Will Germany Step In to Save the Euro?

As Italy and Spain come under real market pressure, the long-run survival of the Euro appears to be coming down to a single important question: Will Germany, Europe's powerhouse that alone has the financial wherewithal to potentially prop up the European periphery, do whatever it takes to save the Euro? While Euro optimists believe that Germany will have little alternative but to agree to Eurobonds and to European-wide bank deposit insurance, mounting evidence suggests that considerations of Germany's own creditworthiness will inhibit the country from agreeing to continually bankroll the Euro project.

Perhaps the most conclusive evidence that Germany is not about to write a blank check for the European periphery has been the consistent response of the German Chancellor, Angela Merkel, to the European debt crisis over the past two years. At each stage of the crisis, she has only rather grudgingly agreed to IMF-EU bailout packages for Greece, Ireland, and Portugal. And in each of these cases, the bailout packages have proven to be barely sufficient to defuse the crisis at hand for more than a month or two.

More importantly, Mrs. Merkel has consistently insisted on conditions for each of the IMF-EU bailout packages. In each case, the recipient country has had to commit to IMF-EU imposed fiscal austerity, allowing Merkel to assure the German electorate that repeated bailouts were to be avoided. The imposed austerity measures are meant to correct the country's underlying public finance imbalances through a policy of draconian public spending cuts and tax hikes. Merkel did so despite the fact that within the Euro straitjacket those conditions have considerably deepened the economic recessions in the periphery and given rise to serious political resistance in the affected countries against further austerity measures.

There is now ample evidence that a German-led European policy of "too little too late" to prop up the European periphery cannot continue much further into the future as Spain and Italy come to need full-scale IMF-EU bailout packages. The overwhelming majority of the German electorate is opposed to bailing out the periphery, while 78 percent of the German electorate would like to see Greece exit the Euro.

Meanwhile, a serious political debate in Germany has begun as to whether Germany can really afford to go along with a European banking union and with the issuance of Eurobonds for which Germany's European partners are now clamoring. Moody's decision, earlier this week, to put Germany's sovereign bonds on negative watch for a possible rating downgrade -- because of the potential cost of a Greek exit from the Euro to the German Treasury - will only fan the flames of the debate.

There is increased awareness in Germany that while Italy and Spain might be too big to fail if the Euro is to survive, those countries are also increasingly being perceived as being far too big for Germany to save. The sovereign borrowing requirements of those two countries over the next two years alone are more than EUR 1 trillion, which is around one third of Germany's GDP. More daunting yet, the bank deposits of Spain and Italy that might need deposit insurance are around EUR 2 trillion thereby constituting a further potential drain on the German Treasury were Germany to accede to demands for European-wide deposit insurance.

In Germany's political debate on the wisdom of the country continuing to bankroll the Euro, both the Bundesbank and the German Constitutional court are lending their voices to those who are wary of Germany taking undue risks with the country's creditworthiness. The Bundesbank is doing so by raising questions as to whether the European Central Bank (ECB) exceeded its mandate by buying EUR 200 billion in sovereign debt of the periphery in the secondary market. It also questions whether the ECB erred by having engaged in a EUR 1 trillion three-year-lending program with European banks at the beginning of this year to address their acute funding problem. For its part, the Constitutional Court is doing so by taking its time in reviewing whether the proposed new European bailout fund for the periphery (the European Stability Mechanism) has been subjected to adequate domestic German political scrutiny. The Constitutional Court has only indicated that it will hand down its ruling by September 12.

Given how high are the economic and political stakes of a potential disorderly unraveling of the Euro, when Europe again stares into the abyss, it is always possible that the Germans will blink and cough up the needed money to keep the Euro afloat despite their deep-seated concerns about Germany's own creditworthiness. However, all the clues now appear to be pointing in the opposite direction.

Indeed, as periphery countries sink further into recession and fail to meet their agreed upon IMF-EU budget targets, they only give fuel to bailout fatigue in Germany. The German electorate is faced by the scary specter of being asked by both its European and G-20 partners to fill a bottomless pit in the European periphery; a prospect that poses a real and clear danger to Germany's own creditworthiness.