Ezrati’s Economic Outlook: Berlin’s Limited Options

Germany has good reasons to preserve the eurozone.

In Europe’s seemingly endless debt negotiations, Berlin would seem to hold all the cards. It is, after all, Europe’s largest economy, its most powerful and its most financially sound. But in reality, Berlin’s options are highly constrained and require a remarkably delicate policy balance. On the one hand, Berlin, as the eurozone’s pay master, seeks fiscal austerity to ensure that its money and aid go to good purpose, to alleviate future financial strains.

At the same time, it dares not push austerity too hard. Its clear self-interest in preserving the eurozone makes it loathe to risk the departure of any member, much less dissolution. That balance has appeared in past negotiations and almost certainly will in future ones as well. Though the outcome remains uncertain, Berlin’s continuing strong commitment to the zone’s integrity surely increases the probability that in the end, the euro will survive.

Berlin’s seeming passion for austerity is an easy call. As the eurozone’s biggest member by far, it knows that it will bear the bulk of the expenses for the rescues or bailouts or aid or whatever the European diplomats prefer to call the spending. Like any financiers, Germany’s leaders want control of how the funds are used to ensure a favorable return—in this case, a resolution of the problems rather than prolonged profligate fiscal and banking behavior.

This powerful need has appeared repeatedly in all the negotiations since the crisis began in 2010. Berlin’s offsetting interest in keeping the zone intact is equally important, but more obscure. It has three elements, all reflecting German self-interest.

The first is Berlin’s realization that Germany will pay one way or the other. If it were to fail to help the weak periphery, defaults and reschedulings would strain German banks severely. German financial institutions report holding some 400 billion euros in official Spanish, Greek, Portuguese and Irish obligations, and that much again in Italian government debt. Should these nations fail to pay on time, German banks could, in the extreme, lose what could amount to 270% of their tier 1 capital or, effectively, 17% of Germany’s gross domestic product (GDP).

Unless Berlin used its funds to fill the gap, such a setback would so curtail the flow of credit that the economy would almost surely sink deeply into recession. Berlin surely sees European-wide aid to the periphery as a less costly and less risky alternative to such a rescue of German banks.

The second and third motivations to preserve the zone are more economic and even more profound. The euro area has provided German industry with an almost captive market. Because Germany joined the euro when the deutschmark was cheap compared to German economic fundamentals, the common currency effectively enshrined a competitive pricing edge for German producers within Europe. Especially because the nations of Europe’s periphery generally joined the euro when their respective currencies were dear compared with their economic fundamentals, the common currency gave German industry an almost natural dominance within the zone. International Monetary Fund (IMF) data show that the currency differences initially gave Germans producers a 6% percent pricing advantage over their Greek, Spanish, and Irish competitors. By encouraging greater industry and investment in Germany and discouraging it in the disadvantaged periphery, Germany’s pricing edge has actually expanded to 12%, 20%, and 32% against these countries respectively.

Third, the euro and its zone also helped German industry compete outside Europe. Had the common currency not existed, a rising deutschemark eventually would have erased much or all of Germany’s pricing advantages in global markets. Because the euro encompasses weaker economies, it could never rise as high as a separate German deutschmark surely would have, so it has protected German producers from such competitive pricing disadvantages. For producers in Europe’s periphery, of course, the euro had the opposite effect. The euro, lifted by the zone’s stronger members, has generally priced their exports higher than their individual national currencies would have done or their economic fundamentals could readily support. In this regard, the Germans may have a greater interest in sustaining the eurozone than Greece, Spain, or any of the others.

This balance of needs has informed German positioning since the start of the debt crisis and was clearly present in the most recent round of negotiations. Berlin has made concessions to preserve the zone but only just what was necessary. Even there, the emphasis on control has remained. In Europe’s latest deal, Berlin seemed to reverse two former positions. It now will allow direct lending to banks from the zone’s stability funds, and it has ceased its insistence on special credit status for the rescue funds, encouraging private lenders by placing their claims on a hierarchical par. Berlin’s initial resistance grew from its belief that only government-to-government arrangements could give enough control. It can give in now because the prospect of zone-wide bank supervision offers Berlin an alternative means to guard against profligate behavior.

For the rest, the old German balance was more obvious. When Italy’s Mario Monti pushed what he referred to as a “semi-automatic” mechanism for Europe’s funds to support “well-performing” nations by buying their bonds in the secondary market, German Finance Minister Wolfgang Schäuble did not dispute him. He simply rendered the term “automatic” moot by noting that such loans would still require a formal government request that, of course, would give Berlin the control it has always sought. Nor was there a need to insist on austerity with “well-performing” nations, since presumably the designation speaks to their greater degree of control.

Similarly, the debate on common debt, the so-called eurozone bonds, followed the old patterns. France and Italy talked them up, while Berlin insisted that such issues would have to wait until the European Commission, and hence Germany, have strict, “irreversible” control over national budgets, including the power to strike them down and sanction nations that  violate monetary-union rules.

Europe will need more summits and other deals before it can put this crisis behind it. The effort will take a long time. But even as the specifics change, Berlin will continue with this balancing act, making what concessions are necessary but never so much as to lose control. Still, a German commitment to zone integrity, even if largely on its own terms, makes it likely that the eurozone and its common currency will survive.

 

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