On December 8, 2008 Gordon Brown, Nicolas Sarkozy, and EU Commission President José Manuel Barroso met in London to discuss how to prevent the current financial crisis from turning into an economic depression. Notably absent from this conference was Germany’s Chancellor Angela Merkel (CDU), leader of Europe’s largest economy, the world’s biggest exporter, and the European Central Bank’s heavyweight. Both Merkel and Peer Steinbrück (SPD), Germany’s finance minister, have been staunch opponents of an American-style fiscal stimulus: short-term government spending or tax breaks targeting consumers to raise aggregate demand. Both have resisted calls for a European Union-wide fiscal package, reflecting fears in Germany that this would allow other European states to run deficits in excess of the EU’s Stability and Growth pact.

Merkel and Steinbrück’s stance is part of a broader opposition among German economists to fine-tuned, Keynesian demand management, one that is rooted in Germany’s historical experience with fiscal policy. The three most significant events of Germany’s 20th century were accompanied by government deficits that led to harmful inflation and currency reform: World War I and the hyperinflation; World War II, and the accompanying hidden inflation; and more recently reunification, federal deficits, and the recession in 1992. While the former two events have certainly been a cause of Germany’s cautious monetary policy, I want to discuss here how Germany’s post-1945 experiences with deficit spending have led policy-makers to steer clear of Keynesian anti-cyclical demand management.

The highest priority of Germany’s Social Market Economy, the theory of political economy erected after World War II to guide German policy-makers, has been setting the economy’s institutional framework. In the 1950s Ludwig Erhard and the Freiburg economists envisioned that the Social Market Economy (SME) would guarantee long-term economic growth by establishing proper ground rules for competition, industrial organization, re-distribution of wealth, and infrastructural development. With this framework in place, so they hoped, the market would correct itself during swings in the business cycle. The state should stabilize production, not provide consumption. Direct involvement in the business cycle was to be more the purview of monetary rather than fiscal policy. West Germany’s earliest post-WWII economists saw the SME’s instruments as “alternatives to Keynesian counter-cyclical fiscal and budgetary policy.”

This outlook changed in 1967 with West Germany’s first real post-WWII recession, when the federal government invested in infrastructure and unemployment benefits as way to combat the downturn. A new belief in managing the business cycle persisted throughout the 1970s, spearheaded by economics minister Karl Schiller and bolstered by his relative success in overcoming the 1967 recession. But in 1982, after a decade of stagflation and a burgeoning federal debt, the new Kohl government moved away from Keynesian demand management, refocused on stabilizing production, and called for a reduction in the federal debt. This return to the core tenets of the SME remained the guiding principle behind economic policy throughout the 1980s.

Yet in the early 1990s the newly unified Germany faced a unique fiscal situation that required massive federal deficits. In 1991 and 1992, with the hopes of raising the productivity of former East German workers, Germany ran large federal deficits in transfer payments and infrastructural investment in the former East. High expectations for a quick convergence of East Germany’s economy with West Germany were not met. Instead, overinvestment in the construction sector, rising prices, high interest rates, the recession in 1992, and the threat all of this posed to EU monetary unification left a bad taste for fiscal stimulus among many German economic thinkers. (For more on this see the discussion on the H-German network from December, 2008.)

What lessons were learned from Germany’s deviation into demand management during the late 1960s and 1970s and its reunification experience? By and large the majority of German economists in the 1990s and early 2000s concluded that demand management was ineffective and even harmful. According to Horst Siebert, member of Germany’s Council of Economic Advisors from 1990-2003, government demand accounts for only 20% of aggregate demand, meaning that any stimulus could never be that large to begin with. Consumers, if they expect future tax hikes to pay off the federal debt, would be more likely to save any stimulus than to consume it. Siebert also maintains that long-term growth requires long-range planning to cultivate production, not short-term stimulus to demand. Moreover, the fiscal deficits of the 1970s and the 1990s left Germany with an immense federal debt, which now stands at roughly 1.5 trillion euros. Peer Steinbrück, commenting on Germany’s fiscal policy in the 1970s, remarked that “government debt rose, and the downturn came anyway.”

Some would argue that Germany’s budget surplus in 2007 proves that the political system can in fact carry through the difficult policy of raising taxes, reducing spending, and running a surplus when called for by Keynesian counter-cyclical theories. But the surplus of 2007 was unexpected. Until 2006 there had been an erosion of confidence in the government’s ability to actually run a balanced budget, much less a surplus, during periods of economic growth. Germany’s public debt has risen consistently since 1970, from roughly 20 percent of GDP to over 60 percent in 2004. Throughout the first four years of this decade Germany’s deficit exceeded the EU’s three-percent limit or was only barely below it. These deficits arose less from spending sprees than from a consistent over-optimism of tax revenue and failure to incorporate extraordinary expenditures into the planned budget. Steinbrück did not expect to achieve a surplus until 2010. Germany achieved one in 2007 more because of a beneficial business cycle – more employed workers and higher corporate profits meant lower unemployment payouts and 5.7 percent more federal revenue than the previous year – than because of the new, higher tax rate. Indeed, the federal government still runs a deficit, one that is offset by surpluses in the German states and the social insurance system. Germany’s history, before 2007, of failing to balance its budget can explain why its policy-makers are leery of giving other EU states too wide an opening to run up their own public debts during the current crisis.

The framework of the Social Market Economy, the lessons drawn from the 1970s and reunification, and the lack of confidence in the state’s ability to balance the budget are all reasons why Merkel, Steinbrück and others across the political spectrum are reluctant to pursue an American-style fiscal stimulus. Yet, as Paul Krugman points out, these are not normal times. If Germany and the EU find themselves in a liquidity trap like the US, monetary policy will not be able to fend off a recession. 2009 could be the world’s worst downturn since 1929. In the coming year Berlin foresees a contraction of German GDP by 2% and the OECD expects at least 700,000 Germans to lose their jobs. A country as highly dependent on foreign trade as Germany, especially with its neighbors in Europe, cannot afford to stand idle while others move ahead with a stimulus plan. January will see German politicians come together at the party and the state levels to address these issues. Merkel and Steinbrück need to move beyond the SME’s long-standing opposition to demand management, realize that the 1970s and the 1990s are not the same as today, recognize that many industrial countries have debt-GDP ratios similar to Germany, and put their weight behind a coordinated, EU-wide plan to deal with this economic crisis.