A series of developments over the last few weeks have set in motion a downward spiral for the eurozone. Unless officials – especially German officials – act fast, the verdict of financial markets is bound to be ruthless.
First, the eurozone has failed to turn the tide. Mario Draghi, President of the European Central Bank, was right to note that, despite numerous ministerial meetings and three summits, implementation of the decision to increase significantly the firepower of the European Financial Stability Facility (EFSF) is still lacking. There are now growing doubts about the effectiveness of the EFSF.
Second, and partly as a consequence, virtually all eurozone countries’ debt is trading at a discount relative to German Bunds. While it was necessary to price risk more accurately, it is difficult to believe that the Netherlands, with a debt ratio nearly 20 percentage points lower than Germany’s, deserves to be assessed as a higher default risk. But now even the mighty Bund has started to suffer from heightened market anxiety.
Third, financial-market participants and, increasingly, real businesses are pricing in a possible breakup of the eurozone, if not the end of the euro itself. It is still difficult to think the unthinkable, let alone work out the details of it, but any rational player must now consider the possibility. If expectations of disaster build, and a growing number of players start positioning themselves to protect themselves, the consequences could become overwhelming. Not only the eurozone would suffer.
Fourth, Germany has become the eurozone’s undisputed leader. Although France continues to play its role as the other half of the European Union’s leading couple, it has lost influence and the ability to take the initiative. A weaker French economy, shakier public finances, and the coming presidential election are all combining to alter the balance with Germany. Political audacity can carry France only so far.
In this context, Germany again finds itself in a situation akin to that of the late 1980’s, when the Bundesbank was setting monetary policy for the rest of the continent. At that time, German Chancellor Helmut Kohl wisely concluded that German economic dominance of Europe was not conducive to a stable equilibrium, and that a better plan for the future was to build on Germany’s weight and influence to create a permanent common monetary order. Kohl’s insight gave birth to the euro.
Today, once again, it is in Germany’s best interest to ensure lasting stability in Europe. With foreign assets worth €6 trillion ($7.9 trillion), most of which consist of claims on its eurozone partners, Germany would lose out massively if the eurozone fragments. Claims on entities within partner countries would be redenominated in weaker currencies – or the borrowers would default on them. Obviously, German exporters would be hurt by substantial currency appreciation.
German Chancellor Angela Merkel has sensibly decided to take the lead on reforming the eurozone. But many Germans feel deceived by some irresponsible eurozone partners, giving rise to the temptation to use Germany’s current strength to toughen sanctions and coerce weaker countries into adopting constitutional changes, especially concerning fiscal policy.
This is a risky attitude. To be sure, Germany has far more leverage today than it has had at any point in the last 20 years. But attempting to extract unilateral concessions from partners is a recipe for disappointment. It is one thing is to be sanctioned for breaching the rules, as with the Stability and Growth Pact; it is quite another thing to permit elected national governments and parliaments to be overruled, and national budgets censored, by an unelected higher authority.
The EU’s members are unlikely to agree to major reform unless Germany offers something in return. Absent a more balanced deal, what is likely to emerge from negotiations is simply another layer of largely ineffectual and ultimately divisive sanctions.
The natural quid pro quo for ex ante budgetary control is solidarity through the creation of Eurobonds. Joint and several liability for public bonds is imaginable only if countries offering their guarantee – and thus potential access to their taxpayers – can exercise veto power and prevent a partner country from issuing more debt. Thus, legally binding ex ante control is a necessary condition for Eurobonds. Conversely, surrendering budgetary sovereignty to eurozone partners is acceptable only if it accompanies their guarantee that they will come to the rescue in case of accident.
Germany should be bold and use its leverage to offer a new contract to its eurozone partners: mutual guarantee of part of their public debt in exchange for strict debt limits and a new legal order in which a eurozone authority can veto an enacted budget even before it is implemented. Only such boldness will deliver the certainty that markets need – and it is Germany’s responsibility to be bold.
By Jean Pisani-Ferry, Director of Bruegel, an international economics think tank, Professor of Economics at Université Paris-Dauphine, and a member of the French Prime Minister’s Council of Economic Analysis.