Photo Gallery: What Merkel's Isolation Could Mean in the Euro Crisis


Austerity Backlash What Merkel's Isolation Means For the Euro Crisis

Angela Merkel's euro crisis strategy is unpopular and she has lost a number of allies. Worse yet, French presidential candidate François Hollande has pledged a change of course from the strict austerity measures she supports. But in the end, the Paris-Berlin alliance will likely survive and austerity will continue, albeit with a few growth initiatives thrown in. By SPIEGEL Staff

German Chancellor Angela Merkel stood behind a podium at the DZ Bank at Berlin's Brandenburg Gate, gazing sullenly into the cameras. She had just received the wrong prop for a photo op, and she needed to get it out of sight as quickly as possible.

To thank her for her speech marking the International Year of Cooperatives, a gray-faced official had thrust a porcelain piggy bank into her hands -- an ugly thing with a milky sheen that appeared to reflect the very coldness said to characterize her policies.

Merkel reflected momentarily, then had the gift quickly tucked away in a box. Photos of the piggy-bank chancellor are not exactly what she most urgently needs right now. In fact, for the past few days, she has endeavored to put a more friendly face on her image as the strict belt-tightening politician who is forcing Europe to adhere to Germany's budgetary discipline dictates.

She is determined to stick by her strategy. But now when she talks about the euro crisis , instead of focusing solely on "structural reforms" and "stability," she has also started to refer to "growth" and "jobs."

Merkel's euro strategy is under fire, and she has lost one ally after the next in recent weeks. In the Netherlands, her most loyal follower, Prime Minister Mark Rutte, has submitted his resignation. In Frankfurt, European Central Bank President Mario Draghi has demanded that Merkel's cost-cutting strategy be supplemented by a "growth pact."  And in Paris, Socialist Party presidential candidate François Hollande  has announced that, if he wins the run-off election this coming Sunday, he intends to lead the European opposition against Merkel. "So many people in Europe are waiting for our victory," he said. "I don't want a Europe of austerity, where nations are forced on their knees."

North and South

Until now, the German-French axis, led by Merkel and incumbent French President Nicolas Sarkozy, has been the best reason to hope for a positive outcome to the euro crisis. But a dangerous rift appears to be looming, along with a relapse into outdated mindsets. Paris is relying on the presumed stimulating effect on the economy from additional government spending, while Berlin trusts in the dogma of tough reforms.

The differences are great, and the two main actors aren't even trying to play them down. On the contrary. Last Thursday, Merkel  underscored that the current rescue strategy is "not renegotiable." Hollande responded: "Germany will not decide for all of Europe."

This reflects differing political traditions and economic ideologies, but it is mainly an attempt to appeal to the differing moods on the Continent. Hollande has stylized himself as the hero of the south -- the defender of the Spanish, Portuguese and Italians who have had enough of pension reductions and hiring freezes, and believe that additional cutbacks will only exacerbate the crisis.

Merkel, on the other hand, speaks in the name of northern European taxpayers, who are repeating another mantra. Before additional billions of euros evaporate in the south, the Mediterranean countries should first do their homework, they say.

Viewed from this perspective, the conflict between Merkel and Hollande is also an attempt to both nurture the illusions of their respective supporters and to pretend that everything in Europe could be restored to the way it once was. It's an attempt to escape the bitter truths of the euro crisis, which is dominated by one truth in particular: If the European currency is to be secured over the long term, additional sacrifices are inevitable, both in the north and the south.

In Europe's Mediterranean regions, though, another axiom is currently popular. Political leaders in Lisbon, Paris and Madrid are saying that the situation can't be turned around by introducing an endless series of new cost-cutting initiatives. That may appear to be true at first glance, but the most recent history of combating crises in Europe paints a different picture. A number of countries on the Continent have managed to recover from severe economic crises precisely because they have unswervingly adhered to their reform policies.

Austerity Success

This has been the case with Ireland, where the budget deficit soared by 31 percent in 2010 after a number of banks ran into trouble. The country had to be rescued with bailouts, and it embraced a radical austerity  program that produced unexpectedly rapid results. Unit labor costs declined, exports rose, and the budget deficit shrank to nearly 9 percent within two years.

This success is also reflected in the country's current account balance. After a huge deficit of €10 billion ($13.25 billion), it is once again positive.

There was a similar series of events in Estonia, where the economy rapidly contracted in 2008 and 2009 and the budget drifted into the red. To balance the budget and boost the economy, the government should have devalued its national currency, the kroon, as textbooks would recommend.

But that was simply out of the question for the Estonians, who were determined to enter the euro zone. Consequently, the government cut wages by up to 40 percent, froze pensions and slashed social services. There were no protests like the ones in Greece and Spain, and unemployment sank from over 18 percent to under 12 percent.

What's more, Germany itself is living proof that their approach to crisis therapy produces results. At the beginning of the last decade, the country was considered the "sick man of Europe." Economists warned that the radical "Agenda 2010" reforms introduced under then-Chancellor Gerhard Schröder would accelerate the country's decline even further.

But the opposite occurred. The reforms of the labor market generated jobs and competitive wage agreements with German industry helped spur exports. Germany has once again become the engine of Europe's economy.

The only question is whether Germany's recovery can also serve as a model for the countries of the Mediterranean region. Merkel's critics argue that the structures of northern and southern Europe differ too greatly, making it all the more difficult to lead countries like Portugal out of the crisis.

No Alternative

In reality, though, the austerity policies have yielded the first fruits of success, as shown by the most recent data from Spain. Granted, the economy has faltered again, and the number of young people out of work has reached a record level, but the recent flood of bad news has overshadowed statistics that give cause for hope. For instance, unit labor costs, which are an important indicator of a country's international competitiveness, have continuously declined over the past two years. In return, Spain's exports are growing, with sales of Spanish red wine in Germany alone rising by 20 percent.

More importantly: There is no alternative. If Spain were to water down its austerity policy, and boost growth with new loans, the result would be particularly disastrous. Economists are convinced that this would lead to growing concerns in the markets that the government in Madrid can't bring its finances under control, and interest rates would rise.

The experts even warn that it's very possible such a growth strategy could ultimately precipitate a recession. "We don't see any possibility of boosting growth through additional expenditure," says a high-ranking representative of the German government.

The government in Berlin would thus prefer to do nothing more. The crisis-ridden countries are making cutbacks, and the euro rescue fund has been expanded. According to Chancellor Merkel and her finance minister, Wolfgang Schäuble, this means that sufficient measures have been taken to put the monetary union on firm footing. Now, they say it's up to each individual country to do the rest.

That's how the Germans see it -- but leading economists take a different view. Henrik Enderlein, an economist at the Hertie School of Governance in Berlin, says that the austerity measures introduced by the German government were the right move, "but they won't fix the euro zone's flaws."

Enderlein is sitting in a café at Berlin's Tegel Airport. He's on his way to attend a session of the Notre Europe think tank, founded by the legendary eighth president of the European Commission, Jacques Delors. The meeting in Brussels deals with an issue that is central to Europe's survival: How can the monetary union be made permanently crisis resistant?

New Initiatives in Brussels

One answer is provided by a comparison with the US, where the monetary union has worked for over 200 years, even during times of economic crisis. If a state such as California falls into a recession, the same rules apply as in Europe. The government has to cut costs, and the economy has to become more competitive.

But the Americans have an additional mechanism to help crisis-ridden regions. National systems such as federal income tax and nationwide unemployment insurance ensure that money automatically flows from rich to poor states, and this reduces the impact of economic downturns. Enderlein is convinced that such transfer systems are missing in Europe. "If we really want to save the euro, the question is not whether we need such financial transfers, but rather how we organize them," he says.

Enderlein says that he could envision a Europe-wide unemployment insurance scheme and a common financial transaction tax and/or standardized corporate tax for all EU member states. The only problem is that it will take many years before such systems can be introduced in Europe.

Countries like Portugal and Spain, which are grappling with a worsening recession, can't wait that long. Indeed, Brussels is currently preparing a range of initiatives designed to rapidly divert money from the prosperous north to the poorer south.

For instance, the European Commission is soon planning to launch "project bonds" to finance major infrastructure projects. On May 7, the day after the French presidential election, the Commission intends to present its plans. EU President Herman Van Rompuy wants to have the plan approved at an EU summit in late June.

The German government also supports the scheme as a way of financing new highways, along with energy and telecommunications networks. Olli Rehn, the European commissioner for economic and monetary affairs in Brussels, enthusiastically announced to EU parliamentarians in mid-April that "there was a breakthrough before Easter." He said the European heads of state had given the green light to pilot projects worth billions, such as building highways in Greece.

From the point of view of all cash-strapped politicians, the project bonds have the appeal that they cost relatively little to start out with. The money primarily comes from private sources. The European Investment Bank (EIB) will provide guarantees that safeguard private investors. In the pilot phase until 2013, EU funds amounting to €230 million are expected to mobilize investments of up to €4.6 billion.

Conflict Will Blow Over

The second major project designed to put an end to the EU's "ruthless austerity," as Hollande calls it, involves bolstering the EIB's financing. The EU countries plan to pump €10 billion into the bank. This would allow the EIB, which is headed by Germany's Werner Hoyer, to loan an additional €60 billion for major projects in the EU. Together with private co-investors, €180 billion would be made available, according to Rehn's calculations.

The increase in capital for the bank is already on the agenda, at least informally, for the next meeting of EU finance ministers scheduled for this week. It's already clear that Germany will contribute the lion's share.

The German government has shown a willingness to do its part. It's reportedly also examining ways that EU organizations and subsidies can be used in a more growth-oriented manner. According to sources inside the German government, instead of funding new highways, Berlin is interested in supporting innovation and programs to promote small and medium-sized businesses. To ensure that this is done as professionally as possible, the Germans would like to see the southern European countries receive their own state-owned development banks, modeled after Germany's KfW banking group. It's hoped that this will get the economy moving in Greece and Portugal.

And so it seems that the loud conflict between Paris and Berlin has momentarily eclipsed what will actually be on the negotiating table between the two countries when the French presidential election is over. That is, no change in Merkel's austerity drive, but additional growth projects for southern Europe and more power for Brussels -- yet all of it done as cheaply as possible.

Will Paris and Berlin find a compromise? This question will be easier to answer after May 6, when the current French election campaign is over. German Finance Minister Schäuble would clearly prefer to see his fellow conservative Sarkozy remain in office. But aside from that, the excellent relations between Germany and France will continue to work as well as they have in the past, regardless of who wins the election.


Translated from the German by Paul Cohen