Japan's decade of decline is the worst fate suffered by an advanced economy since the Great Depression. Contraction in Japan, however, is not only Japan's problem--it is also a drag on the global economy. Japan's withdrawal of capital from Asia and a weakening yen contributed heavily to the Asian financial crisis of 1997-98. Since then, Japan's continuing slump has limited export earnings for emerging market countries, thus strengthening the backlash in Asia and Latin America against globalization and the "Washington Consensus." It is also exacerbating rather than offsetting the current global slowdown.

Japan seems unable to halt its decline, even though its problems are obvious, and effective, albeit painful, remedies are available. But Japan's very wealth and stability seem to be the sources of its inaction. In other words, when enough wealth remains to allow most Japanese citizens to travel the world and purchase luxury goods, to buy off with government programs those who are directly harmed by the recession, and the costs of this and other borrowing can be put off into the future, little political pressure for change can coalesce. Small wonder, then, that financial observers have wondered whether such a fate might befall other advanced economies. When stock market bubbles have burst and deflation appears in prospect, the question "Who will be the next Japan?" has taken on urgency for policymakers and markets.

But it takes more than a bubble to become Japan. Bubble economies can build up overhangs of investment and industrial capacity in formerly overvalued sectors (like telecoms and it), and then work these off in periods of slower growth--as current U.S. economic difficulties demonstrate. Mature economies can also reach the limits of technological catch-up, or find themselves confronting difficult choices about generous social welfare commitments made during times of faster growth and greater export opportunities--as the UK did in the 1980s, and the Netherlands and Sweden did in the 1990s. And practically every economy has suffered disruptions to financial markets and growth from corrupt or undercapitalized banking systems that misallocate credit--from the U.S. savings and loan debacle to France's Credit Lyonnais affair to the Nordic countries' widespread banking crises. In other words, it is possible to have a bad time of it, but still not fall into Japanese-style stagnation.

As it happens, there are four determinants of Japan's negative economic model: incomplete financial liberalization; macroeconomic policy division and deflationary bias; financially and politically passive households; and a lack of openness to trade or capital flows or foreign ideas. Of all the OECD countries, Germany increasingly shares Japan's political-economic profile. It already evidences the first three parts of the Japanese model, and the recent approach to EU enlargement taken by Germany and other EU members--elevating the power and interests of the incumbent nation-states vis-Ã -vis Brussels and the accession countries--threatens to provide the fourth.

All of this is happening gradually, however, so much so that, as in Japan, there is little significant pressure for painful and politically difficult changes. Germany, like Japan, is coming to resemble the proverbial frog slowly heating in the pot, and is in danger of a fatal consequence if it doesn't soon recognize its predicament. In a world economy in which sole reliance on the U.S. economy as the engine of growth since 1995 has created major imbalances--and where transatlantic relations are already under stress--the world can ill-afford a Germany following Japan down the path to economic perdition.

A deepening of Germany's current economic weakness would not just compound the drag from a declining Japan; it would also deprive the United States of a critical partner in the promotion of economic liberalization and in the integration of developing democracies into the global economic system--a role Japan never played. It would also render even more improbable a significant increase in defense spending by the second-largest member of NATO.

The Japanese Model

What a difference a decade makes. Over the last ten years, Japanese public debt and unemployment levels have doubled, and average economic growth has fallen by nearly three-quarters--to about 0.9 percent per year, the lowest of any industrialized economy. Bad debts in the Japanese banking system total an unprecedented $1 trillion and are still rising. On current trends, Japan will be unable to roll over its public or private debts and will fail to meet its internal pension and social security obligations within just five years at most. Japan has gone from being a soft power punching above its weight in international relations to being an aging society of declining significance even within Asia.

Worse, Japan seems unable to free itself from the tightening vise of fiscal erosion and debt-deflation in which its economy is caught. With each passing year of stagnation, tax revenues fall while public demands rise, limiting further the Japanese government's scope for constructive fiscal policy. Debt-deflation, meanwhile, is a vicious self-reinforcing cycle, last seen during the 1930s, where companies and individuals hit by falling prices and incomes are unable to service their outstanding debt obligations and so default or sell their marketable assets. These defaults and fire sales drive prices down further and dry up bank credit, leading to another round of failures. In Japan--with a bank-dominated financial system that offers little corporate access to stock and bond markets--the resulting credit crunch has starved the entire economy of new investment. It has also given aging savers little or no return on their assets, thereby sapping consumption as well.

Japan's troubles have been neither accidental nor inevitable. They are the result of politically driven and economically self-defeating policy decisions that turned a normal recession following an asset-price bubble in 1992-94 into a severe and accelerating decline. We summarize the four interwoven aspects of the Japan syndrome briefly before turning to the German case.

Incomplete financial liberalization. The seeds of the current crisis were sown in 1984 when Japan undertook to deregulate its financial markets. By 1989, most leading companies could exit their bank relationships and go directly to the markets for capital (issuing bonds, commercial paper and stock), thus depriving Japanese banks of their steady business of lending to near-zero-risk clients at high margins. Yet even as banks lost profitable opportunities, the Ministry of Finance equated financial system stability to "no closure of banks", and a network of former financial officials placed into lucrative bank jobs after retirement (the famous amakudari--descent from heaven) provided financial incentives that reinforced this belief.

The consequence was that too many unprofitable Japanese banks have stayed in business, retaining large amounts of Japan's funds to lend. From the mid-1980s to the early-1990s, too, the banks shifted from funding credit-worthy corporations to lending to small- and medium-enterprises solely on the basis of real estate collateral--a much riskier and more cyclical business. When the stock and real estate bubbles that their lending helped to inflate burst in 1990-92, the banks and their borrowers took heavy losses, and returns to Japanese savers began their long decline. The banks have since ceased lending to new businesses, while savings account and certificate-of-deposit holders at those banks have received little or no return on their deposits. As a result, because public-sector financial institutions put such pressure on the private banks' profitability, and because such an overwhelming share of both household savings and corporate finance is still kept in banks, the banks' bad judgments have discouraged investment and distorted markets throughout the economy, devastating growth.

Uncoordinated deflationary macroeconomic policy. During normal recessions, a central bank cuts interest rates to make credit more easily available, tax revenues decline from those with declining incomes, and public spending on unemployment and other welfare benefits increases. In unusual circumstances, such as those following a stock market bubble when there is overcapacity and financial fragility, a more activist macroeconomic policy is undertaken: discretionary tax cuts are made, public works spending is often increased, and the central bank may purchase government bonds on a large scale.

Since 1990, however, macroeconomic policy in Japan has been on balance contractionary, and has worked to deepen rather than to offset the post-bubble recession. The popular but incorrect perception of Japanese fiscal policy is that the government has been on a public-works spending binge. Properly measured, however, the Japanese government has provided little added stimulus as the economy has contracted. Over 80 percent of the increase in Japanese public debt is due to tax revenue shrinking with the economy. In fact, in April 1997, taxes were raised by 2 percent of GDP, cutting short a nascent recovery. Then, starting in July 1999, public investment has been cut month after month for more than three years running. Net public investment is lower now than it was in 1998.

Monetary policy has been at least as contractionary, and is perhaps even more misunderstood. The Bank of Japan was slow to cut interest rates after the bubble burst and investment declined in the early 1990s. By the time the Bank cut its overnight interest rate effectively to zero in 1999, it was too late--inflation had dropped below zero and the banking system was broken, making real interest rates high and credit conditions tight. Since then, the Bank has refused to undertake active quantitative expansion--i.e., printing yen and purchasing large amounts of either government bonds, foreign currency or other real assets--to increase liquidity outside the banking system. The result of the Bank's inaction has been the first extended period of deflation seen in any advanced economy since the Depression. Deflation not only reinforces the accumulation of bad loans and the contraction of credit in a vicious feedback loop, it also deters consumer spending since individuals wait for prices to fall.

Financially and politically passive citizens. Obvious economic underperformance, fed by regulatory neglect and deflationary policies (not to mention overt corruption), would seem to be cause for public outcry. Yet Japanese democracy has not produced a demand for change. While prime ministers come and go, the Liberal Democratic Party retains leadership in the Diet, and neither its members nor the bureaucrats running economic policy are held accountable. The selection by party caucus, not by popular election, of Junichiro Koizumi as prime minister in April 2001 was thought by many to be a signal of potential reform, but nothing much has changed. In October 2002, Koizumi and his party simultaneously gutted the first true bank clean-up proposal since the bubble, and picked up five seats in by-elections nevertheless.

The Japanese population appears to fear high-level stagnation less than it does major changes in established relationships. Indeed, for all the talk of social solidarity, Japan is a society in which the relatively wealthy old exploit younger workers, politically over-represented rural residents exploit urban populations, and incumbent businesses and workers exploit their current relationships to exclude new entrants. These pernicious stabilities are enabled and reinforced by a process in which LDP politicians funnel public largesse and tax breaks to these older and rural voters in return for political (and personal) contributions and safe re-election. Bureaucrats, meanwhile, maintain their power by assuring that current businesses and regulatory structures reinforce each other.

Of course, all advanced societies have special interests, and farmers and pensioners often take advantage of the less-concentrated general public in government budgets. Only in Japan, however, have such narrowly-based interest groups so successfully snatched such a large share of national income, and managed to keep it coming in the face of obvious economic decline.

The same passivity pervades the Japanese financial system. Over 90 percent of Japanese household financial assets are kept in bank accounts, bank certificates of deposit, life insurance or cash. The result is that banks and life insurers in Japan have effectively captive deposits on which they can keep dropping the returns (now nearly zero on most accounts), while their management and shareholders keep their jobs and extract what dividends they can. No one pulls out their money in search of better investments, so there is no more accountability for the banks than for the politicians. This translates into no pressure to write off bad loans or lend to new businesses.

Lack of openness. As a result of all this, Japan's government and established interests have eluded most pressures for change. Passivity is reinforced by the closed nature of much of Japan's economy and society, as reflected by its discouragement of immigration and the virtual absence of regional security or trade integration--there is no East Asian equivalent of NATO, NAFTA or the EU.

Japan's lack of openness is particularly felt in the absence of economic competition for the bulk of its domestic businesses and of its savings to invest. I refer here not to the standard U.S. trade negotiator's demands for market access for American plate glass or apples. What is really at issue is the fact that 80-85 percent of the Japanese economy--particularly service sectors such as retail, transportation and construction--is horribly inefficient, with thousands of politically protected small companies squandering Japan's stock of economic assets. Even many larger manufacturing companies are insulated from competition by tight business-government connections, particularly of bureaucrats to middle management and corporate boards of insiders from companies with cross-shareholdings. These companies secretly allocate the losses from bad investments, delinquent loans and outright waste, and they transfer the cost of those losses to the Japanese consumer and to the 15 percent of Japanese business that is internationally competitive.

Naturally enough, these inefficient companies have a strong interest in not only the substance of protection, but in maintaining the ideological pretense that Japan should have an economic model distinct from that of "the West." In the end, of course, it turns out that the maintenance of their privileges, and that alone, is what constitutes that "distinct" model. This is hardly an environment conducive to the spread of new ideas; rather, it is one that encourages the scapegoating of foreign pressures as a source of difficulty, an indulgence with implications that go far beyond economics.

The German Way

These four determinants of an industrial democracy's proclivity toward the Japan syndrome are all measurable, and, thankfully, it appears that most OECD members have avoided them. The notable exception is Germany.

Germany appears especially susceptible to the Japanese syndrome on account of the structural similarities of the German and Japanese economies. Both were beneficiaries of U.S. reconstruction and open markets after World War II. Both are one-time exemplar economies whose growth rates slowed in the 1980s and fell on increasingly hard times in the 1990s. Both are self-described "consensus" or "stakeholder" societies that organize much of their economic decision-making around tight business-bank ties and collaborative corporate governance. Both de-emphasize stock markets. Both are aging societies with high domestic rates of savings, high labor productivity and low return on capital. And both have been and remain critically dependent on exports for growth.

Of course, these similarities can be misleading, for they do not foreordain similar behavior. Until the late 1990s, there were significant differences in the functioning of the two economies. Postwar West Germany was always more market-friendly than Japan, even after the liberal architect of the Sozialmarktwirtschaft, Ludwig Erhard, left office in 1966. While certainly more regulated than the United States, in contrast to Japan individual German business decisions were not directly influenced by government intervention. German civil servants also tended to stay in government rather than join companies--so that direct business-government ties were limited. Germany also allowed more competition, both domestic and foreign: on the trade side, the value of Germany's imports and exports composes nearly twice the share of its economy as Japan's, and foreign direct investment in Germany is nine times that of Japan. Banks did play the dominant role in German corporate finance and as the place for savings, but German banks were allowed occasionally to fail or be taken over. German bank supervisors were strict.

The electorate held German politicians accountable for economic performance, as well. The decentralized federal political system, installed by the occupying Allied powers, allotted a strong role in determining policy to the opposition in the Bundesrat and in the Länder (state) governments. This gave German citizens a sense of political responsiveness that never developed in one-party, bureaucrat-dominated postwar Japan. The generous distribution of government spoils to average workers and consumers, too, usually through universal welfare programs, reflected the fact that political power in Germany lay with the majority and not, as in Japan, with business management and select interest groups.

Most important, Germany was always more engaged internationally than Japan. This was in large part due to political geography, with West Germany in NATO and on the Cold War's front line. A partial welcome to resident foreigners, from Turkish Gästarbeitern to U.S. troops, added to the sense of openness. (Japan has also hosted resident U.S. troops, of course, but they have been allowed much less social influence in Japan than in Germany.) This was also a matter of enlightened leadership by a succession of German chancellors, strongly backed by a majority of Germans, who simultaneously pursued European integration and the maintenance of transatlantic ties. Membership in the EU, in turn, was then a force for economic liberalization, at least within the single market.

Nevertheless, as with Japan in 1990-92, Germany's main concern now is how to respond to a bubble and its recessionary aftermath. Germany has experienced a real stock market crash--at bottom on October 9, 2002, the DAX index was 68 percent off of its March 2000 peak (compared with a 49 percent drop in the analogous S&P 500 index over the same peak-to-trough period), and the Neuer Markt, Germany's version of NASDAQ, is to be completely shut down by year-end 2003 due to the collapse of the vast majority of its listed companies. Germany also confronts a severe slowdown; since the post-reunification boom of 1990-92, Germany has beaten out Italy for the distinction of being the slowest growing economy in the EU, at an average rate of 1.3 percent a year. In 2002, the German economy grew a mere 0.2 percent, and the government's own revised forecast for real growth in 2003 is only 1.0 percent, which is insufficient to keep public deficits and unemployment from rising further. This is the objective situation. How are German economic decision-makers likely to handle it?

On the first criterion of the Japanese model, incomplete financial liberalization, there is real cause to worry about Germany. In theory, because Germany always had universal banks, there was little to deregulate in terms of bank activities, and banks were already well diversified and so better able to handle shocks. Banks' hidden reserves, comprised of unrealized capital gains on shareholdings of non-financial companies and retained dividends, were supposed to provide cushions to capital adequacy. In practice, however, German financial markets have been in a state of transition in recent years akin to that which preceded the U.S. S&L crisis in the 1980s and Japan's banking problems of the 1990s. And similar to the discoveries made of late by U.S. bank-holding companies, diverse lines of business have proven no defense against cyclical losses.

Like Japan, Germany is not only a high savings country, but a country whose savers increasingly put their money into bank accounts even as returns decline. Germany's deposit-to-GDP ratio is the highest in Europe. Total deposits have grown sevenfold in the last twenty years, while the economy itself only grew by about 60 percent. During these two decades, average interest paid on deposits declined from 4 to 2 percent. A growing (and now the largest) share of these ample loanable funds--four times the amount lent in 1980--have been put to work by German banks in loans to the non-financial services sector, a low productivity set of small- and medium-enterprises whose loans, as in Japan, are secured mainly by real estate collateral. Reminiscent of Japan, too, this lending growth has occurred while Germany's more stable and profitable export-oriented manufacturing sector has steadily raised a greater share of its funds by going directly to foreign markets with securities on offer. The profitability of German banks' loan portfolios has fallen, and the riskiness of its loans has risen as a result. Germany's tough labor laws restricting the firing of workers limit the ability of the banks to improve profitability internally, much as the Japanese banks feel bound to retain their "lifetime employment" workforces.

The number of German banks, however, has not declined to restore profitability--just as in Japan. There are still over 300 commercial banks of various sizes and over 530 Sparkassen (public savings banks). Only the number of credit unions has been shrinking. As in Japan, public banks and special credit entities--including the Sparkassen, their clearing banks (the state-owned Landesbanken), and the Kreditanstalt für Wiederaufbau (the one-time Marshall Plan funds bank that is now a means for the federal government to pursue chosen projects off-budget)--play a significant role in the financial system. These public banks carry as advantages a state guarantee, and therefore a lower cost of funds, as well as non-profit criteria for lending. This puts them into unfair competition with Germany's private banks, further eroding the latter's profitability. The EU has recognized that this system is anti-competitive, and it has legislated that the Landesbanken lose their state guarantees by 2005. But that means at least another two years of eroding private bank capital.

Not surprisingly, then, visible adverse selection has begun to emerge in the German financial system. A credit crunch for new borrowers is developing as asset prices fall, collateral and balance sheets of borrowers are impaired, and banks reduce lending. A standard marker of credit conditions is the spread between government bonds and corporate bonds of equivalent maturity--when this spread widens, borrowers have greater trouble getting loans. In Germany, the spread between ten-year government bonds and highly-rated corporate bonds averaged 0.3 percent between January 1980 and May 1998, and rarely went above 0.7 percent for more than a month, even during recessions. Since June 1998, when German banks began to incur losses from the Asian financial crisis and then the Russian default, the risk spread has been steadily rising. As of September 2002, the spread was a hefty 1.7 percent, having averaged 1.3 percent in the preceding year.

This increase can be credibly linked to declining German bank capital. The national average bank financial strength rating, removing the effect of government guarantees, is now below C+ according to Moody's rating agency--in other words, sub-investment grade. Every other EU country's banking system except that of Greece has a higher average rating. Provisioning for the coming losses on non-performing loans in a time of declining profits will further erode German banks' capital base. Germany today, like Japan circa 1992, has too many banks with too little capital, but no significant exit of savers or public sector competitors.

In the past four years, German macroeconomic policy, the second indicator to watch, has taken on frightening parallels to that of Japan, as well. Until 1999, German monetary policy was quite flexible and stabilizing of the real economy, while German fiscal policy was well within G-7 norms for counter-cyclicality. Since European monetary unification at the start of 1999, however, German monetary policy has been set by the European Central Bank (ECB), and German fiscal policy has been constrained by the eurozone's Stability and Growth Pact. Since then, Germany has suffered from an excessively tight monetary policy. While the German inflation rate averaged 1.5 percent annually since January 1, 1999, and has fallen just below zero percent over the past six months, the ECB refuses to cut interest rates. Meanwhile, on the fiscal side, the Schröder government has raised taxes during the current recession in hopes of bringing the budget deficit back down to the Stability and Growth Pact target of 3 percent of GDP.

As it happens, the EU's Stability and Growth Pact has a built-in destabilizing bias: the larger a recession, the more likely an economy is to breach the 3 percent cap on deficits; and the more likely it is to exceed the deficit cap, the more tax increases or spending cuts must be pursued. Recent proposals to measure the deficit on a cyclically-adjusted basis would offset this bias somewhat. But as long as the rule remains in place mandating a rapid return to below 3 percent deficits, fiscal policy will choke off recovery by tightening credit as soon as growth and tax revenues pick up--repeating almost exactly Japan's mistake of 1997.

Some countries, like France, have defied the Pact and simply put off meeting the deficit targets. The German government, however, has explicitly abjured such measures since its politicians were the ones who insisted upon having public debt and deficit limits built into the Maastricht Treaty and the EMU in the first place. They did so in order to prevent (in their minds) fiscal indiscipline from subverting the stability of the euro. The German government has thus painted itself into a corner of austerity, for it has itself characterized any greater fiscal flexibility as an indication that markets should discount the euro's stability.

Magnifying even further the Japan-like course of increasing austerity in a time of recession is the fact that Germany has the fourth-oldest, and one of the most rapidly aging, societies in the world (Japan's is the oldest society). This will make public debt burdens less and less sustainable over time.

While monetary policy has been too tight in the eurozone since the euro was introduced, it has been particularly harmful to Germany. The ECB came into being as a new and newly independent successor to the revered Bundesbank, extremely concerned about establishing its credibility for toughness on inflation. As a result, it has been even more reluctant to ease credit than the Bundesbank would have been under similar economic conditions. The ECB has pursued an inflation target of 2 percent or less for a weighted average of eurozone economies, a strategy with three inherent difficulties.

First, the "or less" target, rather than a symmetrical one of around 2 percent, imparts an additional deflationary bias, leading the ECB to be more aggressive in offsetting price rises than declines. Second, the target is too low for a eurowide average. The smaller and the structurally-reforming EU economies should be experiencing higher inflation as they adapt, and the large and developed economies (like Germany) would therefore have to average less than 2 percent (which in practice is actually deflation, given the positive bias of all inflation measures). Third, given the lack of synchronization between the eurozone economies' business cycles and of fiscal transfers among the economies, some countries will always suffer from significant divergences between ECB policy and their own cyclical needs. When some countries--like Ireland, Denmark, Spain, and (to a lesser degree) France--are on sustained trends of growth improvement, while other countries--like Germany and Italy--are on secular growth downtrends, monetary policy will not simply balance out over time. It will be chronically too tight for the slower economies, and will reinforce their slowdown. Moreover, now that Germany is in a currency bloc with the majority of its trading partners, it cannot loosen its monetary policy "in effect" by adjusting its exchange rate to make up for excessively high interest rates.

Perhaps the most chilling parallel between post-EMU Germany and post-1992 Japan on macroeconomic policy is in the lack of coordination between fiscal and monetary policymakers in the eurozone. As with the Bank of Japan, the ECB refuses to loosen monetary policy sufficiently or to believe that stronger growth is sustainable without inflation until elected governments pursue structural reforms. And the ECB is on record that it will view any loosening of or non-adherence to the Stability and Growth Pact as undermining monetary stability, and will tighten policy in response. In the eurozone, however, the ECB is playing chicken with not just one but twelve sets of politicians and bureaucrats. And the German Ministry of Finance, alone among those dozen national fiscal authorities, feels the need to self-impose austerity in order to set an example--even though its fiscal discipline alone will be insufficient to convince the ECB to ease policy in return.

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?

Promote a federalist Europe. Giscard and the French statists have not yet won with their vision of a Europe led by national prime ministers, weighted by state size. In fact, most of America's supportive European allies on Iraq and other security issues (with the notable exception of the United Kingdom) favor a federalist Europe with a strengthened executive and European Parliament, and oppose big state domination of EU decision-making. By holding out the carrot of greater recognition of the EU in international organizations (the IMF, the UN Security Council and so forth) as well as the prospect of more extensive bilateral coordination--conditional on Europe moving in a more federalist direction--the United States can support its friends in this debate.

Play to Germany's traditional postwar values. American foreign policy can benefit from a call to Germany's recent past. Since the 1950s, Germany has been committed to a federalist rather than a statist Europe. Until its most recent economic troubles gave it assistance fatigue, Germany had championed the cause of European supranational decision-making in response first to Mediterranean and then eastern enlargement. Germany also was repeatedly in consort with the United Kingdom in supporting liberalizing reforms on the Continent. If the United States appeals to Germany's sense of historic responsibility to eastern Europe, to economic efficiency in the EU, and to wanting to transcend the nation-state, it can influence German policy toward internal EU arrangements.

Encourage liberalization without sanctimony. U.S. economic performance in the 1990s and its military predominance have converged with a moralistic tone in U.S. foreign policy to make American-supported economic liberalization extremely unpopular in many places. The United States would be wiser to pick specific areas in which economic reform will serve a strategic purpose--particularly in saving Germany from stagnation--instead of being generally and promiscuously triumphalist about its superior "model." That would have the additional advantage of being more persuasive to Germans and Europeans in general since it would draw attention to the fact that there are countries doing much better than Germany (Ireland and Sweden, for example) as a result of constructive reform without converging completely on some American ideal.

In the German case, this agenda would include encouraging free international competition for pension fund and investment management, reducing agricultural subsidies and barriers, creating what amount to non-aggression pacts between rich countries of "no corporate bailouts"--rather than encouraging their escalation, as the United States did with its 2002 steel tariffs--and advancing some form of renewed international banking standards. All of these initiatives would directly or indirectly lead to greater openness, financial stability, citizen risk-taking and macroeconomic stimulus in Germany and in a more unified, less statist, European Union. That would be in everyone's interest.

Adam S. Posen is senior fellow at the Institute for International Economics. This essay is drawn from his forthcoming book, Germany in the World Economy, to be published in 2003 by IIE, supported by a major grant from the German Marshall Fund of the United States.

Essay Types: Essay