Germany's Dilemma And The Future Of The Eurozone: Part 1

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by: James A. Kostohryz

Several countries in the eurozone including Italy, Spain, Portugal, Ireland and Greece (PIIGS) are no longer able to raise new debt or even roll over old debt in private financial markets without multilateral assistance. Indeed, without massive intervention from the EU, ECB and other multilateral lenders to secure the financing of new deficits and roll-overs, these PIIGS nations will be forced to default on their debts and possibly exit the common currency.

As the largest and most powerful member of the EU, Germany will play a major role in determining the fate of the PIIGS and of the Eurozone (EZ) as a whole. German leaders must decide whether, how and to what extent their nation will be willing to underwrite comprehensive rescues of PIIGS economies.

Until now, German leaders have insisted on an orthodox approach: Germany has been willing to support emergency multi-lateral financing and other measures, but only on the condition that the aid recipients undergo harsh "austerity" measures. Their position has been that countries that are having difficulties raising money in financial markets must slash spending and raise taxes in order to balance their budgets and restore "market confidence."

It is now clear that such austerity policies have been making things worse rather than better. Austerity policies in the context of depressed economic and financial conditions have caused economies to shrink and fiscal deficits to balloon rather than contract. This, in turn, has caused confidence in financial markets to collapse. Furthermore, the only "confidence" that financial markets have expressed in European policy has been when they have gone in the opposite direction of austerity. The recent rally in risk assets in Europe and the U.S. as reflected in index ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA), (NYSEARCA:EWG), (NYSEARCA:EWQ), (NYSEARCA:EWI) and (NYSEARCA:EWP) have been in response to heterodox and expansionary policies such the recent implementation of LTRO by the ECB or the announcement of the EFSF in October.

As the economic and financial failure of austerity policies in current conditions has become increasingly clear, a growing number of nations inside and outside of the EU are trying to persuade Germany and the EU as a whole to reverse course. Leaders of governments in Portugal, Spain, Italy, Ireland and Greece have been joined by other nations and the IMF in loudly calling for Germany to support aggressive intervention by the ECB in Europe's sovereign debt markets as well as supporting more counter-cyclical fiscal policy. According to the IMF as well as many independent analysts, if Germany's response to the crisis does not change and the downward spiral in the PIIGS is not arrested quickly, the entirety of Europe will face an economic calamity.

The question is: What will Germany's response be?

What Will Germany Do? Factors That Will Influence German Decisions

A forecast of what Germans will ultimately do is not a simple one. Many analysts base their predictions regarding what Germany will do on what they opine Germany should do. This approach is deeply flawed. First, it is not obvious what the Germans should do. Second, even if it could be easily determined what should be done it is far from certain that this would in fact be done. Many idiosyncratic partisan political, personal and cultural factors intervene.

Indeed, if nations always did what they should, history would have witnessed far fewer economic crises, wars and other calamities caused or exacerbated by bad government choices.

So, in addition to acknowledging that it is very difficult to determine what Germany should do a priori, one must approach this inquiry from the proper cultural, historical and personal prisms of the people that will be influencing/making the decisions.

Keeping these basic observations in mind let us very briefly review a few important factors that will influence German decisions.

1. The perceived economic benefits of the euro to Germany. Many analysts, including myself, have noted the economic advantages for Germany of a "hard" currency shared by its European trading partners. Principally, from the perspective of Germany's mercantilist economic model, a common currency eliminates the ability of Germany's trading partners to employ their historic palliative of devaluation to correct persistent German trade surpluses gained via superior productivity growth.

The problem is that a proper analysis cannot end there. There is another side to the ledger of trade surpluses: Trade deficits are the necessary counterpart to trade surpluses; trade deficits are financed by debt; and the debt of trade deficit nations is financed by the accumulated surplus of trade surplus/creditor nations. Such an arrangement can support above-trend growth in a surplus nation such as Germany for a time. However, in the long run, increasing indebtedness of the deficit nations can turn into an solvency crisis which, in turn, devastates the savings pool and financial systems of the creditor nations.

That is, in fact, the situation that many Germans think that they currently find themselves in. An increasing number of Germans believe that continuing to finance PIIGS - either directly or through the ECB - is ultimately counterproductive because these nations have crossed beyond the threshold of insolvency. Thus, rescuing the PIIGS would simply be "throwing good money after bad," and saving the eurozone as it currently exists will to cost more than it is ultimately worth.

Right or wrong, Germans are becoming increasingly ambivalent regarding the economic benefits of the euro to Germany. Thus, judged purely on the basis of their economic self-interest, there is no clear consensus in Germany regarding what the nation should do. Germans would like to preserve the eurozone as it is. But they seem unwilling to pay what is required for its preservation.

2. Geopolitics. I believe that the geopolitical benefits to Germany of the EU are less ambiguous. The EU acts as a global economic superpower, with tremendous leverage in world affairs. And as the dominant partner within the EU, Germany is able to project power around the world - vis a vis the U.S., China and Russia, for example - far more effectively than it could if it had to act as a purely independent nation. The EU is a powerful geopolitical instrument that is at the disposal of Germany to defend and promote its industrial, financial and political interests around the world. This is undoubtedly a strong argument for promoting and perpetuating the EU system from the German point of view.

Of course, there is a downside to German involvement in the EU: As the dominant member of the EU, they essentially cede a considerable amount of scope to maneuver independently. That means that German interests can, to some extent, be held hostage by the whims of Greek, Portuguese, Maltese and other Mediterranean politicians. And this undoubtedly irks many Germans. Indeed, I believe many Germans fear that with respect to fundamental issues they could become isolated within the EU and their national interests be over-ridden by an alliance of what they consider to be "rinky-dink" powers.

On balance, I believe that the EU is a highly favorable arrangement for Germany. However, it is unclear how well Germans understand this. It often seems that German fears of being "ganged up on" by their EU partners are as great or greater than their ambition to wield the international powers that the EU structure provides them.

3. German historical self-consciousness. The history of the world wars make many Germans very reticent to assume the "bad guy" role within the EU. Many Germans are sensitive to being perceived as belligerent or intransigent amongst its putative allies in Europe.

By the same token, many Germans, particularly of the younger generation, are fed up of having to "pay" for the sins of their forefathers. Many Germans resent the expectation by other Europeans that they should somehow be less aggressive in pursuing their national interests than any other nation. Many Germans resent having to assume an apologetic and deferential posture.

On balance, for historical reasons, I believe that Germans would rather avoid confrontation within Europe and that will go to some lengths to do so. At the same time, I believe that the Germans can only be pushed so far before deep seeded resentments of large numbers of Germans bubble to the surface rather spectacularly. Germans are subject to a complex sense of humiliation and victimization regarding their past history and this could become a very divisive factor if and when political tensions rise in Europe.

4. The unification experience. Many forget that in the post-unification period and during the initial years of the euro project, Germany was considered "the sick man of Europe." All, Germans, particularly in the Eastern part of Germany where Chancellor Merkel is from, feel that they suffered greatly during the reunification process. For well over a decade, Germans had to tighten their belts and give up myriad "rights" that they had come to cherish as part of "structural reforms" in order to successfully execute the reunification process. While the "Club Med" PIIGS enjoyed relatively high growth rates and rising property values Germans experienced stagnation of their incomes and property values.

Many Germans now feel a sense of pride for having endured that era of "austerity" and believe that they are a success story that PIIGS should emulate. Furthermore, many Germans simply cannot countenance the notion that they should be called upon to bankroll policies that would prevent PIIGS nations from experiencing the austerity that is their duty to endure (and which many Germans even feel is richly deserved).

In sum, German perceptions of their reunification experience make it very difficult for them to be accepting of "bailouts" of PIIGS nations. Germans feel that the PIIGS need to fend for themselves just as the Germans themselves did for almost two lean decades after reunification.

Note to readers: Part 2 of this article is here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.