Murkier Prospects for Merkel

As last month's Italian elections and, more recently, a misguided levy on Cyprian bank deposits add ambiguity to Europe's future, still more uncertainty will likely emerge as Germany approaches its September elections. Especially because Italy's ambivalent vote may make that country less likely to cooperate with the rest of Europe going forward, questions will increasingly arise about Chancellor Angela Merkel's own cooperative, European approach to dealing with the Continent's fiscal-financial crisis. At the very least, it will make her more vulnerable to her opposition. Her personal popularity will almost surely secure her another term as Germany's chancellor, but she may, as a result of these developments, face new constraints that likely will force her to consider German interests more narrowly than she has to date. Germany and Europe will lose as a consequence.1

Though the average German seems to like Merkel, people are far from being entirely satisfied with the chancellor's approach. Pollsters record concern that Merkel's cooperation in Europe has cost Germany influence within the eurozone and the European Union (EU). People were particularly struck, it seems, when last year the Governing Council of the European Central Bank (ECB) simply outvoted German representatives, ignored their concerns about purchases of the sovereign debt issued by Europe's periphery, and launched into a buying program. More serious is the German public's vague sense that cooperation with other eurozone members has siphoned off German wealth and income. Since some 84% of the German people expect the crisis to become worse, they connect the losses that they believe have already occurred to a frightening and open-ended claim on their taxes, their incomes, and, they have emphasized, their pensions as well. Few, of course, connect the dots between Merkel's cooperative approach and these fears, but no one seems to feel a need to do so either. Indeed, the sense of loss and vulnerability is that much more politically potent because it is vague. Data and economic logic would circumscribe the possibilities and render them less troubling.2

The German financial and political elite seem particularly concerned with the decision to house eurozone-wide bank supervision in the ECB. Merkel's own finance minister, Wolfgang Schäuble, has, more than once, pointed to what he considers an "inherent conflict of interest with the bank's monetary policy tools." Peer Steinbrück, former finance minister and a challenger for the chancellor's office, has gone so far as to question the ECB's ability to shoulder supervisory responsibilities. He points out that there are 6,000 banks in Europe, and the ECB has no staff with any supervisory experience. Others in German financial circles have asked what will become of the London-based European Banking Authority when the ECB takes over bank supervision. German banks, for their own narrow purposes, have resisted the ECB in this role, as has Jens Weidmann, head of the Bundesbank, which would clearly lose authority under the new arrangements.3

It seems most upsetting to these commentators that last June's decision to give supervisory responsibility to the ECB ignored the recommendations of that bank's own commission on the subject. Referred to as the Larosière Commission (after its head, former Banque of France governor and managing director at the International Monetary Fund [IMF], Jacques de Larosière), it warned on several levels against giving bank supervision to the ECB. In addition to all the complaints already voiced in the German debate, the commission also worried over a politicalization of the ECB, as it tried to maneuver among the different rules of the eurozone's 17 members. The commission even doubted whether the EU treaty permits the ECB to operate in a supervisory capacity. Though such criticisms take a technical turn, they, at base, really question the wisdom and coherence behind the June summit's and Merkel's decision. Summarizing that sense, Finance Minister Schäuble concluded, dryly, that it is hard to endorse a decision that is "anything but thought through."4

If none of this is especially flattering to Merkel, neither does it necessarily get to the nub of Germany's interests, at least as she and many in her government see them. Implicitly, if not explicitly, they see the need for a much broader perspective. Germans may object to particular arrangements, but, Merkel clearly recognizes, it can no longer simply pull back from the eurozone to protect itself and its own. Its financial markets and institutions have become too integrated into European finance for that to occur. German industry and business have long since adjusted to the euro and would suffer horribly from its dissolution. If Berlin, ostensibly to save its taxpayers, were to abandon rescue negotiations and leave Greece, Spain, and the others to their own devices, German finance, and the economy overall, would find itself in a precarious situation indeed, no doubt requiring tax resources to save both its own financial institutions and very likely many major German industrial employers as well. Germans would suffer more than they now imagine they do from the eurozone's rescue arrangements. Merkel has proceeded with this broader threat in mind.

German banks are especially vulnerable. A recent report, compiled by the banking community itself, reveals that banks have about €400 billion exposed to Greek, Spanish, Portuguese, and Irish debt. This figure amounts to 260% of German banks' primary capital, and it is more than 16% of the German economy. And it does not even include holdings of Italian debt, which in all likelihood dwarf those of others. Should European support arrangements fail and these nations default or, more likely, engage in a unilateral rescheduling, confidence in German banks would almost surely collapse. A panic and recession would ensue. Even if only the smallest of those debtors were to fail, German banks would remain highly vulnerable to all, since markets, anticipating other failures, would surely mark down the value of all the eurozone periphery's outstanding debt, destroying asset values in German banks in the process and their capital base and public confidence. Certainly, a broad European solution that heads off such a panic would offer a cheaper and easier answer to Berlin.5

But that is not all. Berlin also realizes that the euro serves German industry well. Because Germany joined the euro when its deutschmark stood at lows relative to both the country's own economic fundaments and the rates at which other nations joined, it effectively enshrined a pricing edge for German producers within the common currency. According to IMF calculations, that advantage amounts to 10-25% opposite Greece, Spain, and the rest of Europe's periphery. The euro also gives German industry global pricing advantages it would not otherwise enjoy. Had there never been a currency union and Germany operated separately, there can be little doubt that its deutschemark by now would have risen high enough to price German industry out of the global marketplace. But because the weaker members of the eurozone keep the euro lower than a separate German currency would trade at, German industry retains more competitive pricing. The nation's industrialists no doubt have made these points clear to Berlin, reinforcing Merkel's conviction that fundamental German interests lie within the larger union and common currency.

Merkel can count on retaining her office. For all the anxiety in Germany, recent polls indicate that 42% of the public still backs either her conservative Christian Democratic Union or its Bavarian sister, the Christian Social Union. But the opposition is gaining. Merkel's current coalition partner, the Free Democratic Party, has seen its support fall to only 2% of the electorate. Since the opposition of all stripes will be able to play on voters' evident fears, especially after the ambiguous Italian vote, Merkel may reenter the chancellor's office much more constrained than heretofore. Even now, before the election, the Bundestag has a bill before it to keep German taxpayers free of liability from older, "legacy" debt issued by periphery governments. Merkel's current coalition, even with its comfortable majority, already shows a pointed reluctance to bring any additional bailout legislation to the Bundestag, and Germany's constitutional court, when it established the legality of German contributions to Europe's Stability Mechanism, stipulated that future contributions would require more legislation.6

A constrained Merkel clearly raises the risks for Europe and so for Germany. Markets, fearing the loss of German support, could take control of the situation away from the authorities, marking down the debt of periphery governments, straining existing support mechanisms, and perhaps forcing the failures that investors and the authorities fear. Merkel's clear political abilities may allow her to maneuver around even a constrained, partisan situation and calm markets in the process. Still, that might require more of her then even she may have to offer. At the very least, Europe will likely face rough sledding up through the German vote and very likely for some time afterward.

1 Quentin Peel, "Merkel Popularity at a Record High," The Financial Times, January 9, 2013.

2 Klaus C. Engelen, "Rising Tide of German Anger," The International Economy (Fall 2012).

3 Ibid.

4 Ibid.

5 Brian Blackstone and Christopher Emsden, "Europe Woes Deepen as Economies Contract," The Wall Street Journal, February 15, 2013.

6 Ibid.

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