Germany Will Decide If the Euro Survives the Summer
The last month has seen two developments that precipitated the full blown financial crisis playing out now in Europe. First, the political viability of the bailout-for-austerity trade-off that has characterized eurozone rescue packages since 2010 has been seriously damaged by the May-June Greek election outcomes that have rejected the March 2012 austerity-rescue package. Sunday's Greek election outcome only prolongs the negotiations and uncertainty surrounding the bailout-austerity conundrum.
Second, exhaustion of the crisis-rescue-celebration-crisis pattern that has characterized market behavior in the run up, execution and aftermath of bailouts was signaled by the market's quick rejection of the 100 billion euro June 11 Spanish rescue package within hours of its announcement. Spain's banks are saddled with bad real estate loans that have jeopardized their solvency. Money is fleeing the Spanish banks at a pace that will precipitate their collapse if confidence is not restored. To make matters worse, contagion risks are escalating as Italian banks are also experiencing more rapid withdrawals.
The result of these developments has been to sharply constrain the policy options available to repair the deeply dysfunctional euro system, the disorderly collapse of which could very well precipitate another global financial crisis. Needless to say, such a crisis would greatly increase the risk of another global recession, one worse than that which played out after the September 2008 Lehman crisis.
Just what are Europe's options? There are three: a full political union like that advocated on June 15 by German chancellor Angela Merkel; a sharp increase - well over a trillion euros - in transitional support for Europe's periphery countries to buy time for fiscal realignment among eurozone members and for recapitalization of Europe's increasingly run-prone periphery banks; and/or a collapse or contraction of the European Monetary Union. Europe could end up with all countries reverting to their pre-euro national currencies or with a smaller eurozone where countries like Germany, France, the Netherlands and Austria retain the euro while others revert to their national currencies - outcomes that would necessitate great financial and, very probably, political upheaval.
In reality, the first option is sensible but not feasible. The second would require a huge financial commitment from Germany on a scale its electorate would not accept. The third is highly destabilizing for Europe and the world.
A full political union for Europe that enables a common fiscal policy and expedites resource transfers from stronger to weaker countries has been the right framework all along. Monetary union without fiscal union was never going to work. But fiscal union, requiring, in effect, a United States of Europe is not politically feasible in Europe, at least not in time to defuse the current crisis. Interim substitutes like issuance of European bonds that are claims on all European governments collectively or Europe-wide deposit insurance are only feasible with Germany providing its credit rating and resources to make the plan believable. Such measures all require a larger implicit claim on German resources and credibility in exchange for what will amount to strong German influence over member countries' fiscal policies.
Lacking a fiscal union, an enlarged eurozone rescue plan where Germany explicitly provides over a trillion euros aimed at strengthening the banks and governments of major periphery countries like Spain and Italy could provide an interim solution. But such a massive contribution from Germany alone won't be politically viable without the adjustment mechanisms and structural changes required to alter behavior in a way that precludes the need for still more financing in the future. This brings us, full circle, back to the bailout-for-austerity framework modified with unrealistic hopes for a bigger bailout fund to be provided by Germany in exchange for less austerity - or the fiscal union.
The third option, a collapse or contraction of the eurozone is so unattractive that it is probably in no one's interest. That does not mean it can't happen, especially given a fundamental lack of leadership and political will power. Even Germany would suffer from the sharp contraction in European and global economic activity that such a collapse could precipitate. A eurozone collapse or contraction would result in a much stronger German currency that would further depress its large export sector and threaten deflation. Weighing the likelihood of the euro-collapse option requires a judgment as to whether the threat to Germany entailed by that outcome is large enough to force it to supply more funds and demand less austerity.
There may be a fourth option: an interim eurozone rescue by way of a sharp easing of German monetary policy, leading to a softer euro, more inflation and higher interest rates in Germany. In short, preventing a collapse of the euro without coordinated fiscal policy will require Germany's monetary policy to become more like the rest of Europe's monetary policy rather than the reverse.
And Germany alone will have to decide. I don't know which way the decision will go. I do know that a decision needs to come quickly. If it doesn't, the euro will not survive the summer.