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Mitigating Merkel's Mischief

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If Europe continues its steady march to financial depression and collapse of the Euro, no politician will be more to blame than German Chancellor Angela Merkel. Last week, Merkel repeated the same pattern that has characterized her behavior since the sovereign debt crisis began -- resisting sensible reforms until the costs of delay became overwhelming, and then reversing course 180 degrees only after the damage was far greater than necessary.

First, the back story: It is essential to recall that the European crisis has come in two entirely distinct phases. Europe was actually on the road to a slow recovery in 2009, until hedge funds began attacking Greek government bonds and Greece's neighbors did nothing. This process followed the disclosure by the newly elected Greek socialist government in October 2009 that the Greek state deficit was actually at least three times what had been claimed by the predecessor rightwing government.

The disclosure invited accelerating speculation against Greek sovereign debt, raising Greece's borrowing costs. As Greece fell deeper and deeper into economic collapse, Merkel vetoed any aid from the EU or the European Central Bank (ECB).

Only when Greece having to pay close to 20 percent interest to borrow money, its government was about to default, and the crisis was spreading to the rest of Europe did Merkel relent, in early May 2010. But her price was a stringent austerity program that drove Greece deeper into depression and invited further speculation against Greek government bonds.

Merkel also insisted that the 110 billion euro aid package be dribbled out in small installments, under the close supervision of a "Troika" of the ECB, the European Commission and the IMF, as leverage to make sure austerity was carried out. Often, funds were withheld until Greece was right on the edge of default, creating a psychology of permanent crisis and destroying the entire point of the rescue package.

When this policy backfired and Greece was unable to pay its bills or roll over its bonds, Merkel doubled down on the same failed strategy in the fall of 2010 and early 2011. An additional rescue package required even deeper austerity not just for Greece but binding budget rules for every member nation of the EU.

Merkel repeatedly vetoed direct aid from the European Central Bank or other EU funds to commercial banks that were heavily invested in state bonds under attack by speculators. The stupidity of that policy became clear last month when, at Merkel's insistence, the ECB and Europe's stability fund refused to lend money directly to Spanish banks, but rather agreed to lend funds to the Spanish state, which in turn was to lend the money to the banks. This move only plunged Spain deeper into debt, and intensified the speculative attack against its bonds.

Last week, Europe's other leaders decided they'd had enough. Spain and Italy, much larger economies under speculative attack, were not about to submit to the lethal medicine administered to Greece. The balance of power had changed. Thanks to the election of French President Francois Hollande May 6, the new resolve of Italy's supposedly technocratic prime minister Mario Monti, and the toughness of Spanish prime minister Mariano Rajoy, Merkel found herself thoroughly isolated at the recent European summit.

Monti and Rajoy blocked progress on Merkel's two pet projects, a fiscal pact on budget rules and a permanent rescue fund, as well as Hollande's proposal for a new 120 euro growth initiative, until Merkel relented on two key points. The new European Stability Fund will be permitted to lend directly to banks rather than putting governments deeper into debt to pay for the sins of bankers. And no longer will nations receiving aid have to submit to humiliating and self-defeating austerity programs under merciless supervision of the Troika. The summit also approved the new 120 euro investment funds, to be targeted to the continent's weakest economies.

This is progress, but it comes too late for Greece, Portugal, and Ireland, which have suffered needlessly as austerity programs have driven their economies deeper into the ground. If Europe's bigger nations -- notably Spain and Italy -- are to get aid without coerced austerity programs, common sense and common decency suggest that Greece, Portugal, and Ireland should get no less. An even better policy than adding growth funds would be to suspend austerity programs.

Financial markets were relieved last month when a center-right government was narrowly elected in Athens over a far-left coalition that proposed repudiating the austerity bargain. But no sooner did the new government under Prime Minister Antonis Samaras take office than it, too, demanded relief from the deal's excruciating terms.

Merkel, characteristically, still opposes any respite for the suffering Greeks. It is up to the rest of Europe to isolate her again so that she can reverse course citing changed circumstances. Nor is Merkel willing to seriously rein in the financial speculation against government bonds that turns moderate budgetary problems into dire crisis. This, too, will take the resolve of wiser leaders.

Until German reunification in 1990, there was a delicate balance in the European Union, in which Germany was contained within a broader democratic Europe. Germany was an economic powerhouse, but was appropriately self-restrained politically. Given German history, this was only prudent.

With reunification, Germany not only became even more potent economically, but began throwing its weight around politically. As Merkel keeps proving, this was not a good idea. The rest of Europe's leaders have now restarted the necessary project of containing German influence again, and not a moment too soon.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos.His latest book is A Presidency in Peril.