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Germany Tried to Remake the Eurozone in Its Own Image. The Trouble Is, It Half-Succeeded

The eurozone only just made it through the last worldwide economic crisis. Has it got what it takes to survive the next one?

At first glance, the question seems alarmist. Labor markets are still robust; wage agreements are rising at their fastest pace since 2013, and years of easy money from the European Central Bank have allowed banks to whittle away mountains of bad debts and made it possible for credit to actually flow to where it’s needed.

But the risks facing the region are still daunting.

The most obvious of them is the U.K.’s Brexit, which could see the implosion of a market that took 12.1% of eurozone exports last year. (China took only 8.6%, according to analysts at Berenberg Bank.)

Germany, the eurozone’s engine room, has woken up late to the threat, but the Federation of German Industry now says a “no deal” scenario, in which the U.K. leaves the EU on April 12 without any transitional arrangements, would take half a percentage point off German economic growth this year. Clemens Fuest, one of the German government’s “Five Sages,” said on Monday Brexit “could be the straw that breaks the camel’s back” and tips Germany into recession. Chamber of Industry and Commerce Head Eric Schweitzer notes that some 750,000 jobs in Germany depend directly on exports to the U.K.

That would have knock-on effects elsewhere at an awkward time: France’s manufacturing sector has been shrinking since the start of the year, and Italy’s since October.

The next great threat is an escalation of the U.S.-China trade war, where a rise in one or both countries’ import tariffs would hit all global trade, not least the cars that German companies currently export from their U.S. plants to China.

Of course, both Brexit and the trade war could end benignly. But both are scarier for the mere fact that they are beyond the control of the Europeans themselves.

ECB Governing Council Meets As Eurozone Slumps
Draghi has tried to convince markets that the ECB still had enough tricks up its sleeve to cope with a crisis, but the market hasn’t been buying it. Thomas Lohnes—Getty Images
Thomas Lohnes—Getty Images

That the eurozone is so vulnerable to these outside forces is largely due to the wrenching structural change that Germany and its mainly northern European allies forced on the monetary union during its last crisis. Until 2008, the currency bloc had run a broadly balanced current account with the rest of the world, albeit one that masked enormous imbalances in trade within the zone. But the austerity policies imposed on Greece, Ireland, Portugal, Spain and Cyprus crushed import demand, and essentially remade the eurozone in Germany’s image, relying more on exports than domestic consumption to generate growth. After repeated efforts by Beijing to raise domestic consumption, China’s imports of goods and services are now roughly equal to its exports, whereas it used to run a surplus of over 10% of GDP. By contrast, the eurozone’s current account surplus of over $400 billion is now the largest of all the world’s major economies, an estimated 2.9% of GDP this year.

That leaves the well-being of the continent to a large degree in the hands of foreign consumers—and foreign central banks.

The natural response to a foreign-induced slowdown would be to use fiscal and monetary policy to stimulate domestic demand. In France, President Emmanuel Macron has tried to do just that by buying off the Yellow Vest demonstrators, who have taken to the streets regularly for months to protest squeezed incomes and generally vent at the ruling class. However, Germany’s government recently outlined plans that foresee another four years of zero budget deficits and only tiny increases in public investment—even though the negative yields on German debt mean investors would effectively pay for the privilege of upgrading its infrastructure.

Meanwhile, the EU Commission is doing everything it can to stop Italy, the region’s third-largest economy, from loosening fiscal policy any further as it tries to escape a low-growth doom loop. Italy was in recession through the second half of 2018 and manufacturing activity shrunk at its fastest pace in five years in March, according to research firm IHS Markit.

The Paris-based Organization for Economic Cooperation and Development warned this week that Italy’s public debt would rise to between 144% and 156% of GDP by 2030—far above the level of Greece’s when it descended into crisis in 2010.

None of these factors are brand new, but at least in the past, the eurozone has been able to count on an effective central bank that has, in the words of its President Mario Draghi, done “whatever it takes” to keep the show on the road. But the ECB is bumping up against its limits when it comes to stimulating the economy. It risks going into the next downturn with its key interest rate already at -0.4%, after abandoning tentative plans to exit a crisis-era policy of negative interest rates last month. By contrast, the U.S. Federal Reserve will have the luxury of cutting rates from at least 2.5% when the current tightening cycle ends.

In a speech last week, Draghi tried to convince markets that the ECB still had enough tricks up its sleeve to cope. But for the second time in a month, the markets reacted to his reassurances with a sharp sell-off.

When Draghi steps down at the end of October, the safest pair of hands in the region will be gone altogether. If Brexit and the trade war with China haven’t cleared themselves up by then, his successor will have an almighty challenge on his or her hands.