The price of German leadership

Written by Charles Grant [1], 17 November 2010
From Financial Times

The euro, the European Union’s boldest and most ambitious project, is under threat. Divisions among Europe’s leaders, and their inability to stabilise the euro, have damaged the EU’s reputation on other continents. The good news is that the EU now has an emerging leader. Chancellor Angela Merkel is setting the agenda. The bad news is that some German policies may do more harm than good. Thus Germany’s insistence that the future “crisis resolution mechanism” should make bond-holders take a loss has scared investors, pushed up Ireland’s and Portugal’s cost of borrowing and made their bail-out more likely.

That Germany has taken the lead is not surprising. The economy is performing quite well and it will pay the biggest share of any bail-out. But while Ms Merkel is willing to help eurozone countries in trouble, she is constrained domestically on two fronts. She has a legal problem: the German constitutional court could rule against a permanent rescue mechanism, since it would breach the EU treaties’ no bail-out rule. So she wants the treaties changed to allow such a mechanism. She also has a political problem: the Bundestag could refuse to provide for insolvent countries unless private-sector creditors share the pain. So she wants her EU partners to accept that principle.

Ms Merkel will probably get her way. While France and many other governments had opposed her on both points, at last month’s Franco-German summit, President Nicolas Sarkozy accepted her arguments. This shift reflects France’s increasing anxiety about Germany’s economic strength and assertive diplomacy. German exporters have performed much better than those from other EU countries in Russia and China. The French wonder whether the growing economic divergence between Germany and its partners may make it more eurosceptic and less willing to work through the EU.

Mr Sarkozy has concluded the best way to maintain influence over the Germans is to stay close to them on key questions. Thus France backs Germany’s soft approach to Russia, and has followed Berlin’s lead on supporting IMF involvement in rescues, and stricter punishments for countries that borrow too much.

The other countries are likely to follow Germany’s timetable for treaty change: governments will agree on an amendment next year; parliaments will then ratify the change so that the rescue mechanism is in place by mid-2013 – just before the temporary bail-out facility agreed in May expires, and just before a German general election.

Germany’s desire to make creditors suffer is more controversial. The governments that have problems borrowing, the European Central Bank and the British government warned that to push this principle when markets were jittery would frighten investors. And when that happened the complaint that “German leaders just don’t get markets” was heard in several capitals.

German policymakers are unapologetic and say it is good that markets are disciplining borrowers. The markets’ increased focus on sovereign risk has led to Germany’s re-emergence as Europe’s financial anchor. Everyone is watching the spreads between the cost of borrowing in Germany and in other countries. Before the euro, the D-Mark was the centre of the exchange rate mechanism. The point of the euro, for the French and others, was to make the system European, not German. And so it was for 10 years.

But now Germany’s economic policies constrain others’ freedom of manoeuvre. If Germany tightens fiscal policy, France and Italy risk their spreads rising if they do not follow. And Germany will tighten policy, to comply with its constitutional provision for a balanced budget by 2016. This deflationary bias could spread through the eurozone.

The predominant view in Germany on the medicine required by the eurozone is that if the problem-countries cut spending and enact vigorous structural reform their economies will grow. Most other Europeans think the crisis in the eurozone will last as long as large structural imbalances divide it: Germany and other core countries have weak domestic demand but current account surpluses, while the peripheral countries have low growth and (Ireland excepted) current account deficits. The Germans dislike talk of imbalances since it implies they are partly to blame for low growth in southern Europe. So they oppose initiatives for more intrusive EU surveillance that could lead to reprimands for countries that fail to curb surpluses.

Germany may not get everything its own way. Some smaller states resent diktats from Berlin, countersigned by Paris. What if a national parliament blocks the treaty change? Smaller countries are also uncomfortable with Paris and Berlin minimising the role of the European Commission – their traditional protector – in eurozone rescue mechanisms. If the current, German-led strategy for curing the euro’s ills fails, Ms Merkel will face a revolt.