Angela Merkel's Approach to the Financial Crisis

German Chancellor Angela Merkel has every reason to feel besieged these days. Critics at home and abroad are lashing out at her for what they say is a slow and tepid response by Europe's most powerful economy to the worst global recession in decades. Speaking at a national congress of her Christian Democratic Party in Stuttgart last week, she rejected a growing faction within her party, in the German media and among the country's economists calling for a heftier round of tax cuts and government spending. "We're not going to participate in this senseless race for billions," she insisted. "We have to have the courage to swim against the tide." Just days earlier, she'd told the German Bundestag that she was "deeply concerned" that the policy of cheap money and massive bailouts pursued in the U.S. and elsewhere risked repeating the very mistakes that precipitated the crisis.

Merkel's concerns, echoed by her powerful finance minister, Peer Steinbrück, could be words of wisdom—or reckless hedging amid an unprecedented crisis. In Washington, London and Beijing, governments are taking the line that this downturn requires extraordinary policies, and have passed a plethora of spending programs they say will help their citizens and companies weather the recession. The Germans lead a much smaller group of countries, including Poland and Denmark, that don't deny the depth of the crisis, but weigh the costs of spiraling government outlays higher than their possible benefits.

With the crisis like a fog before us, the jury is still out on who is right. What is certain is that this isn't just a dispute over the effectiveness of policy. It has turned into a fight over influence and money, pitting Merkel and her allies against the leaders of France, Britain and Italy, who are calling for German help (and treasure) for a more muscular European response.

The debate over what to do raged as the news turned from gloomy to outright frightening last week: in America, the service-sector business activity index dropped to a level that suggests GDP is contracting at a rate of 3 percent a year and jobs are disappearing at a rate of more than 650,000 a month, according to London-based Capital Economics. The euro zone's economy is already in a steep recession and is now expected to shrink at a 2.7 percent annualized rate next quarter. As the emergency bank bailouts and interest-rate cuts have so far failed to wind their usual way through the financial system, United Nations chief economist Rob Vos now thinks it is possible that world output could contract in 2009, the first global decline in 80 years. Even the OECD and the IMF have abandoned their usual talk of fiscal sobriety. Now, they are urging the world's governments to flood the markets with an economic stimulus.

But Germany is pushing back against this strategy. On the day Merkel was speaking in Stuttgart, the politics behind the stimulus debate were in full swing at the meeting of Europe's finance ministers in Brussels. According to one of those present, the Germans shot down a call by Italian Treasury Minister Giulio Tremonti for its partners in the euro zone to help finance Italy's mountain of national debt, the world's third highest at 107 percent of GDP. The result of decades of bad governance and failed reform, that debt has suddenly become more expensive to finance, with the risk premiums for Italy and other weak EU economies like Greece rising sharply in recent weeks. "They must be kidding," the German delegates said among themselves, according to the person there.

The Germans get some support for their position from the Danes, who lashed out at Gordon Brown's 2.5 percent cut in the value added tax for 13 months to encourage Brits to shop, saying it was "one of the five worst ways to boost the economy." The Danes did not say what the other four were, but presumably they included a French proposal, also rejected by the group, to eliminate the VAT for hairdressers and cafés.

The biggest pressure to do more, however, has come upon the Germans. The country is, relatively speaking, in a sweet spot: it has no credit or housing bubble, employment has held up astonishingly well, and its public budgets are balanced. "The Germans have much more firepower in their policy arsenal than almost any other government in Europe," says Paul Hofheinz, president of the Lisbon Council, a Brussels think tank. But the Germans say they are now getting punished for having balanced their budget when deficit spenders like Italy and France come to them for aid. They have also cobbled together their own package of what they say will be stimulus, a €31 billion list of assorted measures, including higher child-care subsidies and bigger write-offs for corporate investment, scheduled to be passed by the Bundestag this month. Economists and Germany's opposition Free Democrats say that few of these measures will actually impact spending, and are partially offset by scheduled hikes in payroll and other taxes. Steinbrück, however, has steadfastly refused to get into "a bidding war over who can do the most."

Merkel's focus so far seems to be regulation—plans for a Kyoto-like international accord on what she calls a "new global financial architecture." Behind the scenes, she has worked hard to help bring China, India and other powerful newcomers into the global concert of economic powers. While this would be a vital prerequisite for any future multilateral order, it's not clear what this does to help with the crisis now, nor is it clear how any such accord would avoid the usual problem of regulation: that it deals with yesterday's problem, but does little to address the problems of tomorrow. The Germans, for example, have been obsessed with hedge funds, which have not played a central role in the crisis.

There is another part of the picture where the Germans might play a role. Merkel has rightly noted the global imbalances that helped bring about today's problems, usually referring to the vast U.S. trade deficit and its overspending, overindebted consumers. But Germany, along with China, is the chief beneficiary of the global boom in consumption and investment, yet its own population's consumption has been anemic for a decade. Now that U.S. consumers are cutting back their spending and paying off their debt, the slack in demand can only be picked up if consumers in places like Germany start buying. Policies that shift spending power to German and other surplus countries' consumers, such as tax cuts, might be one part of the rebalancing of the post-crisis global economy.

Merkel's course is entirely understandable. With an election in September, a big tax cut or spending boost now would ruin her administration's proudest (and, her critics say, only) major accomplishment: balancing Germany's budget. If she cuts taxes now, she and Steinbrück risk looking ineffectual once the predicted rise in unemployment hits early next year, well before the election. Any additional stimulus passed now also risks disappearing in voters' minds—especially once Barack Obama's planned $700 billion spending spree, which dwarfs anything the Europeans are discussing, hits the German tabloids.

What's more, her steady-handed, no-panic course is popular with German voters and her approval ratings remain the highest of any major Western leader. Neither the Social Democrats nor the Left Party—whose leader, Oskar Lafontaine, is Germany's loudest advocate of deficit spending—have made any gains from a crisis that should be vindicating their critique of capitalism. That also shows that, to German voters at least, Merkel must be doing something right.

Still there remains the leadership question. In a global crisis of capitalism that ought to be, in the minds of many European leaders, a golden age for the continent's less market-driven, more social-democratic model, Europe once again seems to be fighting with itself. Germany, by its sheer economic heft and role as the world's biggest trading power, seems best placed to help unify in this crisis. Like few other major powers, it has an existential stake in the health of the global economy, stable financial systems, and open, liberal markets. So far, there is little indication that Germany is ready to lead—even as it drives for a more measured, less hectic response to the crisis. "No one—not Merkel, not Steinbrück, not [Foreign Minister Frank-Walter] Steinmeier—is going out and saying, this is what we should do, as one might expect in a crisis," says Jan Techau, political analyst at the German Council on Foreign Relations.

In part, that mat be because in the current mood it's difficult if not impossible for politicians to fight against the tremendous pressures to deliver what Steinbrück mockingly calls the "Great Rescue Plan," or the similar pressures within their own parties to open the public spigots with little regard to effect or cost. Perhaps a steady, conservative incrementalism—as Steinbrück says, a moderating voice amid the chaotic daily barrage of crisis plans—is the best and most useful thing that Germany has to offer.