The elections in Germany this weekend won’t produce drastic change in the country’s euro-area policies, leaving the region vulnerable to risks that are widely underestimated.
One reason to hold this pessimistic view is that the two most plausible outcomes of the Sept. 22 vote would return Chancellor Angela Merkel to power; either her conservative bloc re-forms its existing coalition with the Free Democratic Party or she enters into a grand coalition with the main opposition Social Democrats. For Europe, there is reason to hope for the latter.
Merkel’s approach to the euro area’s financial crisis has four decisive characteristics: It lacks a clearly stated long-term vision; it is very cautious; it is extremely pragmatic; and on fiscal policy, it is dominated by the philosophy of the proverbial Swabian housewife, which holds that there is nothing worse than debt.
These principles are clearly reflected in Germany’s management of the euro crisis. All major steps forward were firefighting measures designed to address only immediate threats, including the creation of the currency area’s two crisis funds: the European Financial Stability Facility in 2010 and the European Stability Mechanism last year. Germany’s sole forward-looking contribution to the policy framework of the euro area is the fiscal compact, which severely limits the ability of governments to incur debts.
There is no reason to think that after Sept. 22, Germany will change course and offer new initiatives to shape the euro area. The muddling-through will continue. This approach is based on the hope that, somehow, problem countries will be able to reach a cyclical turnaround; structural reforms will pay off; and eventually debt-to-gross-domestic-product ratios will start to decline.
The underlying assumption is that the European Central Bank will be able and willing to go on protecting the system against panic attacks in the financial markets. Under this rosy scenario, there is no need to move forward with political integration, particularly in fiscal policy. It may work out, but it is an unnecessary and dangerous gamble to take with Europe’s future.
What happens if this benign future doesn’t materialize? So far, in two large problem countries, Italy and Spain, but also in Greece, the recession hasn’t ended and unemployment continues to rise. Thanks to the ECB’s pledge last year to do what it takes to prevent a sovereign default, Europe’s banking system remains calm. Yet, as deleveraging goes on, new investors will have great difficulty in getting projects funded. And although budget deficits have come down slowly, the debt-to-GDP ratios so closely monitored by investors are steadily increasing.
So far, there are no clear signs that the euro crisis’s three-step vicious cycle -- a banking crisis feeds a public-sector crisis that, in turn, feeds a macroeconomic crisis -- has been broken. Under such a negative scenario, the European Central Bank could be in a very uncomfortable position. For instance, a political crisis in Italy combined with a continuing recession could easily lead to a new wave of investor panic. If crisis strikes, the central bank could fulfill the pledge it made last year to intervene in the market by purchasing bonds, but only after Italy has asked for an adjustment program and once its government has adopted the required policy measures.
What happens if politicians are unwilling to ask for such a program? Or if they are unable to assemble the parliamentary majorities needed to adopt the required adjustment measures? A decision by the ECB to buy Italian bonds unconditionally would create very serious problems for Germany, whose constitutional court would regard such a measure as a monetary financing incompatible with the euro’s underlying treaty.
The impressive stabilization that ECB President Mario Draghi has achieved with his “whatever it takes” pledge shouldn’t be regarded as permanent. The euro area is still in a very fragile state caused by the fundamental problem of the common currency’s institutional architecture, which creates a monetary union but allows the 17 member states to retain their fiscal and political autonomy.
Draghi’s stabilization of the bond markets offered a window of opportunity for fundamental reform that has remained largely unexploited, most recently because debate has been put on hold until after Germany’s elections. There has been progress in building a banking union, but no attempts have been made to bring better political integration to the euro area, and valuable time has been lost trying to secure treaty change.
Consider what would happen if, as is likely, the muddling-through continued and Germany insisted on waiting until the last moment to defuse any crisis. For example, a problem emerges in Italy and the constraints set by the German constitutional court mean the ECB cannot provide the promised unlimited backstop. Then, the governments of the euro area would suddenly have to assume joint liability for Italian debt that would far exceed the capacity of the European Stability Mechanism. In 2011, the German Council of Economic Experts developed a plan for a redemption pact that would resolve such problems by establishing common liability for all public debt in the euro area above a 60 percent threshold, but it isn’t clear that this mechanism could be activated at short notice. A financial meltdown in Europe, together with the uncontrolled breakup of the monetary union, would then be possible.
If Merkel has to cooperate with the Free Democrats again, there will considerable resistance to any fundamental changes to euro-area policy. A coalition with the Social Democrats could be different, however, because that party’s leaders have committed to adopting the debt-redemption pact without waiting for another crisis. A grand coalition would find it easier to implement the measures that Europe needs, even though they would be unpopular in Germany, whatever the result this weekend.
(Peter Bofinger is a professor of economics at the University of Wuerzburg and a member of Germany’s Council of Economic Experts.)
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