01 May 2012

Mohamed A El-Erian: Germany’s Neighbourhood Watch

European officials need to continue to make steadfast progress in three major areas:

• improve individual countries’ domestic policy mix in a manner that targets debt sustainability through both growth promotion and deficit reduction, especially in the most vulnerable peripheral economies;
• enhance the eurozone’s internal financial circuit breakers to reduce the risk of disruptive financial feedback loops and destabilising multiple equilibria; and
• strengthen the eurozone’s institutional underpinnings, as well as its mechanisms for policy coordination and peer review.

None of these steps is easy; and they are certainly not automatic. Moreover, to maximise their effectiveness, they must be implemented simultaneously; indeed, this is a situation in which one plus one plus one equals more than three. And this will not happen unless two other, even more controversial steps are taken.

First, Germany must play an even larger role in conducting and coordinating the eurozone’s policy responses. I know that many Germans are uncomfortable with this. But there is no workable alternative for Europe’s well-being – and, therefore, that of Germany.

The European Union’s institutions still lack the authority and credibility needed to take on this role. The European Central Bank does not possess the proper structural policy tools, and it has already been forced to bear burdens that, arguably, are beyond its strictly defined mandate. And there is no other economy that comes close to Germany in size, influence and economic and financial health.

Second, the eurozone, led by a Germany that is working closely with France, needs to clarify decisively what it intends to look like in the medium term. There are two alternatives, both sensitive and controversial, and the choice is for Europeans alone to make and sustain; but they must make it if they are decisively to put behind them the risk of eurozone fragmentation.

On one hand, they can decide to let politics dominate economics... On the other hand, they can decide to allow economics to prevail. Here, eurozone members would collectively opt for a smaller and less imperfect union that includes countries with more similar initial conditions – economically, financially, politically, and socially. 

Until these difficult and controversial decisions are made, periods of relative tranquility in Europe are likely to be interrupted by the recurrent eruption of financial instability and bouts of political bickering and dithering. And the longer this continues, the greater the risk that Germany’s neighbourhood will erode the robustness of what the country has painstakingly built.

Ultimately, there can be no strong Germany without a stable eurozone; no stable eurozone without a strong Germany; and no global economic stability without both. It is time for Europeans to make the difficult longer-term choices that are critical to sustaining and enhancing their historical regional project.

Full article

© Project Syndicate