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Time for Last-Minute Merkel to End Her Euro Brinkmanship

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Back in November when the temperature in the sovereign debt crisis was on the rise, a euro zone central banker speaking to The Economist admitted that his mind had turned to historical catastrophes such as the First World War and how Europe's leaders had blundered into them. "From the middle of a crisis," he said, "you can see how easy it is to make mistakes."

As the euro crisis has dragged on over the past couple of years, the common sense view has been that given the stakes involved, and given the level of economic devastation which a euro break up would generate, that at the last minute someone would blink. Faced with a financial meltdown, so the conventional wisdom goes, the cautious Bundesbank would finally take the shackles off the ECB and allow it to formally act as a lender of last resort instead of it having to buy government bonds in the shadows as it does now. Or if the situation got especially sticky, that Angela Merkel would finally agree to the issuance of joint euro bonds to prevent the onset of Eurogeddon.

Like the proverbial frog in the pan of water, though, the concern is that the euro crisis has been going on and off the boil for so long that Europe's leaders might not recognise 'the last minute' when they see it. They might blink (or jump) too late.

While Europe is not yet at the stage where lives are being lost on the battlefield, euro zone leaders meeting in Brussels this week resumed their confident march towards the precipice. The German driven austerity pact adopted by 25 out of 27 EU countries at the summit on 30 January represents another false step in the tragi-comedy which has characterised the crisis to date. Described by economist Joseph Stiglitz and a leading fund manager as "a suicide pact" the Europe wide agreement signed up to in Brussels commits its signatories to balance their budgets along strict German lines.

Like the latest flawed remedy agreed at the summit on Monday, the crisis itself is as much a German phenomenon as a Greek, Italian or Spanish one. Just as economic imbalances between the export driven Germany and the consumption driven PIIGS states helped lay the basis for the current problems, so every botched, reactive and belated solution put forward so far to end the crisis has had 'Made in Berlin' stamped all over it. With Greece likely to default on its debt, and Portugal teetering on the brink, the Teutonic answer is for Europe to cut its way back to economic health through fiscal rigour.

Of course, neither Germany nor France were quite as disciplined when creating and nurturing the euro in its formative years. Indeed, two more dysfunctional parents would be hard to find. First off, was bending the Maastricht rules on the national debt to GDP ratio to allow Italy to join with a debt of 120 percent when the criteria for euro membership allowed a maximum of 60 percent. Surely a case of European country club politics overriding pesky economic realities. The real damage, though, was done in 2003 when both France and Germany were allowed to break the sacred 3 percent annual deficit limit, setting the tone for other euro zone countries to follow.

Now Germany is ordering the rest of the euro zone to march to its balanced budget drum during a period of economic contraction, propelling the continent into an ever tightening downward spiral, which ratings agency S&P describes as "self defeating." Even for Harvard's Niall Ferguson, never a fan of unsustainable deficits, the German inspired fiscal rules agreed to in Brussels on Monday are essentially a "pact of death that nobody runs a budget deficit." Whatever the long term outcome of the new arrangements, for now they may well have done most harm by distracting euro zone leaders from making the hard political choices necessary to ensure the viability of the single currency in the long run.

Chief among these would be for Angela Merkel to be frank with German taxpayers and say that Germany cannot ask other euro zone states to adhere to Berlin's system of fiscal prudence without also agreeing to debt mutualisation through a US style transfer union which can support weaker EU states. This was Nicholas Sarkozy's original wish when he lobbied Germany to agree to jointly issued euro bonds to reassure the markets and put the currency on a sounder footing.

After a handbagging from the Chancellery in Berlin, though, Sarkozy changed his tune, and declared that: "It would be a funny idea to mutualise the debt so that France and Germany would have to pay for the debt of others without having control over it." Almost as funny as creating a new currency with neither a state nor a lender of last resort to support it.

The fruits of this confusion are all too evident in the countries bearing the brunt of Germany's austerity or bust programme for economic salvation. Despite the searing criticism of Greece regularly heaped upon it by politicians in Berlin, the head of the IMF's mission in Athens has praised the progress that the country has made so far while warning of the dangers of pushing the Greeks beyond the threshold of what a people can realistically be expected to endure.

Recognising the danger, World Bank President Robert Zoellick urged Germany last week to support reform efforts in other countries before it's too late: "Rather than be dragged grudgingly to help bit-by-bit at the last moment, Germany and its European partners should put incentives on the table now," he said.

After the EU 'suicide-pact' summit concluded on Monday, I was reminded of a quote attributed to British Foreign Secretary Sir Edward Grey after he learnt of the German declaration of war against France, signalling the start of the First World War. Looking out of his window at the Foreign Office in August 1914, Grey is said to have remarked presciently: "The lamps are going out all over Europe. We shall not see them lit again in our lifetime."

In 1914, Grey and many other European statesmen saw the danger of war only at the last minute and acted too late to prevent calamity. Today's European leaders and especially the leader of Germany have the tools to prevent a collapse of the euro, provided they can find the political will to use them in time. This requires Chancellor Merkel to stop her destructive brinkmanship with the bond market and begin an honest dialogue with the German people about what the euro really means to them. It means asking them how much more they are prepared to give to poverty-stricken Greeks, Spaniards, Portuguese and Italians in order to maintain the illusion of a shared European identity. Otherwise, to paraphrase Robert Zoellick, 'at the last minute' may well be Merkel's epitaph as well as the euro's.