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Merkel’s Moment

Wednesday, November 23, 2011

If past is prologue to the future, there is little reason to believe that Merkel will allow the ECB to provide unlimited support to the periphery.

As Europe’s sovereign debt crisis now envelopes Italy, Spain, and even France, one has to pity Angela Merkel, the doughty German chancellor. She now finds herself helplessly caught between two irreconcilable forces.

The markets, together with the French, Italian, and Spanish governments, are clamoring that she should lean heavily on the European Central Bank (ECB) to provide unlimited financial support to reduce Italian and Spanish interest rates to affordable levels. Yet, closer to home, her electorate is balking at any notion of putting additional German taxpayer money at risk for yet further bailouts for the crisis countries. Her electorate is also against taking financial pressure off the peripheral countries to mend their wayward ways.

Merkel is constrained by public opinion, the backbenchers in her own party, and a fiercely independent constitutional court.

Despite Silvio Berlusconi’s replacement by Mario Monti as Italy’s prime minister, and despite meaningful ECB intervention, the Italian bond market remains under enormous pressure, as indicated by Italian borrowing rates at close to 7 percent. At the same time, the interest rates that markets are demanding of the Spanish and French governments are now at their highest levels in the past decade. The markets have correctly sensed that any further increase in these interest rates for any length of time would put the sustainability of those countries’ public finances in serious question. The market well knows that these countries can simply not afford to finance themselves at these levels on a long-term basis. This is prompting further selling of those countries’ bonds, which, if unchecked, could be a self-fulfilling prophecy.

With Italy, Spain, and France now all firmly in the market’s sights, the very survival of the euro is in question. This is prompting desperate calls from the French, Italian, and Spanish governments on Merkel to lean heavily on the ECB to act decisively to calm the markets. They would like to see the ECB actively play the role of lender of last resort to Europe’s embattled periphery. In particular, they want the ECB to stand ready to buy as many Italian and Spanish government bonds as might be necessary to reduce their interest rates to levels consistent with long-run fiscal sustainability.

The interest rates that markets are demanding of the Spanish and French governments are now at their highest levels in the past decade.

Merkel’s predicament is that the German public and the German financial establishment have a very different view of the ECB’s role. In their view, the ECB should not be in the business of bailing out countries, especially since it would effectively put German taxpayers on the hook in the event that those countries were to default. Rather, they adamantly believe that the ECB should stick to its limited mandate of operating as a monetary institution to ensure price stability and to safeguard the soundness of the currency.

Last week, at the very time that the eurozone debt crisis was escalating, Jens Weidmann, president of Germany’s central bank, further articulated Germans’ resistance to large-scale ECB intervention in the Italian and Spanish sovereign debt markets. He raised questions as to whether the ECB had already strayed beyond what was legally permissible under the Lisbon Treaty. He also raised questions about the wisdom of having the ECB take pressure off the Italians and Spanish to undertake the painful adjustment that is needed to put their public finances on a sounder footing.

With Italy, Spain, and France now all firmly in the market’s sights, the very survival of the euro is in question.

Since the start of the eurozone debt crisis some 18 months ago, Merkel’s response has consistently been of the too little, too late variety. At each stage of the crisis she has done the bare minimum of what was necessary to stabilize the situation without providing a permanent fix to the problem. She has done so not because she does not understand what is needed to get ahead of the markets, but rather because of the very real political constraints she has faced at home from public opinion, the backbenchers in her own party, and a fiercely independent constitutional court.

If past is prologue to the future, there is little reason to believe that Merkel will now throw caution to the wind and allow the ECB to provide unlimited support to the periphery. She will not do so even though that is what might be necessary to save the euro. Rather, the most that might reasonably be expected of the German chancellor is that she will allow the ECB to significantly step up its purchases of Italian and Spanish bonds, subject to stringent conditions on those countries to undertake fiscal austerity and structural reform. This should allow the can to be kicked forward yet again for a few more months. However, it will not eliminate the very real risk that the euro could unravel in the course of 2012, especially as the European economy sinks deeper into recession.

Desmond Lachman is a resident scholar at the American Enterprise Institute.

FURTHER READING: Lachman also writes “It’s Europe’s Economic Growth, Stupid,” “A Tale of a Euro Exit Foretold,” “Will Greece Destroy the Eurozone?” “A Two-Speed Reaction To the Euro Crisis,” and “As Greece Faces Default, Where Is Europe's Firewall?

Image by Darren Wamboldt | Bergman Group

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