Splendid Isolation

German governing coalition members like to think that their boss, Chancellor Angela Merkel, is getting exactly want she wants from her European partners. The successful bond auctions in Spain and Italy on Thursday are seen as the reward for the German-style fiscal austerity measures undertaken by those countries. German government officials are urging their skeptical American counterparts to start looking at Europe with some optimism.

So far, their appeals have fallen on deaf ears. On the campaign trail, Republican frontrunner Mitt Romney has turned Europe into a punching ball. In his words, the continent is overregulated and dangerously close to socialism. This type of Europe bashing is guaranteed to draw applause. Some investors in New York boast to clients about having warned them for years about “Europe’s unfunded liabilities,” meaning the generous welfare systems.

At a recent event on the West coast of the United States (US) organized for big financial institutions, a World Bank representative was asked by a US investor what sort of assistance Italy was receiving from the World Bank these days. The official said he remained speechless, unsure whether to laugh or cry – of course there is no such program. Finally, he responded simply: “We focus on developing countries at the World Bank.”

To many in the US, the European mess is still too complicated and obscure to fully comprehend. Old prejudices against the hybrid nature of an imperfect union made up of countries willing to share sovereignty, but not yet ready to create a federal Europe, have gained traction, fueled by the self-doubts that European themselves have displayed in the past months.

Even Europeans at the highest government level have shown a deep ignorance about what is happening in neighboring countries. While recently visiting Paris, Italian Prime Minister Mario Monti was surprised to be asked by his French colleague Francois Fillon whether the plans for deep pension reforms were likely to be implemented. Monti had to explain to the Frenchman that they were not merely plans, but reforms that had already been passed by the Italian parliament. When he visited Germany a few days later, the Italian prime minister stressed his concern that Europe was not taking real notice of what was happening in Italy. He concluded by saying that while his country was doing its duty, Europe now needed to do its part.

Anecdotal evidence seems to indicate that many market participants have only a superficial understanding of developments in Europe. European officials themselves are largely to blame for the contradictory messages coming out of the euro zone, a trend likely to continue given the political pressures of leaders in each individual country.

While reading between the lines will continue to be a challenge, the facts on the ground have started speaking a very plain language – and it isn’t German.

In fact, especially in the last few weeks, Berlin has found itself more and more isolated.

First: The crisis will not be solved by fiscal austerity alone. France and Italy have already announced loud and clear that they have reached the end of the road and from now on will focus their efforts on growth. The problem is there will be no growth if interest rates on sovereign bonds stay high, because they negatively affect the whole economic system. The European Central Bank (ECB) and Germany need to create the environment for rates to go down.

Secondly: With its massive liquidity injection into the European banking system in December, the ECB has in fact become the lender of last resort, as many outside of Germany have invoked. In private conversations, big European banks were asked by the ECB to invest part of the cash they were getting into bonds of the European Financial Stability Facility (EFSF), also known as the bailout fund. The central bank encouraged financial institutions to use those bonds as collateral to obtain further loans from the ECB. Furthermore, central banks of Euro member states apparently asked their big banks to buy sovereign bonds. In other words, the message from the ECB to European banks was: I’ll scratch your back if you scratch mine.

Thirdly: Since the Netherlands – one of Germany’s staunchest allies in the battle against raising more bailout money – pulled its support, the German government is apparently no longer opposed to raising the cap of the combined force of Europe’s bailout funds, the EFSF and the European Stability Mechanism (ESM), which presently stands at 500 billion Euro.

Fourthly: The fiscal compact now under discussion is a watered down version of the original deal Germany and France had pushed through at the last European Union summit in December 2011. While still reflecting the common will to adhere to stricter rules, and to start the journey towards a fiscal union, the draft currently circulating in the Euro zone capitals lacks real teeth. The fiscal compact could become a political fig leaf for additional financial help for distressed countries ultimately funded by German taxpayers. In the words of a member of the German ruling coalition, the treaty is to be seen as the condition “for the rescue package, not (…) for Eurobonds.”

Last but not least: On the question of the introduction of Eurobonds, we shall see. For Merkel’s junior coalition partners, it seems to be the only line in the sand left to defend.

Most red lines have come and gone. As Germany is forced to abandon an increasing number of its principles, the official explanation in Berlin is likely to sound something like what I heard from a German politician visiting Washington in the last few days: “It is true that we have crossed a lot of lines, but only after we got something in return”. Peripheral Eurozone countries such as Italy or Spain would never have engaged in such profound structural reforms, or challenged deeply engrained, vested interests, had it not been for Germany’s hard line, so the argument goes.

But then of course, Germany always wanted these countries to stay afloat and for the Euro to succeed. The irony is that even if the crisis has pushed Germany further away from its own principles, the Eurozone as such could soon be on a slow, albeit rocky, path to recovery.

The views expressed are those of the author(s) alone. They do not necessarily reflect the views of the American Institute for Contemporary German Studies.

Alexander Privitera

Alexander Privitera is a Non-Resident Fellow at AICGS. He focuses primarily on Germany’s European policies and their impact on relations between the United States and Europe. Previously, Mr. Privitera was the Washington-based correspondent for the leading German news channel, N24. As a journalist, over the past two decades he has been posted to Berlin, Bonn, Brussels, and Rome. Mr. Privitera was born in Rome, Italy, and holds a degree in Political Science (International Relations and Economics) from La Sapienza University in Rome.