The Fallacy of Austerity and the Paradox of Thrift in the Eurozone Crisis

German Ordoliberal Logic: In the aftermath of 2009–2010, German policymakers argued that the Eurozone periphery’s troubles stemmed from fiscal profligacy and eroded competitiveness. The prescribed cure was fiscal consolidation (austerity) to restore market confidence and “internal devaluation” – essentially wage suppression and cost-cutting – to regain export competitiveness.

The German mainstream economic view held that countries like Greece, Spain, and Portugal had “lost competitiveness” by allowing wages and prices to rise too fast, and had “excessive consumption” fueled by debt​ ecfr.eu. From this perspective, the solution was for deficit countries to cut wages and public spending, reducing unit labor costs so that exports would rise and imports fall. Any demand shortfall would be temporary; improved trade balances would supposedly kick-start growth. Crucially, German officials believed adjustment had to come from the debtor countries alone, not through German inflation or fiscal transfers. This reflected an ordoliberal philosophy stressing budget discipline and price stability, rooted partly in Germany’s historical aversion to inflation and bailouts ​ecfr.eu​ecfr.eu.

Austerity’s Impact on Competitiveness and Demand: In practice, the austerity programs imposed on Greece, Portugal, and Spain delivered sharp contractions rather than quick competitiveness gains. Government spending cuts and tax hikes, combined with wage reductions, caused aggregate demand to collapse. For example, Greece’s GDP shrank by over 25% between 2008 and 2016, a depression-level contraction​bis.org. Unemployment in Greece skyrocketed from single digits to around 27% at its peak​ bis.org, and similar explosions in joblessness were seen in Spain (which reached 26%+ unemployment in 2013)​ rabobank.com and Portugal (peaking above 17% in 2013) ​ffms.pt. Domestic consumption in these countries plunged (e.g. Portugal’s household consumption fell over 10% during the crisis) ​ffms.pt. While lower wages did gradually improve unit labor costs, the benefit to exports was limited in the short run by the collapse in internal demand and investment.

Competitiveness gains cannot boost growth if there is no demand for the extra output. Indeed, austerity measures often led to a vicious cycle: falling incomes shrank the tax base and worsened debt-to-GDP ratios despite fiscal tightening, undermining the very confidence and stability that austerity was supposed to restore​ bis.org. As the Governor of the Bank of Greece noted, the fiscal multipliers (the knock-on effect of budget cuts on GDP) turned out “higher than initially anticipated, aggravating the recession”, and the economy was soon “caught in a vicious circle of austerity and recession.” ​bis.org. In short, when everyone slashed spending at once, the contraction fed on itself.

The Paradox of Thrift in the Periphery: The outcomes in Southern Europe illustrated the classic Keynesian “paradox of thrift.” This paradox (a special case of the fallacy of composition) is that while it may be rational for an individual country (or household) to cut spending and increase savings in a crisis, if all countries do so simultaneously, aggregate demand falls and everyone ends up worse off.

That is exactly what happened in the Eurozone periphery under collective austerity. Greece, Spain, Portugal (and others) all tightened belts together, causing Eurozone-wide demand to contract. As a result, GDP fell and debt burdens became even harder to service. Even the IMF later acknowledged that “austerity in a weak economy is self-defeating.” As the budget deficit is reduced, the economy slows down and the ability to repay debt is undermined, making further fiscal targets ever harder to reach​ weforum.org. In other words, rather than restoring confidence, the synchronized fiscal consolidation after 2010 largely worsened the downturn – the textbook paradox of thrift scenario ​weforum.org.

Notably, German officials initially dismissed such Keynesian warnings. They believed that austerity would be “confidence-inducing” and spur private investment, and that each country’s improvement in finances would reassure markets. But this ignored the fallacy-of-composition problem: one country can improve its trade balance by cutting imports or prices, but if all neighbors do the same, they can’t all export their way to growth at once. Without offsetting stimulus from somewhere, collective thrift becomes contractionary.

As an analysis of Germany’s role put it, by “ignoring long-established ideas like the Keynesian ‘paradox of thrift’ or the ‘fallacy of composition,’ Germany [advocated] a serious dose of austerity in the European periphery without offsetting those negative effects with stimulus or inflationary policies at home.” sais.jhu.edu​sais.jhu.edu The result was a Eurozone-wide slump. In effect, every country tried to save its way out of trouble simultaneously, so demand evaporated – a coordination failure at the heart of the Euro crisis.

Export-Led Recovery: A Fallacy of Composition: The German strategy assumed the peripheral economies could “export their way to recovery” through internal devaluation. But this collided with simple arithmetic: in the global economy, not everyone can be a net exporter at the same time. One country’s trade surplus is another’s deficit. During 2010–2013, all major economies – the U.S., China, Germany, and the Euro periphery – were struggling; there was insufficient external demand for all of them to increase exports simultaneously. Germany itself was running massive trade surpluses, increasingly at the expense of its neighbors. By 2013, Germany’s trade surplus hit record highs, absorbing a “large chunk of the available external demand across the rich world”​ bruegel.org.

The Eurozone as a whole actually moved from near balance to a current account surplus of about 2% of GDP during the crisis years​ bruegel.org, meaning the bloc was a net saver contributing to global demand deficiency. This generalization of the German surplus model to the entire Eurozone created a deflationary bias: with Europe as a whole trying to export more than it imported, there was insufficient demand to go around​ bruegel.org. The U.S. Treasury at the time criticized Germany for exactly this reason, noting that Germany’s huge surplus was “creating a deflationary bias for the euro area, as well as for the world economy” ​bruegel.org.

In short, it was mathematically impossible for all countries to net-export their way to growth when every major economy was in slowdown. Lacking a big external buyer of last resort, the Eurozone’s collective austerity simply deepened stagnation.

Alternatives to Self-Defeating Cuts: Could the periphery have regained competitiveness without the self-defeating contraction of universal austerity? In theory, yes – if adjustment had been more symmetric.

Instead of forcing deficit countries to do all the “heavy lifting” via deflation, surplus countries like Germany could have boosted their own spending and wage growth (raising their inflation a bit), which would help deficit countries adjust relatively without such deep recessions. Economists outside Germany argued for a demand-side rebalancing: e.g. fiscal stimulus in the core, Eurozone-wide investment programs, and policies to raise German consumption.

Another mechanism was a transfer union or shared fiscal capacity – for example, using Eurobonds or EU-wide funds to support spending in depressed regions. The United States offers a comparison: during U.S. recessions, federal transfers (like unemployment insurance or stimulus funding) automatically flow to weaker states, preventing local budget cuts from spiraling into deep downturns. The Eurozone lacked such fiscal federalism. Without exchange rates or sufficient central transfers, the adjustment burden fell entirely on internal prices and wages, which is painfully slow and costly. The European Central Bank (ECB) eventually provided some relief (OMT promises, QE) to halt the sovereign debt panic, but by then economies had already suffered severe damage.

In summary, the German recipe of austerity and internal devaluation was a fallacy when applied across an entire depressed region. It rested on the false assumption that each country could cut its way to export-led growth, even though collectively this was impossible without an external source of demand. The actual effect was to trigger the paradox of thrift on a continental scale – everyone cutting spending together and thus shrinking the economy together.

As we’ll see next, a major factor behind Germany’s insistence on this one-sided adjustment was its deep-seated aversion to inflation and reluctance to boost its own demand.

Historical Aversion to Inflation: Germany’s economic policy has long been shaped by a structural aversion to inflation. The collective memory of the 1923 Weimar hyperinflation (and to a lesser extent the 1940s) ingrained in German society and institutions a fear that inflation can destroy savings and social order. Post-WWII German economic philosophy, influenced by Ordoliberalism, placed a premium on price stability and fiscal rectitude​ ecfr.eu​ecfr.eu.

In ordoliberal thinking, inflation is dangerous because it “distorts price signals” and undermines the competitive market order ​ecfr.eu. This intellectual tradition discouraged activist demand-side policies and instead favored rules-based discipline. As a result, modern Germany is often unwilling to tolerate policies that could risk even moderate inflation. For example, through the 2000s and 2010s, the Bundesbank and German officials frequently warned of inflationary risks and opposed measures like large-scale bond-buying or debt mutualization, citing moral hazard and stability concerns. This mindset partly explains why Germany was reluctant to see higher spending or monetary easing as the solution to the Euro crisis – such steps conflicted with deeply ingrained anti-inflation norms and legal mandates (the Bundesbank/ECB mandate is strictly price stability-focused).

Wage Suppression and Export Bias: In addition to fear of inflation, Germany’s own economic model since the early 2000s relied on wage restraint and export-led growth. During the early Euro era (late 1990s–2000s), German unions and government agreements kept wage growth very low – well below productivity growth – in order to restore competitiveness after reunification. This “wage repression” policy helped Germany significantly undercut other Euro members’ unit labor costs​mainlymacro.blogspot.com.

From 2000 to 2007, German domestic consumption was almost stagnant (Germany was dubbed “the sick man of Europe” in the early 2000s), and growth came almost solely from net exports​levyinstitute.org​levyinstitute.org. By 2007, Germany had built up a massive current account surplus, particularly vis-à-vis Southern Europe (e.g. Germany’s trade surplus with Spain and Italy roughly doubled in the 2000s)​ sais.jhu.edu​sais.jhu.edu. This was effectively a beggar-thy-neighbor strategy: Germany’s suppressed domestic demand meant it was not buying much from its neighbors, while its high competitiveness meant it was selling a lot to them. Those trade deficits in the periphery were financed by capital flows (often from German banks), setting the stage for the debt buildup.

When crisis hit, Germany’s stance was that debtor countries needed to “live within their means” and emulate Germany’s belt-tightening. The idea of Germany absorbing more demand (by spending more or raising wages) was largely off the table. German officials saw their past wage restraint as a virtue, not something to reverse.

Indeed, as an ECFR analysis notes, German economists believed stronger wage growth in Germany would simply hurt German competitiveness and reduce investment, with little benefit to others​ ecfr.eu. This belief led to resistance against calls for Germany to boost internal demand or accept higher inflation. Even as the Eurozone periphery was imploding, Germany continued to run budget surpluses after 2011 and kept wage growth moderate. It also pushed through a constitutional “debt brake” (“Schuldenbremse”) law to prohibit structural deficits above 0.35% of GDP, locking in its fiscal conservatism ​osw.waw.pl.

Reluctance to Absorb Periphery Excess Capacity: The consequence of these choices was that Germany, the largest Eurozone economy, refused to act as an engine of recovery for the others. Unlike the U.S. after 2008 – where the richer states (and the federal government) implicitly subsidized demand in the poorer states via transfers and large deficits – Germany insisted each country adjust on its own. It maintained high savings and exports throughout the crisis, rather than spending more.

The Kindleberger theory of crisis resolution argues that a hegemon must provide public goods in a crisis – like a “market for distress goods” (importing others’ excess output) and expansionary lending​ sais.jhu.edu​sais.jhu.edu. Germany did the opposite: it continued to export its goods aggressively (its EU trade surplus actually grew during 2009–2013) and turned off the credit flow that had previously financed periphery imports​ sais.jhu.edu​sais.jhu.edu. Germany’s final consumption fell as a share of GDP in the 2000s (from ~79% to 74% of GDP), while its gross savings rate rose sharply​ sais.jhu.edu – clear evidence of its bias toward saving over spending. In crisis, this meant no offsetting demand stimulus to counter the belt-tightening elsewhere.

The result, as noted, was persistent stagnation. The Eurozone “rebalancing” became one-sided, with deficit countries forced into deflationary adjustment while Germany retained a surplus posture. As one commentator quipped, “the Eurozone as a whole cannot all become Germany, because the others were what let Germany be Germany” – i.e., somebody must consume if someone else saves. Insisting every country follow the same model guaranteed systemic weakness, not stability ​sais.jhu.edu​sais.jhu.edu.

How Moderate German Inflation Could Have Helped: Many economists argue that if Germany had instead accepted higher domestic inflation and wage growth for a period, it would have greatly eased the Eurozone’s rebalancing.

The logic is straightforward: suppose Germany’s unit labor costs and prices rose faster than the Euro average (say 3-4% inflation in Germany vs. ~1% in the periphery) for a number of years. Then Germany’s real exchange rate would appreciate relative to Southern Europe, without the periphery having to go through outright deflation. In practical terms, German households with higher wages would consume more, buying imports from Greece/Spain/Portugal, and German firms would face a bit more cost pressure, reducing their competitive edge. The deficit countries would gain export market share and see their trade balances improve because Germany’s surplus shrank. This is the symmetric adjustment that a currency union without internal transfers really needs.

Even the ECB recognized this: in 2012, ECB officials and analysts noted that “less inflation in Italy and more inflation in Germany are urgently needed to achieve rebalancing in the euro area.” bruegel.org. In other words, the burden of adjustment should not fall solely on deflating the high-inflation countries; it should also come from inflating the low-inflation country (Germany). By tolerating, say, 3% inflation in Germany, the Eurozone average could stay around 2% while allowing Spain or Italy to only be ~1% – narrowing competitiveness gaps with far less pain.

Germany, however, was politically and culturally unwilling to pursue this path. Wage growth in Germany did start to pick up slightly after 2010, but very slowly. Berlin also resisted calls for fiscal expansion (despite running budget surpluses and having fiscal space) that could have stimulated imports. The German government’s reluctance to use fiscal policy for Eurozone-wide rebalancing was tied not just to fear of inflation, but also to a principled opposition to “rewarding” countries it saw as fiscally irresponsible.

Legal and Constitutional Constraints: German aversion to more aggressive remedies was reinforced by legal constraints. The German Constitutional Court closely guarded the country’s budget sovereignty and adherence to the no-bailout clause of EU treaties. For instance, when EU-wide recovery funds or bonds were proposed, they were legally framed as one-off exceptions, precisely because a permanent pooling of debt (“debt mutualization”) is seen as incompatible with German Basic Law without a referendum. Indeed, Germany’s court ruled that the 2020 EU COVID Recovery Fund had to remain temporary​ reuters.com. This makes ideas like Eurobonds or a fiscal union politically toxic in Germany – they are viewed as unconstitutional unless Germany amends its constitution.

Similarly, the debt brake in Germany’s constitution strictly limits deficit spending​osw.waw.pl, constraining any significant fiscal expansion even when it might be needed for macroeconomic balance. The ECB’s mandate, shaped by Bundesbank tradition, also forbids monetary financing of governments, and Germany has been vigilant that the ECB not stray into what it views as fiscal territory. For example, proposals for the ECB to act as a true “lender of last resort” to governments (as the Fed does for the U.S. Treasury) have met German resistance on legal grounds. Bundesbank officials like Jens Weidmann warned that such actions “would add to instability by violating European law”​ sais.jhu.edu.

In short, Germany’s economic ideology and legal framework together created a structural rigidity: policies that other major economies used (like large deficit spending or debt mutualization by a central authority) were largely off-limits in the Eurozone, due in no small part to German veto power. This left the Eurozone with few tools besides austerity and unconventional ECB measures, which, as discussed, were inadequate to quickly end the crisis.

To summarize, Germany’s inflation-phobia and insistence on supply-side discipline led it to reject the kind of demand-side solutions that could have helped the periphery recover. If Germany had tolerated a bit more inflation via higher wages or fiscal stimulus, it could have acted as a much-needed consumer of last resort – boosting imports from struggling neighbors and easing the required austerity. Even the IMF and European Commission later suggested Germany should use its surpluses to stimulate growth for the sake of the whole union. However, between political unwillingness and legal barriers, Germany stuck to its low-inflation, low-debt orthodoxy. The result was a prolonged stagnation and painful adjustment for Southern Europe.

The lessons from this episode extend beyond economics into other realms – for example, how Europe finances common goods like defense, which we turn to next.