Pity Germany. It goes to Thursday’s two-day European summit in Brussels in a visible lose-lose situation, and with no easy way out of a complex dilemma that pits good politics against bad economics. Its hard-fought economic gains, earned over many years through restructuring and fiscal discipline, are threatened by the crisis in peripheral eurozone economies that adopted a different policy approach. To add to the irony, these challenged countries (and indeed the zone as a whole) now look to Germany to fund one rescue package after another.
Up to now, Germany has co-operated. It has been the biggest contributor to the bail-outs for Greece and Ireland. It has also supported the European Central Bank’s decisions to buy peripheral government bonds, and to provide unlimited liquidity to struggling banks. In doing so Germany has sought to buy time for the weaker members (and European banks) to get their houses in order – as well as to reduce pressure on the integrity of the zone as a whole.
Of course Germany’s support has not been unconditional. It has insisted on serious policy corrections from profligate peripheral European countries. It has also pushed for a sovereign debt resolution mechanismthat, starting in 2013, would ensure that the burden of adjustment is not carried just by taxpayers but also by creditors and shareholders. And it has resisted multiple calls to stimulate its internal demand and thus act as an economic locomotive for the eurozone as a whole.
The problem is that this approach – centred on dealing with liquidity problems now and solvency issues later – is not working. On Wednesday, credit ratings agency Moody’s threatened furtherto downgrade Spanish government bonds, because of problems associated with raising funds in 2011, along with difficulties with its banks. More generally, rather than being reassured by the provision of liquidity to peripheral countries, existing depositors and creditors have used the rescue funds to exit their holdings. Meanwhile, new money remains sidelined by concerns about these countries’ debt overhang and their lack of competitiveness.
Less investment in peripheral Europe means fewer jobs and deeper economic contractions, making it even harder to deliver austerity plans that are already contributing to social unrest, including Wedneday’s disturbances in Athens. So the pressures on Germany to do more are rising. In the last week, Germany has been called upon to back even more ambitious bailout initiatives, with proposals to create a unified European bond and double the size of the emergency funding facility for peripheral countries. In the process, the country also finds itself in a growing standoff with an ECB that now wants to limit the weakening of its own balance sheet.
Sensing the risk that Germany’s balance sheet (and that of the ECB) may continue to be contaminated by someone else’s problems, the markets have started to signal some initial concerns about the country’s fiscal robustness. In addition to some jitters at a recent government bond auction, German interest rates have followed American ones sharply higher even though the two countries’ fiscal paths diverge dramatically.
All this highlights the dilemma facing a Germany that feels politically compelled to support a liquidity approach for peripheral Europe’s solvency problem, but knows the economics of the situation are wrong and, ultimately, harmful. A liquidity approach that delays the day of reckoning may be good regional politics, but its bad economics. It does not restore sustainable growth to the periphery, and it exposes the core to contamination – be it through peripheral liabilities being transferred to the German tax payer or the ECB’s balance sheet coping with by purchases and repos of peripheral bonds.
This is not the first time that Germany faces such a dilemma. After the fall of the Berlin wall, West Germany judged that good politics trumped bad economics, and agreed to reunify with much-weaker East Germany at a one-to-one exchange rate. It took years to overcome the costs of this decision.
The situation this time suggests good economics should play a greater role. Rather than simply doubling up on a faltering liquidity approach, the time has come for Germany to lead a more holistic solution focused on addressing the periphery’s debt overhang and competitiveness problems.
The writer is chief executive of Pimco