The Bleak View from Berlin
Pity German chancellor Angela Merkel. It must now be painfully clear that the country she leads simply cannot avoid paying dearly in this crisis: one way or the other, whether there are bailouts or not, whether the euro holds together or not. Faced with such a Hobson’s choice, Berlin no doubt realizes that its least costly option is to hold together as broad a Eurozone as possible. But if that is where the cost-benefit analysis leads, it is worth remembering that political calculations often diverge from rational lines.
Germany has good reason to hold the Eurozone intact. When it functioned, it benefited the country greatly. Because Germany joined the euro when the deutschmark was cheap relative to German economic fundamentals, the common currency has effectively enshrined a competitive pricing edge for German producers across the entire zone—especially compared to producers in Europe’s periphery nations, which joined the euro when their respective currencies were expensive. International Monetary Fund (IMF) data shows that these currency differences initially gave German producers a 6 percent pricing advantage over their Greek, Spanish and Irish competitors. But today, by encouraging greater industry and investment in Germany and discouraging it in the disadvantaged periphery, that advantage has actually grown. Recent IMF data put Germany’s current pricing advantage over these countries at 12, 20 and 32 percent respectively.
The euro has also helped Germany compete outside of the Eurozone. Had the common currency not existed, a rising deutschemark eventually would have erased any German pricing advantages in global markets. But because the euro encompasses weaker economies, it never rose as high as a German deutschmark surely would have. Without the euro, some German producers would have found themselves priced out of global markets. The common currency has saved them. For producers in Europe’s periphery, of course, the euro proved a burden, as the zone’s stronger members kept it priced higher than their individual national currencies would have been or than their economic fundamentals could readily support. The euro, on this basis, very likely priced some producers in peripheral economies out of the global competition even as it enabled the German competition to remain in the game.
If the Eurozone were to fly apart, Germany would lose both of these significant advantages. German producers, back on the deutschmark, would have to cope with a stronger currency that would drag up the global price of their products and erase a competitive pricing edge to which they have grown accustomed. Even as German business would lose its advantages, those in the periphery outside the zone would see their competitive situation improve as their reconstituted national currencies fell in value and their producers could sell at cheaper prices than previously—perhaps even cheap enough to take from Germany’s market share.
Likewise, a reduced Eurozone membership, in which the weaker nations go their own way, would cost Germany dearly. It would, of course, lose that once-natural market to the south, and the remaining, stronger countries in the reduced Eurozone would prompt a rise in the euro’s value above where it would have settled had the weaker members remained. German producers might not face quite the currency appreciation they would suffer under a separate deutschmark, but circumstances would be much less advantageous than with the broader zone intact.
Germany would suffer still other disadvantages should the Eurozone dissolve or shrink. In all probability those nations departing would repudiate their euro-denominated debt or, at the very least, reschedule it. German finance would suffer immediately in either case. German banks and other financial institutions hold 400 billion euro in Spanish, Greek, Portuguese and Irish obligations as well as much more in Italian government debt. Left unaddressed, this loss of some 270 percent of the German banking system’s Tier 1 capital and 17 percent of Germany’s gross domestic product (GDP) would curtail the flow of credit in Germany’s economy such that the country would almost surely tip deeply into recession. To prevent this economic pain, German taxpayers would need to extend credit or subsidies to replace much of the lost bank capital and liquidity. Even if the ECB were to help in such an effort, it would still be hugely expensive.
Rather than suffer on all these fronts, Germany would do well to support the weak periphery. Bailouts and rescue packages might look large in the headlines, but ultimately they impose burdens far lighter than the economic and financial costs implicit in any Eurozone dissolution, complete or partial. Still, in opting for bailouts, Germany, quite understandably, has no desire to play the chump. If money must flow from north to south in Europe, Berlin wants assurances that it will go to ease the debt situation and not to feed additional profligacy. If German financial resources must carry the bulk of the rescue burden, Berlin surely wants to ensure that France, the Netherlands and other stronger members of the zone do not get a free ride and carry at least some of the burden. Even if Germans are vaguely aware of the great competitive advantages they have enjoyed and feel an obligation to help those who suffered disadvantages in the common currency, they still see little value in carrying the entire burden or turning aid into charity.
Facing such constraints and unattractive options, German negotiators seem likely to push along three lines: First, Berlin will insist on austerity to ensure its aid does something to alleviate fiscal pressures, but its need for as broad a zone as possible will lead it to make concessions in order to keep aid recipients within the zone. Second, to ensure that Germany does not carry the entire burden, Berlin will insist on safeguards such as resisting Eurozone bonds (unless they are highly circumscribed) and any zone-wide banking union (unless it offers significant protections for German liabilities and also considerable control). Lastly, while insisting on tight, typically-German monetary policy, Berlin increasingly should look for ECB help with rescues, pressuring the bank to soften its former reluctance to add liquidity to European markets and banks. Whether such a three-part strategy will prove sufficient to defuse the crisis remains an open question, but it surely would help for Berlin to show its commitment and purpose clearly.
Milton Ezrati is Senior Economist and Market Strategist for Lord, Abbett & Co. as well as an associate of the Center for the Study of Human Capital at the State University of New York at Buffalo. He writes frequently on economies and finance and is just completing a book on demographics and globalization.