The €uropean


Will Germany Break the Monetary Union Once Again?

            Might the large and growing fiscal deficit in Germany break the Monetary Union once again? This would be the second time, the first time was early in the 1990s.

            In fact, when the Berlin Wall came down – back in 1989 - it was the beginning of the end for the European Exchange Rate Mechanism (call it the ancestor of the euro, if you wish).

            Germany started to run up a huge budget deficit in order to finance the rebuilding of East Germany. At the same time, the Bundesbank was unwilling to tolerate any inflation and embarked on tight monetary policy. The result was that Germany experienced strong domestic performance accompanied by high interest rates. Such a mix of policies was probably congruent with Germany's own aims, but proved to be unsustainable for other members of the European Monetary System (EMS).

            In fact, the other members had to adjust their interest rates to the new benchmark, because they had to guarantee the currency pegs. The process went on and on until the burden of high interest rates became unbearable to some countries and in the fall of 1992 Italy and the UK dramatically abandoned the European Exchange Rate Mechanism. The outcome was unintended and unanticipated but it was the intrinsic conflict between Germany's objectives and the needs of Italy and the UK to abort, if temporarily, the ancestor of the euro.    

            Might it happen all over again?

            What we do know is that under the impetus of the crisis, Germany is about to build up a large budget deficit once again: the general government balance is expected to jump from equilibrium in 2008 to a deficit of some 4% of GDP in 2009, a huge annual change.

            There is a danger that high government deficits in Germany accompanied by a decisive expansionary fiscal policy, may drive heavily indebted countries out of the market. Spending similar amounts of money would bankrupt nations such as Italy or Greece. Yet, Germany's dynamism may force European partners to follow.

            The auto sector provides a case in point: Berlin has recently introduced certificates of 2,500 euros each for consumers who scrap a car that is at least nine years old and buy a new model. At some point you could buy the same Fiat in Germany at a generous discount to Italy, threatening Italy's official car dealer system (because of imports from Germany in the secondary market). Accordingly, Rome was forced to enact a similar rule, allowing for a 1,500-euro certificate.

            Further, capital is being attracted in Germany by rising budget deficits, putting under strain the debt of weak European partners which have to compete with Germany to service their debt. The substantial widening of the spreads over the benchmark German 10-year bond rate is widely recognized. But a widening spread when the general trend for interest rates is down is not especially worrisome, because the absolute amount of interest to be paid remains stable. For instance, it is true that the spread between Italian and German bonds has moved to 150-160 basis points; however the absolute level of the rate on Italian bonds continues to fluctuate around 4.3 to 4.8%. What happens when the overall interest rate cycle turns up will be much more significant (and dangerous).

            We also do not know how far Germany will push its fiscal engine. But we do know that Germany is entering the worst recession of its modern history and that the next general election is scheduled for September 2009.

            The main parties are already firmly on an election footing. Accordingly, there is a possibility that fiscal stimuli will go further than currently envisioned. Just as in the early 1990s, this may be the right mix of policies for Germany but it is not sure that it is equally benign at the periphery of Europe.

            Germany is accelerating its expansionary fiscal policy. For instance, last fall the cabinet raised criticism to the UK tax cuts, arguing they would create debts that would take a generation to pay off. However, when the outlook for the economy worsened, chancellor Angela Merkel greatly enlarged the scope for fiscal stimulation, passing a second and heavier economic package on January 27.

             Will the euro survive?

            Some investors have adopted the stance that the severe and unprecedented financial and economic crisis would drive one or two of the weakest member states out of the euro block. Hopefully, such alarms are misplaced and the eurozone will survive intact through the test of hard times, especially because there isn't any political willingness to break the euro: California is laboring under very unfavorable interest rate differentials, but no one is thinking of abandoning the dollar.

            Moreover, if a country exited the euro, that would elicit an allergic reaction from the markets; the debt servicing costs would skyrocket and the national banks would quickly become insolvent, making the default on government debt all the more likely: clearly this alternative is less attractive than remaining within the eurozone.            

            However, if there is a risk that markets currently underestimate, it is that Germany, once again, embarks on policies that in due time will drive interest rates to levels that become unsustainable for the more indebted member states. This may happen both by running large and growing budget deficits and by emergency interventionism in the economy (as in the auto and banking sectors) that forces the weakest European partners to spend public money beyond their means just to protect national industries against unfair competition from Germany. 

            Ironically, the greater risk may come when economic activity picks up, because that is the time when interest rates will really come under pressure.          

            In short: if Germany has a reasonable deficit this year, investors may think that in 2 years from now, German interest rates could move back to 4%. But if Berlin goes on a spending spree, investors may think that interest rates will advance to 6 or 7% when the economy recovers. Now, perhaps Germany may live with such interest rates, but operating under so unfavourable borrowing costs would bankrupt Italy or Greece. Accordingly, if I am an investor, I can think that the more Germany spends now, the more Italy and Greece are likely to go out of the euro tomorrow. No one is noting this risk.

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