Reading about developments in the euro zone these days makes me recall the old American TV sci-fi show Lost in Space. Every time the Robinson family got itself into trouble, their robot would swing its arms and flash its lights and yell “Danger! Danger!” Perhaps we need to send this robot through the streets of Berlin, Paris, and other major euro zone capitals, since the leaders of Europe apparently aren’t getting the message on their own. More and more countries are getting dragged down into the euro zone debt crisis as its leadership continues to dither. Much like the Robinson family, they just seem lost, wandering from place to place, with no clear progress on getting where they need to go.
Let’s get to the facts. Belgium saw its credit rating downgraded on Friday and its bond yields have been rising steadily. (That pressure, though, seems to have finally convinced the country’s squabbling political parties to strike a compromise and form a government, which will give Belgium its first permanent administration in over 18 months.) The situation in Italy continues to deteriorate. In auctions on Friday, Italy was forced to pay sharply higher interest rates on short-term financing. In fact, the yield on three-year bonds spiked above the yield on 10-year bonds, at one point topping 8%. It’s a really bad sign when countries have to pay more for short-term money than long-term money. That’s an indication of increased concern in markets that Italy might default in the near term. Both Italy and Spain are paying more for short-term funding than Greece. Whatever little faith investors may have had that newly appointed Prime Minister Mario Monti can turn the Italian ship around appears to have quickly evaporated.
Yet amid all of these dramatic events, the most stress-inducing actually came from a very unexpected source: Germany. On Wednesday, a German government bond auction failed, raising only about 60% of the targeted amount. Some analysts tried to explain this event away as a result of technical factors and special circumstances, and thus not a statement on Germany’s creditworthiness or demand for Bunds. Perhaps that’s true. But we can’t ignore the implications of that auction either. Could Germany get embroiled in the debt crisis as well?
Of course, Germany is already embroiled in the debt crisis, just in a very different way from Italy or Spain. As the euro zone’s largest economy, and one of its strongest, Germany is under increasing pressure to employ its financial muscle to save the euro zone. As I noted in this week’s TIME magazine, the only real way to solve the debt crisis is through deeper European integration. But that inherently means Germany stepping in to support the monetary union. In other words, whether the euro survives depends on German willingness to use its resources to keep it alive. Either way, there are consequences for Germany. And not all of them are good.
On one hand, you could easily make the case that it is clearly in German interests to rescue the euro. Germany has benefited greatly, perhaps more than any other country, from the formation of the monetary union. To a certain degree, you can credit the euro with Germany’s tremendous economic performance in recent years. And just try to imagine what would happen if the euro zone fell apart. The turmoil would disrupt Germany’s key export markets, dampening growth, while causing capital to flee Europe, making it more expensive for Germany to find affordable financing. From that standpoint, Germany would be downright self-defeating to allow the euro to slip away, as Sebastian Mallaby, senior fellow in international economics at the Council on Foreign Relations, recently wrote in the Financial Times:
The currency union that makes adjustment in the periphery so excruciating is the very same currency union that handed Germany its export boom. Rather than condemning lazy southerners, the Germans should share the loot…So yes, the Germans have it right: Europe’s currency union does indeed involve transfers. But it is not true that these transfers flow only one way. Germany pays out via bailouts and intra-regional transfers; but it also receives benefits via trade and monetary channels. If only Germany could accept this truth, it might yet muster the will to rescue the euro – and salvage a generation of efforts to build an integrated Europe.
But salvaging an integrated Europe will take cash. Lots of it. And no matter how the bill gets paid, a big chunk of the cost will end up coming out of Germany’s wallet. It cannot be a coincidence that Germany’s failed bond auction came the same day that the European Commission announced a proposal for introducing eurobonds (or as the eurocrats renamed them, “stability bonds”) to quell the debt crisis. A eurobond is a debt instrument backed by the entire euro zone. The idea would work this way. Euro zone countries would be able to issue these eurobonds in place of regular national sovereign bonds, within certain restrictions. That would allow weaker economies like Italy to finance themselves at lower cost, since the bond would be backed by the financial might of the entire zone. In other words, Italy, Spain and other troubled governments would piggyback on the stronger creditworthiness of countries like Germany to bring down their borrowing costs. Such a scheme could quiet the debt crisis by permitting the beleaguered economies of the euro zone better access to cheaper funding. But, of course, there is potentially a cost to Germany, at least in the short-to-medium term. Eurobonds are a form of debt consolidation that would bring convergence in creditworthiness among euro zone countries. That means Germany’s credit standing might actually suffer, since it would be on the hook for debt issued by its weaker neighbors. Germany therefore could see its borrowing costs rise. And if Italy, Spain and the other troubled members of the zone fail to reform their economies and strengthen their national finances, Germany could end up stuck with the tab, meaning German taxpayers would be paying Italian debts. It is no wonder, then, that Berlin has been fiercely opposed to eurobonds.
Without such measures, though, Germany could still find itself with a heavy price to pay for the debt crisis. As borrowing costs for Italy and Spain increase, it is becoming increasingly likely that they will require some sort of external support. A bailout of Italy and/or Spain would be incredibly expensive. Capital Economics recently figured an Italian rescue would require some $950 billion. Even measures short of that would be costly. Barclays Capital, in a recent report, argues that since both Italy and Spain still have access to debt markets, a Greek-style bailout might be unnecessary at this point. Instead, they may need some kind of contingency funding, or a financial “shield” to stabilize markets and preserve their access to cash. Yet such a shield (for both Italy and Spain) could require as much as a staggering $1.1 trillion, by Barclay’s calculations.
Germany, therefore, finds itself in something of a Catch-22. Suffer if you save the euro, suffer if you don’t. Here’s how Capital Economics put it in a recent report:
Germany is caught between a rock and a hard place. If she rides to the rescue of her neighbours, she will undermine her own credit standing. If she chooses not to, the euro-zone will probably collapse…The dilemma facing Germany is not new. It is just that time is running out. Soon she will have to decide whether to compromise her integrity or allow market forces to take their course.
So there you have it. Whether the euro lives on is increasingly dependent on the willingness of Germany to pay for it. Berlin is fiercely resisting this reality. The leaders of the euro zone are instead talking about giving EU institutions more power to sanction countries that break rules on debt and deficits. That may be necessary, but not sufficient. Stricter enforcement of euro zone directives won’t help the zone escape the debt crisis today. Nor are many of the weaker economies of the euro zone in any position to meet those targets in a reasonable period of time.
In the end of the day, the costs of maintaining the monetary union continue to mount. Unless Berlin is willing to pick up the tab, there may be no way of paying for them. So the answer to our original question is: Germany is already a victim of the debt crisis. That’s a fate Berlin can’t escape, no matter how hard it tries.