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The time for vacillation in German decision making over Europe is running out. With Greece on the cusp of an official default and with the European debt crisis now having metastasized from Greece, Ireland, and Portugal to Spain and to Italy, pressure is mounting on Germany both from its European and its G-20 economic partners to throw its full weight behind a European fiscal union and a European banking union to save the Euro.
Yet, it is far from clear that Germany can or will step up to the plate. All too understandably, Mrs. Merkel vacillates on these issues as she weighs the relative political and economic costs to Germany of inaction as opposed to that of putting German taxpayers further on the hook for what is all too likely to prove to be an exorbitantly costly guarantee by Germany of the European project.
The markets seem to offer Mrs. Merkel little guidance in her critical choice. Among the many paradoxes in the European debt crisis is the market’s apparent ambivalence as to the future state of Germany’s public finances. Judging by Germany’s record low sovereign interest rates, including negative interest rates on its 2 year-bonds, one would be excused for thinking that Germany’s public finance prospects should be a source of pride and comfort for German policymakers giving them much room to provide Europe with additional support.
Yet judging by the record prices for credit default protection on Germany’s sovereign debt, which now exceeds 100 basis points, one would think that Mrs. Merkel is right to be highly concerned about saddling the German Treasury with the further burdens that Germany’s European and G-20 partners are expecting it to bear.
In assessing their policy options, experience would suggest that German policymakers would be correct not to place very much weight on market interest rates, which all too often emit misleading policy signals. After all, as late as the summer of 2009, at a time when Greece’s budget deficit was ballooning, the Greek government could borrow at ten years for barely 20 basis points over the rate at which the German government had to pay. And today, in another manifestation of an international flight to safety, the US government is borrowing long-term at all- time record lowest rates. And it is doing so despite every indication that its public finances are clearly on the most unsustainable of paths.
In making policy decisions as to how much further support Germany should be providing to Europe, Mrs. Merkel would do better to consider the potential cost to Germany of the support that it has already provided to Europe over the past two years. This support has come mainly through Germany’s participation in the European Central Banking System, in the European Financial Stability Fund, and in the International Monetary Fund. In that context, it is of note that in the Target2 system of the ECB alone, the Bundesbank has amassed a creditor position in excess of EUR 700 billion. This amounts to around 20 percent of Germany’s GDP, which could prove to be very costly to German taxpayers in the event that debtor countries were to start exiting the Euro.
More pertinent for Mrs. Merkel’s calculation as to whether to support an early move to Eurobonds and to European wide deposit assurance is the potential costs of those undertakings to the German Treasury. In that respect, Mrs. Merkel might want to consider that Spain and Italy’s public financing needs for the next two year alone are in excess of EUR1 trillion. She also might want to consider that the bank deposits in these two countries alone that might need insurance are around EUR 2 trillion. This would make the cost of underwriting these countries’ sovereign borrowings and of guaranteeing their bank deposits excessive for a Germany that is now being expected to shoulder this burden practically on its own.
Yet a further major risk to the Germany Treasury is the danger that sovereign borrowing guarantees and deposit insurance in the periphery would remove the incentive for adjustment in the periphery. This would raise the specter that Germany would be putting itself on the line to finance a bottomless pit.
The horrible dilemma facing Mrs. Merkel is that costly as underwriting sovereign bonds and guaranteeing deposits in the periphery might be for the German Treasury, not providing such support runs the risk of an early unraveling of the Euro with all of its attendant political and economic costs for both Germany and Europe. This puts Mrs. Merkel in the unenviable position of having to choose between saving the Euro and preserving Germany’s long-run creditworthiness. With a German presidential election scheduled for the fall of 2013, the odds would seem high that Mrs. Merkel will yield on the issue of Eurobonds and European wide deposit guarantees to forestall a full blown Euro crisis. However, considering the very high long-run cost of such an operation, it is far from clear whether that would be in Germany’s long-run interest.
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