Germany Knows What Doesn’t Work

Commentary, Equalization, Frontier Centre

Sometimes a research note drops into your inbox that just makes you want to reach for your tin hat, crawl under your desk and wait for the carnage to stop.

Thus it was last week, when Patrick Artus, chief economist at French bank Natixis, published a note entitled, with disarming honesty, "Germany should accept federalism in the euro zone for its own self-interest."

One has to give Mr. Artus high marks for having the courage to come over to the lions’ den in Frankfurt and market his ideas in person.

The note quite correctly argues that Germany has an interest in sustaining euro-zone demand for its exports (although the relentlessly increasing share of German exports going to emerging markets makes this argument a wasting asset). It also correctly identifies the risk to German welfare of a default elsewhere in the euro zone, and the near-impossibility of advanced economies "re-industrializing" once they have lost their industrial base. Neither point is sufficiently appreciated in Germany.

But even if some investors were sophisticated (and polite) enough to hear him out, the chance of Mr. Artus’s ideas gaining any traction among the German population or its opinion-formers in the universities and research institutes, let alone the press, is close to zero.

There is no willingness in Germany to finance any further open-ended transfers to sustain its partners’ consumption in a downturn or to share liabilities for their debts: the core competences of a fiscal union to underpin the monetary one.

Had Mr. Artus flown to conservative, euro-skeptic Munich, the chances are that he would have returned properly tarred and feathered.

It is not just that the German population is still in shock at being lied to by successive Greek governments, nor is it just the release of pent-up frustration at seeing decades-worth of transfers to the EU budget siphoned off by corrupt practices. It isn’t even down to ingrained and mythical stereotypes among the population that cast the Germans as thrifty and hard-working and all others as lazy and conniving.

Germany has a perfectly good, home-grown reason for resisting an expanded system of fiscal transfers between euro-zone states; its own one patently isn’t working.

The federal states have since 1950 been required to pay into the "Laenderfinanzausgleich," a scheme that aims to iron out the differences in incomes between rich and poor states, ensuring that the state can provide a roughly equivalent level of public services to all Germans.

The trouble for Mr. Artus is that the system is ridden with false incentives. States that receive money from the mechanism have no reason to improve their financial management, or their economic strength by structural reforms. Only one, Bavaria from the mid-1980s onward, has ever transformed itself durably from a net recipient of transfers to a net donor.

When the eastern states were first incorporated into the system in 1995, it was assumed that public and private investment would gradually strengthen their economic base and reduce the need for transfers. In fact, with the exception of Saxony-Anhalt, all of the eastern states have taken more out of the system in the past five years than between 1995 and 1999.

The performance of some of the western states is almost more shocking.

Despite being home to one of Germany’s best natural ports in an age when global and German trade have exploded, Bremen has remained a resolute net recipient. The concentration of sunset industries such as coal and steel in states like North Rhine-Westphalia may explain why it has slipped from being a net donor to a net recipient, but it does nothing to explain the persistently dismal performances of Rhineland-Palatinate, Lower Saxony and Schleswig-Holstein.

If a system so manifestly fails to work at home, among their own flesh and blood, it is only natural for Germans to assume it won’t work abroad either.

With another five years of spending cuts ahead of them as they comply with the new constitutional amendment aimed at eliminating the structural budget deficit, it’s no wonder the donor states are now challenging the system in the Constitutional Court.

It isn’t just Germany that is being forced to re-examine the way it redistributes income between rich and poor regions. In Italy, Spain and, most dramatically, in Belgium, the trend is unmistakable: the unbearable pressures put on state budgets by the financial crisis and the ensuing recession are flushing out all the hidden subsidies and transfers that governments have built into their economies in the name of national cohesion and social peace over the past six decades.

The first and best step to whittling these down to the most essential will be to tell electorates just how big they are.

This would be politically difficult, even incendiary, at the best of times. For one thing, such transfers, particularly in more centralized states, are fiendishly difficult to define (how, for example, to balance Westminster’s welfare check to Scotland against the fact that energy resources produced off the Scottish coast are taxed at the point of consumption in England?).

But democracies risk becoming completely dysfunctional if they duck such questions. It cannot be right to add a new, opaque layer of subsidies, even for the sake of European solidarity.