Financial and Monetary Systems

Should Germany leave the Euro?

Michael Heise
Chief Economist, Economic Research and Corporate Development, Allianz SE
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The debate about whether Greece should leave the eurozone has revived the idea that Germany, and other similarly strong economies, would best serve the rest of the continent if they were the ones to exit the monetary union. But, though that notion may win some applause, implementing it would be shortsighted, impractical, and economically dubious.

For starters, it would not be easy to extricate Europe’s largest economy from the single currency. Any serious discussion of such an objective would cause chaos in financial markets, given the many uncertainties attached to the process.

Even more important are the argument’s economic flaws, three of which are immediately apparent. First, the proponents of a German exit put far too much faith in the power of weak currencies to fuel an economy. They argue that if Germany left, the rest of the eurozone would devalue and that this devaluation would restore growth. This is unlikely.

Before the introduction of the euro, countries such as Italy, Greece, Spain, and Portugal – and until the 1980s, France as well – regularly devalued their currencies. The result was inflation with little growth. It was precisely the painful consequences of their sliding currencies that enticed these countries to join a monetary union with Germany.

Currency devaluation can boost exports in the short term, but it also makes imports more expensive, eroding households’ purchasing power. Workers then demand higher wages to compensate. Unless the central bank is very strong and prepared to engender an economic slowdown, higher wages tend to push up inflation. The result is often a wage-price spiral that quickly offsets the competitiveness gains of a weaker currency.

Second, advocates of a German exit argue that its economy is too competitive to share a currency with weaker players like Italy, France, and Spain. This is flattering but wrong. Since 2000, France’s cumulative GDP growth has been the same as Germany’s. Ireland and Spain have done even better, despite the deep slumps they had to endure during the crisis.

Competitiveness does not depend only, or even primarily, on the exchange rate. Fundamentals such as productivity, education, research and development, and the tax system are more important. In these areas, Germany is far from being in a league of its own. On the contrary, the country will have to stop resting on its laurels and restart domestic reforms if it is to keep its strong position in the eurozone and globally. In any case, it would be absurd to rearrange the currency union every time individual members’ relative competitiveness changes.

Finally, proponents of a German exit claim that the eurozone in its current form is deeply flawed (although they usually are reluctant to provide details regarding exactly how). To be sure, the eurozone does not fully meet all of the conditions of an optimal currency area (which include an open and diversified economy, free movement of capital and labor, and flexible prices and wages). But, although the eurozone certainly has plenty of room to improve, the crisis has brought much progress in terms of integration and flexibility. The eurozone may not be perfect, but it is good enough to last.

One of the most important – but often ignored – conditions for a successful currency union is its members’ ability to agree on certain fundamentals of economic policy. Regardless of the historical and cultural differences that persist among the economic systems of, say, Italy, France, Spain, and Germany, all of these countries agree on the fundamental principles of a market-based economy. Most notably, they agree that it is the private sector, rather than the state, that is responsible for creating jobs, and that sustainable economic growth requires open product and labor markets.

In the case of Greece, these fundamental ideas do not appear to have been universally accepted. For decades, the state acted as the employer of first and last resort. Product markets were strangled by regulatory red tape, owing to the influence of vested interests. This system could persist only through sustained public borrowing. Over the last 20 years – including the period before Greece joined the euro – the country’s average annual budget deficit was more than 7% of GDP.

Greek wages and prices have already fallen sufficiently to restore competitiveness; the country now needs a framework in which private economic activity can thrive. If the conditions attached to its third bailout package help Greece move to a more sustainable economic model, then it, too, will have a future in the eurozone.

The eurozone’s survival requires, first and foremost, that all of its member countries have strong and flexible economies, which means that all of them must undertake continuous efforts to remain competitive. Wondering whether more (or less) competitive economies should leave the monetary union might be an interesting intellectual exercise. But it contributes little to the task at hand.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Michael Heise is Chief Economist of Allianz SE.

Image: The TV tower at Alexanderplatz square during sunset in Berlin, November 2, 2014. REUTERS/Fabrizio Bensch

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