Eurobond

Germany's historic dilemma and its global consequences

August 23, 2011: 5:00 AM ET

Germany has a choice: Abandon the eurozone and face stalled growth, or prop up its ailing eurozone partners. Neither is good for Germany.

Angela Merkel

German Chancellor Angela Merkel

FORTUNE -- Germany is facing a maddeningly difficult choice that could shape the future not just of the European community, but the world economy. Now that the European debt crisis is spreading to nations far too big for temporary bailouts, Germany must decide between two extremely unattractive options. It must either abandon its stubborn resistance to guaranteeing the debts of ailing eurozone partners, at great risk to its taxpayers. Or, it can escape sheltering the weak by abandoning the eurozone. That would bring the German growth engine to a sudden halt. The threat to one of the world's leanest and largest economies is a major reason world markets are now in turmoil.

The historic dilemma arose just a few weeks ago, when investors attacked Italian and Spanish government bonds, pushing rates to levels that made their big debt loads, in the case of Italy, and yawning deficits -- that's Spain -- unsustainable. The European Central Bank came to the rescue, pushing rates lower by purchasing as much as $10 billion a week in their sovereign bonds. The ECB is making it clear that those purchases will be short-lived. So the EU is doubling the size of the European Financial Stabilization Facility, the bailout fund that supports Greece, Portugal and Ireland, to $620 billion, and expanding the EFSF's charter to allow purchasing government bonds in the open market.

Even at its new size, the EFSF won't remotely marshal the resources needed to save Italy and Spain if bond vigilantes keep attacking their debt, an excellent possibility. The only long-term solution, the fix that would calm markets by assuring the euro's survival, is a new type of securities backed by all 17 countries in the eurozone. These eurobonds could be issued to finance a fixed portion of each nation's debt. For example, the regime would allow Greece, Ireland or France to cover 50% of their total borrowings with totally safe eurobonds, and the other half with their own government securities.

Since the total interest costs would fall because of low rates on the eurobonds, the pressure on their budgets would recede. So the non-eurobonds they issue would look a lot safer than their sovereign debt looks today.

But so far, Germany adamantly opposes the eurobond solution. It's probable that the nations would guarantee those bonds in proportion to their national income. Since Germany accounts for 40% of the eurozone's GDP, its citizens would suffer big tax increases to cover defaults by nations that, as Chancellor Merkel keeps pointing out, brought on their own woes through reckless borrowing and spending.

Unless Germany changes course, the eurozone will dissolve. It's not clear how the split would happen. Southern countries might restore their own currencies, leaving a northern group of Germany, Austria, Finland, the Netherlands and possibly France in a shrunken eurozone. Or Germany could go its own way by replacing the euro with, say, the Neue Mark, and in the process freeing itself from the shadow of wildly unpopular bailouts.

For Germany, the costs of either scenario would be enormous. Germany has profited mightily from the euro. "It has shown far more rapid gains in productivity than its neighbors," says Robert Aliber, the distinguished international economist. "So over time, its exports have become more and more competitive."

In effect, the euro made German products artificially cheap on world market, and rendered those of weaker economies such as Italy, Portugal and Greece excessively expensive. The edge of a "weak" currency, compared to the old Deutsche Mark, also enabled Germany to garner booming sales in China and other Asian countries hungry for its cars and machine tools.

In effect, the eurozone helped bring big surpluses to Germany, and large deficits to  its southern partners. If it splinters, the exchange rates for Italian, Spanish and Greek currencies would fall sharply, lowering the prices, and raising sales, of their exports, and doing the opposite with imports. Their deficits -- and demand for German goods -- would collapse. Germany would suffer from the reverse effect. Its Neue Mark would soar versus its trading partners' currencies, making its cars and machine tools far more expensive around the globe. Asia will have another reason to make its own machinery.

Overnight, Germany will lose its status as a conqueror on world markets. Its enormous trade surplus, the source of its prosperity, would quickly vanish.

"Once the German surpluses are gone, the country would fall into a severe recession," says prominent Greek economist Yanis Varoufakis. Germany has succeeded in the past decade of becoming highly competitive not just by maintaining a relatively cheap currency, but by limiting the growth in wages. But that policy created a large contingent of working poor, people who have jobs but also qualify for welfare payments because of their low salaries. "To restore competitiveness after their currency appreciates, German companies would need lower costs by laying off workers. So exiting the euro risks turning the working poor into the unemployed," says Varoufakis.

It's certain that Merkel is acutely aware of the price of clinging to principle. Hence, the probable outcome is the following: The ECB and the EFSF won't succeed at holding down rates for long. The moment of reckoning will indeed arrive. And Germany will make a grand and historic concession to protect the eurozone, the system that so enriched it, and despite its grand ambitions, did nothing to improve the performance of the weak partners now desperately seeking its help in return.

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