Europe’s fate depends on…

Germany.

Financial meltdown has been averted in Europe – for now. But the future of the European Union and the fate of the eurozone still hang in the balance. If Europe doesn’t find a way to reactivate the continent’s economy soon, it will be doomed to years of gloom and endless mutual recrimination about “who sabotaged the European project.”

European growth is constrained by debt problems and continued concerns about the solvency of Greece and other highly indebted EU members. As the private sector deleverages and attempts to rebuild its balance sheets, consumption and investment demand have collapsed, bringing output down with them. European leaders have so far offered no solution to the growth conundrum other than belt tightening.

The reasoning seems to be that growth requires market confidence, which in turn requires fiscal retrenchment. As Angela Merkel puts it, “growth can’t come at the price of high state budget deficits.” 

But trying to redress budget deficits in the midst of a collapse in domestic demand makes problems worse, not better. A shrinking economy makes private and public debt look less sustainable, which does nothing for market confidence.

So Europe needs a short-term growth strategy to supplement its financial-support package and its plans for fiscal consolidation. The greatest obstacle to implementing such a strategy is the EU’s largest economy and its putative leader: Germany.

If Germany wants the rest of Europe to swallow the bitter pill of fiscal retrenchment, it will eventually have to recognize the implicit quid pro quo. It must pledge to boost domestic expenditures, reduce its external surplus, and accept an increase in the ECB’s inflation target. The sooner Germany fulfills its side of the bargain, the better it will be for everyone.

Read the full article here.

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