Like marriage, membership in the eurozone is supposed to be a lifetime commitment, “for better or for worse.” But as we know, divorce does occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible, and that one or more countries might revert to a national currency. The prevailing thought has been that one of the weak periphery countries would be the first to call it a day. It may not, however, work out that way: suddenly, the biggest euro-skeptics in Europe are not the perfidious English but the Germans themselves.

Marshall Auerback

English

Research Papers in Economics

	 Policy Note 2011/1					1
Levy Economics Institute of Bard College
Policy Note
2011 / 1
Like marriage, membership in the eurozone is supposed to be a lifetime commitment, “for better 
or for worse.” But as we know, divorces do occur, even if the marriage was entered into with the 
best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself 
might also be reversible, and that one or more countries might revert to a national currency.
As far as the Economic and Monetary Union goes, the prevailing thought has been that one 
of the weak periphery countries would be the first to call it a day (in Ireland’s situation, one could 
make a good case for it on the grounds of persistent spousal abuse). It may not, however, work out 
that way: all of a sudden, the biggest euro-skeptics in Europe are not the perfidious English but the 
Germans themselves. Take a look at these headlines:1 
Germany and the Euro: We Don’t Want No Transfer Union
  —The Economist, December 2, 2010
  Business World: Where Are the Business Europhiles Now?
  —The Wall Street Journal, December 4, 2010
And even a recent book by Hans-Olaf Henkel, formerly of IBM (Germany) and hitherto one of 
Germany’s great euro-enthusiasts: Rettet Unser Geld! (2010). English translation: Return Our Money!
of Bard College
Levy Economics
Institute
Research Associate marshall auerback is a senior fellow at the Roosevelt Institute, a fellow of Economists for Peace and Security, and 
a global portfolio strategist for Madison Street Partners, LLC. 
The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the  
discussion on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made  
by the author. 
Copyright © 2011 Levy Economics Institute of Bard College   
WHAT HAPPENS IF GERMANY  
EXITS THE EURO?
marshall auerback	 Policy Note 2011/1					2
So let’s consider what would happen if Germany decided to 
follow Herr Henkel’s advice. On the plus side, given Germany’s 
historic reputation for sound finances, the country would likely 
emerge with a strong Deutschmark, a global “safe haven” cur-
rency for currency speculators keen to find a true store of value.
But this would likely come at a huge cost: Germany would 
probably save its banking system at the expense of destroying its 
export base. The newly reconfigured DM would soar against 
the euro and become the ultimate safe-haven currency. This 
would mitigate the write-down impact of the inevitable hair-
cuts on euro-denominated debt, because the euro (assuming 
it is retained by the remaining eurozone countries) would fall             
precipitously. Even if the euro itself vaporized, the Germans 
would simply pay back debt in the old currencies, likely at a 
fraction of their former value.
But Germany’s external sector would be wiped out. The 
resultant appreciation of the new Deutschmark, along with the 
inevitable banking crises in the periphery (which would exert 
significant deflationary pressures in those countries and there-
fore reduce consumer demand in the eurozone ex Germany), 
would engender a huge trade shock: Germany’s growth would 
slow dramatically, as exports compose such a large proportion 
of its GDP.
Another interesting byproduct: by accounting identity, a 
fall in Germany’s external surplus would mean an increase in its 
budget deficit (unless the private sector began to expand rap-
idly, which is doubtful under the scenario described above), so 
Germany would find itself experiencing much larger deficits. 
Let’s elaborate a bit further. We start with the standard 
macro observation that, in any accounting period, total income 
in an economy must equal total outlays, and total saving out 
of income flows must equal total investment expenditures on 
tangible assets at the aggregate level. The financial balance of 
any sector in the economy is simply income minus outlays, or its 
equivalent, saving minus investment. A sector may net save or 
run a financial surplus by spending less than it earns, or it may 
net deficit spend as it runs a financing deficit by earning less 
than it spends; but at the aggregate level, the dollar spending of 
all three sectors combined must equal the income received by 
the three sectors combined. Aggregate spending equals aggre-
gate income.
At the end of any accounting period, then, the sum of the 
sectoral financial balances must net to zero. Sectors in the econ-
omy that are net issuing new financial liabilities are matched 
by sectors willingly owning new financial assets. One sector can 
run a surplus (spend less than its income) so long as another 
deficit spends. In macro, fortunately, it all has to add up. This is 
true not only of the income and expenditure sides of the equa-
tion but also the financing side, which is rarely well integrated 
into macro analysis.
Next, we can divide the economy into three major sectors: 
the domestic private sector (including households and busi-
nesses), the government sector, and the foreign sector (imports 
and exports). We can then ask a simple question relevant to cur-
rent developments: what would happen if one of those three 
variables experienced a dramatic shift from surplus to deficit, as 
we envisage occurring here under Germany’s external accounts?
Although the country runs a large current account surplus, 
it is insufficient to offset a high private sector predisposition to 
save (which means there is some deficit). But its current account 
surplus does allow for a smaller budget deficit than those of 
its so-called “profligate” Mediterranean neighbors, whilst still 
facilitating  the  private  domestic  sector’s  desire  to  net  save. 
As we have argued before, it is the “profligacy” of Germany’s 
Mediterranean trading partners that has allowed it to rack up 
huge current account surpluses, and therefore run smaller bud-
get deficits than the likes of the PIIGS (Portugal, Ireland, Italy, 
Greece, and Spain).
Once divorced from the euro, Germany would regain its fis-
cal freedom—in itself something the Germans should celebrate, 
providing their government takes advantage of it. Remember, 
by  returning  to  the  DM,  Germany  becomes  the  issuer,  as 
opposed to the user, of a currency (as is the case under the 
euro), and fully sovereign with respect to its fiscal and monetary 
policy. Consequently, the German government could offset the 
external shock by running large budget deficits, making new net 
financial assets available to the private sector (by adding to non-
government savings). 
It  would  be  almost  impossible  to  run  budget  surpluses 
under this scenario, but this is not a bad thing for any country 
that issues debt in its own free-floating, nonconvertible cur-
rency. As unpalatable as this conclusion might be for many, 
it is entirely consistent with national income accounting. As 
Bill Mitchell (2010) has pointed out, “The systematic pursuit 
of government budget surpluses (G < T) is dollar-for-dollar 
manifested as declines in non-government savings. If the aim 
was to boost the savings of the private domestic sector, when 
net exports are in deficit, then taxes in aggregate would have 	 Policy Note 2011/1					3
to be less than total government spending. That is, a budget 
deficit (G > T) would be required.” (The sector financial bal-
ances approach to national income accounting is outlined in the 
Appendix.)
A budget deficit per se, then, would not cause any problems 
per se for Germany, as it would no longer have any external con-
straint, having restored the DM as its currency of choice. But 
historically, Germany has embraced an export-based model at 
the expense of curbing domestic consumption.
So its policymakers would face a choice: to offset the decline 
in its current account surplus via a more aggressive fiscal policy 
by choice—that is, proactively, in search of a full employment 
policy—or reactively, via the growth in the automatic stabiliz-
ers. If the German economy slumped (as I expect it would), the 
deficits would rise as a matter of course, via the automatic sta-
bilizers. Germany could easily counter that if it chose to do so. 
It’s never a laughing matter to see an economy slump, but 
anybody with a sense of irony would naturally be wondering 
whether  the  Germans—the  government  as  well  as  voters—
would get themselves into a frenzy about being so “profligate” as 
the inevitable trade shock developed. I suspect there would also 
be a touch of schadenfreude on the part of its recently divorced 
eurozone “ex-spouses” (how does one say “schadenfreude” in 
Greek or Spanish?). Personally, I’ve never seen the merits of 
eliminating government debt simply to force the private sector 
into greater deficit, and perhaps the Germans would eventually 
figure that out as well. In any case, one suspects that it would 
be a nice “teachable moment” for Frau Merkel if Germany did 
embrace the course of action now so enthusiastically endorsed 
by the likes of Herr Henkel. But the country might well find 
truth in the adage “Be careful what you wish for.”
Appendix2
The model devised by the late Distinguished Scholar Wynne 
Godley and detailed in the Institute’s Strategic Analysis series 
divides the macroeconomy according to its three main sectors: 
domestic government, domestic nongovernment (or private), 
and the foreign sector. By accounting identity, the deficits and 
surpluses across these three sectors must sum to zero; that is, 
one sector can run a deficit so long as at least one other sector 
runs a surplus.
The basic income-expenditure model in macroeconomics 
can be viewed in (at least) two ways: (1) from the perspective of 
the sources of spending; and (2) from the perspective of the uses 
of the income produced. Bringing these two perspectives (of the 
same thing) together generates the sectoral balances.
From the “sources” perspective, we get this equation:
GDP = C + I + G + (X – M)
This formula simply indicates that total national income 
(GDP) is the sum of total final consumption spending (C), total 
private investment (I), total government spending (G), and net 
exports (X – M).
From the “uses” perspective, national income (GDP) can be 
illustrated in the following way:
GDP = C + S + T
This  equation  indicates  that  GDP  (income)  ultimately 
comes back to households who consume (C), save (S), or pay 
taxes (T) with it once all the distributions are made.
In aggregate, we can express the formula in the following 
manner:
C + S + T = GDP = C + I + G + (X – M)
So, after simplification (but obeying the equation) we get 
the three sectoral balances view of the national accounts:
(I – S) + (G – T) + (X – M) = 0
That is, the three balances must sum to zero. In addition:
The private domestic balance (I – S) is positive if in deficit, 
negative if in surplus.
The budget deficit (G – T) is positive if in deficit, negative 
if in surplus.
The current account balance (X – M) is positive if in sur-
plus, negative if in deficit.
These balances are usually expressed as a percent of GDP, 
but that doesn’t alter the accounting rules that they sum to zero; 
it just means that the balance-to-GDP ratios sum to zero.
This is also a basic rule derived from the national accounts. 
It always applies. This is not high Keynesianism but simple dou-
ble-entry bookkeeping, developed some six centuries ago. Call 
it the tyranny of Accounting 101. 	 Policy Note 2011/1					4
You can then manipulate these balances to tell stories about 
what is going on within a country, as we are seeking to do here 
with Germany. For example, when an external deficit (X – M 
< 0) and a public surplus (G – T < 0) coincide, there must be 
a private deficit. So if X = 10 and M = 20, then X – M = -10 
(a current account deficit). Also, if G = 20 and T = 30, then G  – T 
= -10 (a budget surplus). So the right-hand side of the sectoral 
balances equation will equal (20 – 30) + (10 – 20) = -20.
As a matter of accounting, then, (S – I) = -20, which means 
that the domestic private sector is spending more than they are 
earning because I exceeds S by 20 (using whatever currency 
units we like). So the fiscal drag from the public sector is coin-
ciding with an influx of net savings from the external sector. 
While private spending can persist for a time under these con-
ditions by using the net savings of the external sector, the pri-
vate sector becomes increasingly indebted in the process. It is an 
unsustainable growth path.
This situation describes the recent history of the United 
States, notably during the Clinton years, when the country was 
running budget surpluses. By the same token, using the sectoral 
balances approach, we can say that a current account surplus 
(X – M > 0) allows the government to run a budget surplus (G 
– T < 0), which applies in the case of many Asian countries or 
to a European country such as Norway (where the world does 
its spending for it). 
Notes
1.  James Aitken of Aitken Advisors, LLP, kindly drew my
  attention to these headlines.
2.  Adapted from Mitchell 2010.
Reference
Mitchell, B. 2010. “Norway and Sectoral Balances.” Billy Blog:
Alternative Economic Thinking, May 19, 2009.
 

Norway and Sectoral Balances.” Billy Blog: Alternative Economic Thinking,

"What Happens if Germany Exits the Euro?"

http://www.levyinstitute.org/pubs/pn_11_01.pdf

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