Merkel’s pyrrhic victory leaves a nightmare
AS FAR as Germany is concerned, the drama of the euro crisis is over. Chancellor Angela Merkel did what was necessary to ensure the euro’s survival, and she did so at the least possible cost to Germany. She won re-election resoundingly.
But it was a pyrrhic victory. The eurozone status quo is neither tolerable nor stable. Mainstream economists would call it an inferior equilibrium; I call it a nightmare that is inflicting pain and suffering that could be easily avoided if the taboos that sustain it were dispelled. The problem is that the debtor countries feel all the pain, while the creditors impose the misconceptions and taboos.
One example is eurobonds, which Merkel has declared taboo. Yet they are the obvious solution to the root cause of the crisis, which is that joining the euro exposed member countries’ government bonds to the risk of default. Usually, developed countries never default because they can always print money. But, by ceding that authority to an independent central bank, the eurozone’s members put themselves in the position of a developing country that has borrowed in foreign currency. Neither the authorities nor the markets recognised this before the crisis.
When the euro was introduced, the authorities declared member states’ government bonds to be risk-free. Commercial banks could hold them without setting aside any capital reserves and the European Central Bank accepted them on equal terms at its discount window. This created a perverse incentive for commercial banks to buy the weaker governments’ debt to earn what became just a few basis points, as interest-rate differentials converged to near zero. But this convergence caused economic divergence. The weaker countries enjoyed property, consumption and investment booms, while Germany, weighed down by the fiscal burden of reunification, had to adopt austerity and implement structural reforms. That was the origin of the euro crisis, but it was not recognised at the time.
Converting all outstanding government bonds into eurobonds would be the best remedy. It would require no transfer payments, because each country would be responsible for servicing its own debt. And it would impose stricter market discipline on debtor countries than they face at present, because they could issue eurobonds only to refinance maturing ones; any additional borrowing would have to be in their own name, and markets would impose penalty rates for excessive borrowing.
Yet eurobonds would substantially reduce the heavily indebted countries’ borrowing costs and go a long way to re-establishing a level playing field in the eurozone. Germany’s credit rating would not be endangered, because eurobonds would compare favourably with bonds issued by other major countries.
Eurobonds would not cure disparities in competitiveness; eurozone countries would still need to undertake their own structural reforms. But they would remedy the euro’s main design flaw. All the alternatives are inferior: they either involve transfer payments, perpetuate an uneven playing field, or both. And yet, because of Merkel’s opposition, eurobonds cannot even be considered.
Germany would do well to remember it has benefited from debt write-downs three times in its history. The Dawes Plan of 1924 sought to stagger Germany’s reparations payments for the First World War. The Young Plan of 1929 reduced the sum Germany owed in reparations and gave the country more time to pay. The post-Second World War Marshall Plan provided debt relief as well.
French insistence on harsh reparations payments after the First World War prepared the ground for the rise of Adolf Hitler. The rise of Greece’s neofascist Golden Dawn is a similar phenomenon. These two examples justify my description of the euro crisis as a nightmare. Only Germany can end it because, with the highest credit rating and the largest and strongest economy, it is in charge.
Germany, mindful of its recent history, does not want to be cast in the role of a hegemonic power; the present situation is not the result of some evil German plot. Still, Germany cannot escape the responsibilities and liabilities that go with that role. It must learn to act as a benign hegemon. Doing so would earn Germany the lasting gratitude of the countries that are subordinated to it. Failure to seize this moment would, I believe, lead to the disintegration and eventual collapse of the European Union.