A series of events over the last few weeks have created a new situation in Europe.
First, the euro area has failed to turn the tide. Mario Draghi was right to note last week that in spite of numerous ministerial meetings and three summits, implementation of the decision taken in July is still lacking. There are by now growing doubts about the very wisdom of holding them.
Second, and partially as a consequence, the debt of virtually all euro-area countries is trading at a discount to the German Bund. While a more accurate pricing of risk was necessary, it is hard to believe that with a debt ratio nearly twenty percentage points lower, the Netherlands deserves to be assessed more prone to default than Germany. Even the Bund started to suffer from market anxiety last week.
Third, market participants and, increasingly, real businesses are pricing in a break-up scenario. It is still hard to think the unthinkable, let alone to work out the details of it, but any rational player has to consider the possibility of it. If disaster expectations build up and a growing number of players start positioning themselves to protect themselves from it, the consequences could become overwhelming.
Fourth, Germany has become the undisputed leader of the euro area. Although France continues to play its role in the couple, it has lost weight and initiative. A weaker French economy, weaker public finances and the coming presidential election are all combining to alter the balance in the old couple. Political impetus can defy the laws of gravity, but only up to a point.
In this context Germany finds itself again in a situation akin that of the late 1980s, when the Bundesbank was making monetary policy for the rest of the continent. At that time chancellor Kohl wisely assessed that German economic dominance was not a stable equilibrium and that a better plan for the future was to build on Germany’s weight and influence to create a permanent common monetary order. This is what gave birth to the euro.
Today again Germany’s best interest is to ensure lasting stability in Europe. With foreign assets worth 6 trillion euros, most of which consist of claims on euro-area partners, Germany would lose out massively in a fragmentation of the euro area. Claims on entities in partner countries would either be redenominated in weaker currencies or the borrowers would default on them. And, obviously, German exporters would be hurt by substantial currency appreciation.
Chancellor Merkel has sensibly decided to take the lead on reforming the euro area. But many Germans feel deceived by irresponsible euro-area partners. There is therefore the temptation to use Berlin’s current strength to toughen sanctions and coerce weaker partners into adopting constitutional changes, especially in the budgetary field.
This is a risky attitude. For sure, Germany today has far more leverage than it has had at any point in the last twenty years. But to attempt to extract unilateral concessions from partners is a recipe for disappointment. It is one thing is to be sanctioned if you breach the rules, as today with the Stability and Growth Pact, and quite another thing to move to a new system that gives a higher-level authority the power to overrule national parliaments and censor a budget before it is enacted. Partners are unlikely to agree on major reform if Germany does not offer something in exchange. What is likely to emerge from negotiations is, rather, another layer of largely ineffectual sanctions procedures.
The natural quid-pro-quo for ex-ante budgetary control is solidarity through the creation of Eurobonds. Joint and several liability over public bonds is imaginable only if countries offering their guarantee – in effect potential access to their taxpayers – can exercise veto power and prevent a partner country from issuing more debt. So legally binding ex-ante control is a sine-qua-non condition for Eurobonds. Symmetrically, surrender of budgetary sovereignty through the granting of veto power to the partners is acceptable only if it comes in exchange for a guarantee from these partners that they will come to the rescue in case of accident.
Germany therefore should be bold and use its leverage to offer a new contract to its euro-area partners: mutual guarantee over part of public debt in exchange for strict debt limits and a new legal order in the framework of which a euro-area authority could veto a budget passed by a national parliament even before it starts being implemented. Only boldness will deliver.
A version of this column was also published in Handelsblatt