Two Down, Two to Go?

Germany today already has in place the first two components of what fed Japan's decline a decade ago--incomplete financial liberalization and an uncoordinated deflationary macroeconomic policy--compounded by a stock market crash and the economic slowdown needed to set the full declinist syndrome in motion. What, then, of the third element? Are German households sufficiently passive financially and politically to allow this process to gain momentum? Yes, they are.

On the political side, reunification has diversified and fragmented the composition of the German workforce, and both the pork-barrel benefits of government programs and the protections of government regulations have become more narrowly distributed as a result. Demands for protection from the sustained growth slowdown, declining employment in some manufacturing sectors (as in Japan, these are the most efficient and export-competitive businesses in Germany, while backward sectors retain unneeded employees), and the rising number of long-term unemployed have reinforced a change in Germany from dispensing mostly universal benefits to more targeted interest-group rents. (Mancur Olson was perhaps right to argue in The Rise and Decline of Nations [1978] that economies become sclerotic over time because rent-seeking groups accumulate.)

Notably, there are fewer traditionally unionized workers, but the relative benefits of being such a worker versus working elsewhere or being unemployed have increased. This development allies long-term German employees and uncompetitive companies in efforts to maintain the status quo and to protect specific businesses--and the protection of those businesses includes maintenance of their credit lines from either state-supported or uncompetitive banks, just as in Japan. Meanwhile, the long-term unemployed, particularly in the former East Germany, with little hope of good union jobs, have no interest in challenging the system of protections so long as the unemployment benefits and regional public-works keep coming.

Thus, as in Japan, Germany now has special-interest blocs that exploit the average German and that are capable of vetoing change. Meanwhile, ECB decisions on monetary policy, and those of the European ministers on the Stability and Growth Pact's fiscal rules, are so far removed from democratic control, let alone anything German voters can directly effect, that the decision-making process itself feeds political passivity about macroeconomic policy. And in contrast to all the German national elections since the mid-1960s, the September 2002 election offered little choice to voters on economic and social policy between the two major parties' platforms. Unsurprisingly, turnout was down, the electoral shares of the SPD and the CDU/CSU differed by only tenths of a percentage point, and political cynicism rose sharply. As in Japan, the average German voter is less willing and less able to hold policymakers accountable for economic performance.

On the financial side, too, recent events have taken a toll on German savers' willingness to move their capital out of German banks, or out of Germany altogether. The privatization of Deutsche Telekom in 1999 was meant to be the founding act in creating an Aktienkultur (stock-holding culture) in Germany, and the creation of the Neuer Markt and a unified Deutsche Borse was meant to take advantage of this increased demand for equities, deepening the market. At peak, however, only 10 percent of German households held stocks or stock funds, even after these initiatives. Unfortunately, the telecoms collapse has imposed huge losses on Deutsche Telekom shareholders in a very short time, and for many Germans this was their first and their major, if not their only, stock holding. Those few who took speculative risks on "new economy" stocks in the Neuer Markt were similarly burnt, and are now held up as cautionary examples. Many wealthier Germans had moved savings abroad to secret accounts in Luxembourg, Switzerland an d other centers of bank privacy, but on December 16, 2002, Chancellor Schroder announced a new combined flat tax on savings interest and a temporary tax amnesty to bring those funds home. Average Germans, particularly the elderly, share with their Japanese counterparts an aversion to risking their money abroad--or even anyplace beyond the neighborhood savings bank.

Corporate governance scandals in the United States have further reinforced popular German suspicions about financial speculation. And this most inopportune increase in risk aversion and bank dependence in Germany happens to coincide with EU efforts to integrate Europe's banking markets, open Germany's corporations to hostile takeovers and remove the privileges of the Landesbanken. Germany's uncompetitive public banks and small businesses dependent upon those banks for credit are taking advantage of this fortuitously timed (for them) bad press for "Anglo-Saxon finance capitalism" to pressure their government to resist such liberalization. So Germany appears to be following Japan on the third step to the path of perdition, financial and political passivity in response to the first two steps.

Will Germany's greater openness, then, save it from the proverbial pot? That depends upon the actions of the EU, and right now those are mostly heading in the wrong direction. The European Union's constitutional convention, led by former French Premier Valery Giscard d'Estaing, has sought to enhance the power of the nation-states--particularly of the largest states in the EU, France and Germany--vis-a-vis the European Commission and Parliament in the face of Europe's expansion to include ten countries from the east. This statist approach increases the likelihood of German economic decline in four ways.

First, weakening the European Commission will impede Brussels' independent efforts to push liberalization (including of banking) on unwilling European governments.

Second, by making decision-making in the EU more akin to that in the U.S. Senate, horse-trading and logrolling will promote national champions and bailouts rather than healthy compromises.

Third, stunting the development of the European Parliament to promote rule by national ministers will magnify the EU's democratic deficit, making citizens in Germany and elsewhere still more passive about economic policy.

Fourth, the premium placed on state leadership, with France at the forefront, will make establishing a separate EU identity--including a foreign policy divergent from that of the United States--the priority rather than internal development and international integration.

Combine these effects with the likely combative and retrogressive response of the ECB to any political measures that the Council of Ministers might undertake, and Germany ends up fulfilling all four steps to Japan-style stagnation.

U.S. Policy Options

THERE IS room for the U.S. government to forestall such a development in Germany and in Europe, and good reason to do so. Expanding growth in the major economies should be a U.S. foreign policy priority. We have already seen the damage done to American interests in East Asia by Japanese stagnation: withdrawal of Japanese export demand, credit, technology transfers and investment from the region; economic contraction in 1997-99 throughout those markets, reducing living standards and shifting cheap exports to the U.S. market; post-crisis political instability in Indonesia and varying degrees of increased anti-Americanism from Malaysia to South Korea as a result of scapegoating "failed" U.S./IMF policies; resistance to further multilateral trade liberalization and economic integration; Japan's withdrawal from international leadership even as a donor or soft power; and the enhanced opportunities for China in the region as a result.

We can ill afford a similar destabilizing sequence taking place among the NATO members of eastern Europe, along Russia's border, and in Turkey and North Africa. That is, however, what will happen if the German economy does become the next Japan. And it is likely to cause problems worse than those of East Asia for three reasons. First, global economic distress cumulates both directly and politically-if we add German decline and east European or Mediterranean economic instability to that already incurred in East Asia (and occurring in Latin America), the effects on global growth will be multiplied, and the political reaction against market economics will increase. Second, Germany is more geopolitically influential than Japan because its economy is more integrated with those of its neighbors, it plays a significant role as a NATO member, and it has generally played a large role in supporting U.S. multilateral initiatives (the obvious exception being treatment of Saddam's Iraq).

Third, the timing is very dangerous. The U.S. economy is no longer growing as fast as it was during the Asian financial crisis, and cannot afford to take in its current level of imports indefinitely, let alone increase it from emerging markets even as it readies a war budget. Yet formerly liberalizing but now economically frustrated governments throughout East Asia, Latin America and, if Germany goes, eastern Europe are looking for additional evidence to use in blaming their economic travails on Western indifference or laissez-faire processes.

Thus, while security goals may indeed be ultimately more important than economic ones for American national interests, as the Bush Administration proclaimed upon entering office, the economic policies of the United States and its allies are critical to achieving those security goals. Preventing Germany from going farther down Japan's path should be the primary U.S. foreign economic policy priority, and one of the main U.S. security priorities overall. There are four steps that the United States can take to pursue this priority.

Practice reverse linkage. Making Germany's and other allies' economic policies a security goal means linking progress on this front to U.S. cooperation in other issue areas, rather than artificially separating "high" and "low" politics. This reverses the nature of the economic linkage in the days of U.S.-Soviet detente where political concessions by the Soviets were rewarded by trade deals. Japan has demonstrated how a country that runs a trade surplus and keeps vast national savings at home will not be constrained from pursuing deflationary policies that are harmful well beyond its own borders, and there is little direct economic leverage the United States can bring to bear upon such a country. U.S. policy under both Presidents Clinton and Bush has been able to move Japanese economic policymakers when broader diplomatic and security concerns linked Japanese economic decisions to other things desired by Japan. So why not Germany as well?