The old adage “Beware the company you keep” is something very much on the minds of many Germans these days. They believe they have been tricked by reckless southern Europeans into embarking on a journey that is endangering every long-held German principle of fiscal prudence. In two years, markets have pushed an increasing number of euro zone members to the brink of insolvency, testing the nerves of reluctant rescuers—particularly the Germans. In a recent cover story, the British magazine The Economist published a fictional memorandum to German chancellor Angela Merkel, outlining two possible scenarios for a partial euro break up, one with Greece leaving the euro zone, the other with all current recipients of aid, including Spain, reintroducing national currencies. The headline read: “Tempted, Angela?”
Why Germany Cannot Allow the Euro to Fail
It would appear that Angela is not tempted—but Germans are. Therein lies the danger for the German chancellor and for the euro. If German voters decide that Merkel’s actions do not match her words, that in fact she will pay any price to save the euro—including sacrificing some of the very principles she so strongly defends publicly—she will lose their support. Furthermore, if Germany is seen to be willing to foot any bill, no matter how large, the pressure on peripheral countries to push through unpopular reforms will evaporate.
Merkel’s strategy for dealing with the crisis is a difficult balancing act. That is why, so far, Merkel has only provided limited financial solidarity to struggling euro zone partners and has always linked her help with the need for painful adjustments in countries receiving support. Her current success in polls can be explained by the fact that she is seen as both principled and pragmatic. But all too often these two drivers seem to force her in opposite directions. This creates uncertainty; this uncertainty has infected the markets. The coming months will be decisive in the battle to save or re-launch the common currency. Merkel has to find a way to reconcile her rhetoric with her actions. She has to close the gap between her need to be principled and the necessity to act pragmatically. It will not be easy.
The euro was never very popular in Germany. In the 1990s, when a group of European nations led by Germany and France decided to give up their national currencies, a solid majority of Germans opposed the idea. Over the previous forty-plus years, the Deutschmark had become a powerful symbol of German wealth and stability, a reality that had vanquished the specter of inflation once and for all.
However, then-chancellor Helmut Kohl decided to go ahead with the project despite popular opposition. It was both a political and an economic decision. Political, because it cemented the European project and German ties with her traditional foe, France. Economic, because since the collapse of the Bretton Woods system and the end of the dollar peg in the early 1970s, Germany had lobbied hard for an exchange rate system that would reduce the exposure of its export-driven industries to currency fluctuations. Not surprisingly, the German establishment, both political and economic, was and still is deeply vested in the project of the common currency.
Germany has more to lose from a collapse of the euro, both politically and economically, than any other country in the euro zone. About 60 percent of German exports go to countries in the European Union. The share of exports going to the more limited number of member countries of the euro zone is about 40 percent. Despite the rising significance of emerging markets, only about 18 percent of German exports are headed to the so-called BRIC countries. These are underlying facts that should never be forgotten when trying to make sense of short-term turbulence.
When Angela Merkel says: “If the euro fails, Europe fails,” she means it.
Merkel does not believe that Germany is strong enough to act alone in a world undergoing such huge transformation. To keep trade channels open and the German economy humming, Berlin needs Brussels. The EU is not a superpower in traditional terms. It still has no army and no real foreign policy, but when it comes to disputes about trade and regulating the single market, the EU Commission dwarfs the national governments. Berlin has no illusions about this reality and no desire to reverse sixty years of European history. Germany’s support of the EU is quite pragmatic:
- The political leadership in Berlin knows very well that a breakup of the euro could lead to a breakup of the single market.
- A breakup of the single market would jeopardize the whole European project.
- The European project is still seen by the German establishment as the best insurance policy against political instability in the core of Europe.
In fact, despite public comments by members of her government to the contrary, the chancellor even considers an exit of Greece from the euro zone as undesirable. A Grexit, as it is termed, in the course of this year would be hugely expensive. By some estimates, Germany would be stuck with a bill of around €110 billion. Such an amount would be manageable, some might say. Perhaps, but consider this: the so-called contagion effects are not taken into account in such a narrow calculation, and in a worst-case scenario, a disorderly default could well lead to a Balkanization of Greece.
While nobody can safely predict whether Greece will ultimately stay in the euro zone, (and of course it is wise to prepare for a possible, albeit improbable, exit), it may be safe to assume that even small, measurable improvements in Athens will be enough for Berlin to keep Greece in the club. Merkel is a cautious politician.
Merkel’s Goals and Strategy
Overall, Merkel is trying to achieve three main objectives. First of all, she wants to avoid going down in history as the woman who destroyed Europe. Second, she wants the euro zone to emerge from the crisis as a stronger entity, more German in character, and, if at all possible, with Greece still on board and on a slow but measurable path to economic and fiscal recovery. Last but not least, she wants to win the German elections in the fall of 2013 and stay, with or without her present coalition partners, at the helm of the German government.
A fourth element should also be kept in mind. Merkel’s strategy needs to accommodate two powerful national institutions that have often exacerbated, rather than eased, the international crisis. These are the Federal Constitutional Court, which is seen by Germans as the ultimate custodian of the postwar democratic order, and the German central bank, the Bundesbank, which many see as the guardian of German wealth. Merkel tries to keep these different players on board, but when interests diverge, it is an impossible feat. We are in such a phase now. Both the constitutional court and the Bundesbank seem to be determined to limit her maneuvering room in addressing the crisis pragmatically.
Despite all the talk about Germany’s predominance, Merkel is not in a very good bargaining position. Ultimately, she has no choice but to do whatever it takes to save the euro. She can keep the euro zone alive by offering substantial, albeit limited, financial help, or foot a massive bill by allowing the common currency to fall apart. Which would you choose? The first option has the advantage that Germany’s taxpayers might even get most of their money back, paid with interest. In the case of a full or even partial breakup, the costs would be instant and incalculable. Compare the current situation with a high stakes poker game. Germany has been dealt a very bad hand and is trying to bluff its way out of a losing position. For two years Germany has kept everybody guessing. The Germans have tried to extract as many concessions as possible from its partners before putting their cards on the table. This crisis is a classic example of political brinkmanship, as well as a typical example of European political brinkmanship.
The struggle we are witnessing is not only economic. It is mostly about the redistribution of political power within the European Union, and particularly within the euro zone. To put it bluntly: Germany is trying to make sure that the “New Europe” that will emerge from this crisis is more German in character. As new institutions emerge from the crisis, Germany is asserting its influence to ensure a more dominant position for itself. It has become quite clear that the old balance between France and Germany is out of whack. Conscious of this, France is even tempted to look elsewhere—namely, toward Madrid and Rome—to gain a better bargaining position. In order to make it easier for Europeans to digest a more “German” Europe, Berlin is trying to popularize its economic views, or the so-called “German model.” The not so subtle pitch to its partners is: become a bit more like us and you will regain competitiveness and reap economic benefits. France and the Mediterranean countries, on the other hand, are seeking to preserve their own identities, and to some extent, the current status quo.
A third dimension can be linked to the struggle, one that goes beyond politics and economics: religion, or better, morality. It could be argued that what we are witnessing in Europe is a struggle between a protestant, largely Lutheran view of the world and a Roman Catholic approach to life. This is, of course, a simplification, but since the eruption of the euro crisis in 2010, there has been the tendency in Germany to view the euro through a moralistic, Protestant lens almost as if it was the Catholic church of the sixteenth century—powerful, corrupt, and foreign.
Debt, Inflation, and the German Psyche
When Germany negotiated the Maastricht treaty that led to the introduction of the euro, it wanted the nascent currency to be as solid and stable as the old Deutschmark. The main goal was to keep inflation at bay.
Germans fear inflation more than most things—including recessions. For a nation of savers, for whom putting money away is not only economically desirable, but also a moral imperative (the necessary foundation for a righteous life and a successful economy), the silent expropriation brought about by rising prices must be resisted almost at any cost.
Debt, regardless of whether it is private or public, carries a moral stigma. For Germans, the debt crisis represents more than just a dramatic economic downturn in the advanced economies, but also the result of moral failure. This moral dilemma is one reason why politicians in Germany who advocate unlimited financial support for peripheral European countries struggling to finance their debt face, and will continue to face, tough resistance. That is also one of the main contributing factors to the stiff German resistance against Eurobonds.
For this reason, when Germany provides financial backstops, it tries to do so through the back door or through proxies, the most prominent being the European Central Bank (ECB). Before addressing the role of the ECB, the question of debt, and in particular, resistance to the idea of pooling debt, should be discussed.
Let’s be clear about one thing: Eurobonds will have to be introduced at some stage. They will either come at the end of this painful journey as a reward to weaker euro zone members for good behavior, or, in some form or another along the way, as a tool to fight the crisis.
The Question of Eurobonds
Since the eruption of the European debt crisis, the German government has tried to shield German taxpayers from Eurobonds. The “NO” to mutualizing debt is the only, and very symbolic, red line Chancellor Merkel is not willing to cross—at least not until the German elections are over in late 2013. What we hear from government officials in Germany and large parts of the academic community is: “You don’t resolve a debt crisis by piling up more debt.” Eurobonds are even described as a sweet poison. While these types of statements clearly resonate with German voters, they make it much harder to adopt a more pragmatic and less absolutist approach to the crisis.
In fact, reconciling long-term objectives (a closer union that includes common debt) with short-term action (keeping peripheral countries afloat) has been one of the biggest challenges in this crisis. Germany has convinced its partners on the overall goals (deficit reduction, economic reforms, and more European integration), but there is deep disagreement over how to achieve those objectives, as well as over what steps need to be taken first.
Reconciling long-term objectives and short-term steps is a crucial element in fighting this crisis. If striking the right balance is in itself a challenge, imagine how hard it is to explain to the German public that in order to put the economies of peripheral countries on the right path in the long term, their debt needs to be financed at reasonably low interest rates today. It may even be necessary to do so using morally questionable methods, such as allowing the ECB to intervene in bond markets and switch on the printing press.
Not surprisingly, having witnessed long and largely fruitless debates about Eurobonds and the size of European firewalls, investors are once again turning their attention to the European Central Bank, the lender of last resort.
The Role of the ECB
The ECB’s new president, Mario Draghi, has in effect become the bridge between the European Union’s north and south. Draghi has positioned himself as “Rescuer-in-Chief,” and arguably one of the main European strategists. He has articulated long-term goals and mapped out all the necessary steps in between, including the need for a banking union. He has argued strongly about the need for a common narrative, a road map to closer integration that includes clearly defined benchmarks. He has become the closest ally that Merkel and Finance Minister Wolfgang Schäuble currently have in Europe.
At the latest governing council of the ECB at the beginning of August, Draghi announced that the Bank is prepared to reactivate its Security Markets Program (SMP) and buy short-term debt on the secondary market. He reiterated the need for long-term structural reforms in the euro zone countries, but he stressed that reforms could be jeopardized if the delicate balance between political and market pressure on one side and short-term relief on the other gets out of whack. According to Draghi, sovereign bond markets are currently in a state of “severe malfunction.” Draghi argues that acting on the bond market to reactivate the monetary transmission channels is “classic monetary policy” and well within the mandate of the Bank.
A massive intervention by the ECB would, in effect, amount to what the advocates of Eurobonds are asking for. It could significantly stabilize bond markets and reduce the spreads between German bonds and sovereign bonds of Spain and Italy.
Despite the resistance of the Bundesbank to such a program, the German government has openly sided with Draghi, and in so doing, signaled that it is prepared to endorse significant short-term relief for Spain and Italy. Of course, conditionality remains an important component of any financial support provided with German help. In order to maintain the political pressure on peripheral countries, Draghi has specified that the efforts of the ECB would be focused on the “shorter part of the yield curve.” In other words, the role of the ECB would not be to rescue countries like Spain or Italy, but rather to help them buy a little more time to implement their structural reforms.
Governments in the periphery should therefore not assume that they are about to get a blank check from the ECB. On the contrary: if politicians fall short of their commitments to stay on course, market pressure will likely punish these countries in a year or two when the short term debt that the ECB is prepared to buy needs to be refinanced. This element is key. Of course, it implies a transfer of sovereignty from the periphery to Brussels. Yet, such loss of sovereignty is exactly what Germany is trying to extract from its partners.
The Case of Spain and Italy, and the Struggle to Reshape Europe
Spain, and to an even greater extent Italy, are the true battlegrounds where the fate of the euro will be decided. The real price for the rescue of Spain and Italy is a partial loss of sovereignty. In Germany’s view, stronger European integration introduces safeguards that would make it more unlikely for the crisis to return in the future and jeopardize the common currency.
It always takes a crisis to move things, and this time is no different. The problem is that if a New Europe is to emerge from the crisis with a greater balance of power in Brussels’ favor, everyone needs to be on board and moving in the same direction. This means that Germany, along with its southern partners, must show the same willingness to cede control over its own budgets to Brussels. So far the German government has resisted, citing (among other things) the rulings of the German Constitutional Court, which has given Merkel a very narrow space to maneuver. The result is that many Italian and Spanish voters see a partial loss of sovereignty in their countries more as a transfer of power to Berlin than to Brussels.
Not surprisingly, national governments in Madrid and Rome are reluctant to ask for help, and they expect the ECB to act without strings attached. They also fear that asking for an official rescue program could set in motion the very market turbulences that the SMP is trying to fight. Rather than reducing spreads, private investors might flee. Spain and Italy could very well end up being shut out of market access.
This is a legitimate concern. It is a likely outcome if the ECB was to cap its intervention and act timidly. But that is clearly not what Draghi has in mind.
Draghi is walking a fine line: He has to act with boldness, but he cannot ignore Germany’s concerns. His main partner is the political leadership in Berlin. If he can keep Merkel on board, even the attacks coming from the orthodox Bundesbank can be successfully repelled.
Of course, the ECB cannot foot the whole bill for its intervention. Its bond-buying program would amount to monetary financing, and the central bank would be acting outside its mandate. The backlash in Germany would be enormous, and Draghi would surely lose the support of Merkel and Schäuble.
A decision of the governing council of the ECB is expected in September, a month that is quickly shaping up as make or break for the current euro zone:
- We are waiting for the German Constitutional Court to clear the way for the European Stability Mechanism (ESM), the permanent bailout fund, to become operational. The decision is expected on September 12.
- On that same day the Dutch will vote to elect a new national parliament. They could decide to give euro skeptic politicians even more power. They could also decide to side with those Europeans opposed to tight fiscal straightjackets.
- In September, the European Commission will present a first concrete proposal for a European banking Union
- EU finance ministers convene and will in all likelihood deliberate on a full rescue program for Spain
- In late September, the so called troika, composed of the EU Commission, the ECB and the International Monetary Fund, will report on Greece. Based on that report, euro zone leaders will decide whether Athens is making enough progress and should be granted some leniency in meeting its deficit reduction targets.
Things are coming to a head. Merkel’s original timeline—in other words, to kick the can down the road at least until Germany’s parliamentary election in the fall of 2013—has been obliterated by the rapid pace of the crisis.
The coming months will be crucial. Surely, the bargaining will be hard and add to the climate of uncertainty. But when watching this new chapter of the crisis unfold, we must all keep the underlying facts in mind, consider the deeper realities rather than being distracted by the noise that accompanies hard bargaining.
Merkel is the captain on a ship with a problematic crew. But she must weather the storm. If Merkel wants to continue this journey, she has no choice but to stick with this group of countries. The alternative is the end of the euro and most likely her political career.