What Will Germany Do?

A choice of Break-Up or Break-Down

By Anatole Kaletsky

Now that the Greek election is over, with the pro-bailout parties gaining enough seats for a slim majority, Europe can return to the regular cycle of panic, relief, disappointment and renewed panic, that we have observed for the past two years. This time, however, the relief rally may be even shorter than usual, since the market's attention will soon shift from Athens to Madrid, Paris and, above all, Berlin. Since Greece has no chance of meeting its financial targets, the new government will soon need significant new concessions from the troika. Assuming that Germany resists such concessions, as well as the much larger ones that will soon be required by Spain, the fundamental contradiction of the euro project will again be brought into focus. A single currency can only be sustained within a fiscal and political union that can mutualise and monetize the debt— something that Germany refuses even to discuss.

If this situation persists, then one of two things could happen. The debtor countries could resign themselves to permanent depression and bankruptcy as they sink further into debt traps and Greek-style crises which will ultimately push them out of the euro one by one. Or they could turn the tables on Germany. Instead of letting Germany impose its economic and political philosophy on Greece, Ireland and Portugal—and in the near future on Spain, Italy and probably France—the Club Med countries could unite and impose their economic philosophy on Germany.

With every day that passes, and especially since the French election, it is becoming clearer that the problem country for the euro—the odd man out in terms of economic structure and the chief obstacle to any political resolution of the euro crisis—is not Greece, Spain or Italy. It is Germany. It is Germany that refuses even to talk about mutual debt and banking guarantees. It is Germany that insists on self-defeating fiscal austerity and intolerable political conditions for the debtor countries. It is Germany that vetoes quantitative easing by the ECB, which could cap bond yields and relieve deflationary debt traps. And it is Germany that makes the other euro countries uncompetitive, discourages devaluation of the euro against the dollar and refuses even to relax its own domestic fiscal policies to reduce its trade surplus and support growth.

Suppose then that Angela Merkel refuses to make any compromise on debt mutualisation or ECB monetisation when a political or market crisis next strikes one of the debtor countries, as it surely will. The obvious answer would be for the Club Med governments to point out that Germany has become the obstacle to a resolution of the euro crisis. Mrs Merkel could then be asked, one last time, to abide by majority decisions that are necessary for the survival of the euro and in the interests of all its members. If she refused to do this, Germany could be politely asked to leave. And if Mrs Merkel refused to fall in line or voluntarily leave the euro, the other countries could easily call her bluff by creating conditions that would be unacceptable to the German public. The obvious way to do this would be to force a vote in the ECB for unlimited quantitative easing to monetise government debts.

German public opinion would surely oppose this, but they could not prevent it because Germany has just two votes on the Council of the ECB —and even assuming support from Austria, Finland, the Netherlands and Slovakia, the German faction would command only 6 votes out of 23. If the two German ECB representatives were forced to resign in protest (again!), it is easy to imagine German public opinion demanding immediate withdrawal. A new Deutschemarks could rapidly be issued by the Bundesbank and, while the German banks and insurance companies would suffer large losses because of a mismatch between their euro assets and their New D-Mark liabilities, they could be readily recapitalised by a government suddenly freed of the contingent liabilities imposed by the rest of the eurozone.

This kind of euro break-up triggered by German revaluation would be much less disruptive than a "break-down" caused by devaluation in Greece or Spain. In the case of a German revaluation, there would be no contagion or capital flight, as there would be if Greece, then Spain, then Italy and France were knocked out of the euro one by one. There would be no lawsuits by disgruntled creditors.

Best of all, from both the legal and the economic standpoint, the legacy euro created by a German withdrawal would survive as a more viable common currency for the remaining countries of the eurozone. With Germany outside the euro, France, Italy and Spain could rapidly devalue their way back to competitiveness within Europe—and also internationally, by encouraging the new euro to devalue rapidly against the dollar, yen and RMB. Without German opposition, the ECB could imitate the Fed and the Bank of England, buying bonds without limit so as to slash long-term interest rates. And if quantitative easing produced an even weaker euro or higher inflation, so much the better, since the Club Med countries have always relied on devaluation to promote export growth and inflation to eliminate debts.

A break-up of the euro caused by Germany's departure would be very bullish for practically all global risk assets, with the obvious exception of German export and bank stocks. German bonds would also suffer huge losses, since the German government could decide to repay its bonds in legacy euros, rather than redenominating all its obligations into appreciating new Deutschemarks. For a government that had just spent hundreds of billions on recapitalising its banks for the losses they suffered in France, Spain and Italy, it would be tempting to burn foreign bondholders, rather than offering them a further currency windfall.