A French military officer (Ferdinand Foch) with sword showing "Terms" of past-World War I reparations to German military officer, possibly William II. Source: Library of Congress, Prints and Photographs Division

Germany's Perverse Devotion to Austerity

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May 14 (Bloomberg) -- Next summer will mark the 100th anniversary of the chain of diplomatic missteps that led to World War I. In light of recent economic blunders, this also should be the opportunity to revisit the war’s aftermath, when miscalculations seeded the conditions that led to World War II.

In 1919, at the Versailles Peace Conference, France and the U.K. resolved to impose draconian “reparation” payments on a defeated Germany. The idea was both to compensate the U.K. and France for the horrific costs of the war, and to ensure that Germany could never again threaten Europe.

The terms required Germany to make an initial payment of $5 billion, almost half of Germany’s annual gross domestic product, by May 1921, -- plainly an impossible sum. The postwar settlement included no recovery plan for Germany; on the contrary, it was required to transfer lands and industrial assets to the Allies.

This financial vise led directly to the ruin of Germany’s economy, its recourse to printing money, the hyperinflation of 1923, the destruction of the middle class and the rise of Adolf Hitler.

A generation later, the Allies again faced a defeated and destitute Germany. Then, too, many leaders wanted to destroy it as an industrial power. The U.S. Treasury secretary, Henry Morgenthau, had a plan to make Germany a largely agricultural economy. Soviet leader Josef Stalin expropriated German factories as a down payment on reparations.

Cold War

But that policy soon changed to one of relief and recovery, not because the Allies had learned from history, but because of the incipient Cold War. The U.S. needed a strong Germany.

The emblem of the European recovery policy was the Marshall Plan. However, even more important was forgiveness of German war debt.

In prosecuting World War II, Hitler ran up the largest share of national debt to GDP of any country --- 675 percent. In June 1948, as part of a currency reform that created the new deutsche mark, the Allies canceled 93 percent of the Hitler-era debt. Repayment of the rest was deferred for almost half a century.

As a result, West Germany had a debt of about 12 percent of GDP in the early 1950s, far smaller than the liabilities of the victorious Allies, which had sacrificed to defeat Hitler. This act of macroeconomic mercy was key to the postwar German economic miracle.

Germany today is the enforcer of European austerity, and the cancellation of most of the Nazi war debt in 1948 has disappeared from the national memory. Had Germany been kept in a straitjacket of debt repayment, its path to recovery would have been far more arduous. It might never have returned to democracy.

As the dominant political and economic power of the European Union, Germany is imposing a perverse austerity on smaller and weaker nations for three interconnected reasons.

Many Germans, including those in the government of Chancellor Angela Merkel, draw questionable lessons from their own history. The hyperinflation after World War I is taken as a cautionary lesson about fiscal and monetary discipline. What’s forgotten is that Weimar Germany’s ruinous actions in 1923 were the result of external pressures to collect impossible-to-repay debts in desperate times, not the result of Germany’s own profligacy.

German Reunification

Second, the rest of Europe is being required to atone for Germany’s sins. In the years after reunification in 1989-90, the federal government in Berlin spent about 2 trillion euros ($2.6 trillion) on the reconstruction of eastern Germany. The Bundesbank raised interest rates to contain inflation, resulting in higher credit costs across Europe. Germany demanded that all the major European nations run deficits that exceeded the fiscal limits of the 1993 Maastricht Treaty on European Union as a way to combat a recession.

When Merkel became chancellor in 2005, she resolved to rigidly enforce the treaty’s deficit-and-debt limits, including sanctions. This policy arguably made sense in good economic times, but it is the opposite of what’s needed after a financial collapse.

Third, Germany’s own self-interest undermines enlightened policies for the rest of the continent. Economists at the University of Munich have calculated that if Germany still had the deutsche mark, it would trade about 40 percent higher than the euro. For Germany, an undervalued euro produces a huge export advantage. Also, the crisis elsewhere attracts capital, giving the Germans artificially low interest rates. The nation that gave us the term schadenfreude profits from the misfortune of others while presenting itself as a role model.

Lately, the rest of Europe has turned against austerity. Spain, Portugal, France and Italy have all moved to ease belt tightening. But Germany still vetoes pan-European solutions. Greece, under pressure from the “troika” -- the European Commission, the European Central Bank and the International Monetary Fund -- just fired an additional 15,000 civil servants, to qualify for the latest installment of bailout funds. But the aid goes to repay creditors, not to help Greece, where unemployment is approaching 30 percent.

In 1948, when U.S. President Harry Truman was promoting the Marshall Plan and wrote off most of Germany’s debt, he was monumentally unpopular in the U.S. and widely expected to lose the November election. But he risked his presidency on an act of statesmanship, and went on to win.

Chancellor Merkel faces re-election in September. Mercy for Europe’s presumed fiscal sinners isn’t popular with the German electorate.

Though there is no Cold War to justify a fiscal amnesty, the debt relief of 1948 was a central reason for Germany’s rise to its current pre-eminence. This would be a good moment for Merkel to revisit her nation’s history and lead Germany to a more enlightened self-interest.

(Robert Kuttner is co-editor of the American Prospect and senior fellow at Demos. He is the author of “Debtors’ Prison: The Politics of Austerity Versus Possibility.” The opinions expressed are his own.)

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To contact the writer of this article: Robert Kuttner at Kuttner@prospect.org

To contact the editor responsible for this post: Max Berley at mberley@bloomberg.net