All consented to its design by ratifying the relevant treaties. All had a chance to adjust. Yet this argument is false too. Not everyone had the same chance to adjust. As I argue in my recent article for Foreign Affairs (‘Misrule of the Few: How the Oligarchs Ruined Greece’, ) membership in the European Union has not improved the institutions of the weaker members. It has actually made them worse. When they joined the EU, Greece, Ireland, Portugal and Spain opened their borders and exposed themselves to new waves of trade, immigration and finance. Competition with other member states was meant to bring about ‘creative destruction,’ whereby inefficient firms – i.e. those who could not compete internationally – would go out of business. In order to avoid short-term hardships, the peripheral economies were set to receive large sums of EU funds by way of compensation. These funds were supposed to be invested in restructuring the domestic economies. But this happened very imperfectly. The funds strengthened those who administered them. In the absence of a strong civil service in most of the peripheral EU members, these were simply the local political classes. In small societies with weak checks and balances, the effect was transformative. This money operated as a ‘natural resources curse’. Since the money was not the result of taxation, domestic accountability for its spending was seen to be an unnecessary luxury. This situation was made worse once the Eurozone was created. With the ECB looking away, Spain, Portugal, Ireland and Greece built not only asset bubbles with cheap and easy credit (which happened elsewhere) but also opaque and politically driven banking systems. As a result, cheap credit impeded reform and damaged institutions in all the countries of the periphery. Membership in the Eurozone directed funds to wasteful investment, made cronyism exceptionally profitable, provided new incentives for political corruption and strengthened already existing hierarchies. If all the members of the Eurozone were equally strong, if they all had, for example, an outstanding and independent banking regulator, a powerful judiciary and strong internal mechanisms of accountability, perhaps these things would not have happened. Yet, they did happen. The examples of the failed banks, Bankia in Spain, Allied Irish in Ireland, and Proton in Greece speak for themselves. In Greece, in particular, the EU has stood by while the political system has been undermined by a small group of oligarchs who have illegally occupied television frequencies for 25 years. By escaping any effective regulation and controlling news and commentary for their own purposes, they have dominated political and business life and undermined the credibility of the political class in its entirety. The bailout deal with the ECB, the International Monetary Fund and the European Commission has not touched their privileges. In some of the members of the Eurozone the main legacy of the Euro is economic implosion, rising inequality and widespread corruption. This is not the result of isolated domestic failures. It is a result of collective European decision-making that misfired spectacularly throughout the periphery. The relentless pursuit of an ‘ever closer union’ made EU institutions neglect the question of the quality of this union. It is time to change course. Unless Europe addresses the deep unfairness at the heart of the Eurozone, the crisis is not going to end. Pavlos Eleftheriadis is Associate Professor of Law and a Fellow of Mansfield College at Oxford University.