By Peter Coy
It was Thanksgiving Day in the U.S., but just another tension-filled Thursday in Strasbourg, part-time home to the European Parliament and thus the fulcrum upon which the world’s financial future teeters. Angela Merkel arrived uncharacteristically late, keeping Nicolas Sarkozy and Mario Monti waiting. No matter. The press conference couldn’t start without Merkel any more than a performance of Hamlet could begin without the prince.
The day before, the debt crisis that’s been spreading for two years singed Germany, as investors shied away from an auction of 10-year government bonds. By the market close, Germany’s 10-year borrowing costs stood at 2.2 percent a year, three-tenths of a percentage point higher than those of the wastrel U.S. For Merkel, it seemed like a moment of truth. Germany is the sole country in a position to prevent a collapse of the euro currency—an event that could trigger a financial crisis and perhaps another global recession. It’s only a slight exaggeration to say that the fate of the world is in one woman’s hands. Yet to the frustration, bewilderment, and mounting anger of leaders from Paris to Beijing to Washington, Merkel repeatedly has refused to act.
Ten minutes into the news conference, as Merkel’s turn to speak arrived, markets and fellow politicians were parsing her German for a sign that the Chancellor was ready to quell the panic by finally agreeing to issue euro bonds, perhaps, or supporting unlimited bond purchases by the European Central Bank. Or something.
Merkel yielded not a millimeter. Euro bonds—by which German taxpayers would become jointly liable for debts incurred by the likes of Greece and Italy—were “not needed and not appropriate.” She called once again for fast-tracking European Union treaty revisions that would force debtor nations to fix their finances. And she scored a diplomatic victory when Sarkozy, the French President standing at the podium to her left, promised to stop pressuring the ECB to step up its response to the debt crisis.
Merkel succeeded on her own terms, but outside the bubble of German decision-makers her Strasbourg performance was a groaner. “The veil has been torn off Merkel’s policy of muddling through,” said Sebastian Dullien, a senior fellow at the European Council on Foreign Relations in Berlin. “It’s only got us closer to the endgame, either the breakup of the euro or euro bonds. The strategy has failed.”
The contagion that began in Greece and then took out Ireland and Portugal has spread to the core of Europe. Budget-cutting austerity is slowing economic growth and thus tax receipts. Borrowing costs are rising because skittish investors are demanding higher yields on government bonds. The Continent’s banks have been infected by huge losses on their holdings of sovereign debt. One red flag is that European banks are having the most trouble borrowing in dollars since 2008. In an emergency action on Nov. 30, the Federal Reserve lowered the rate on loans of dollars to the ECB and four other central banks for relending to their member banks. Central banks “are seeing something in the functioning of the banking system that worries them,” Mohamed El-Erian, chief executive of bond investor Pacific Investment Management, told Bloomberg Television.
There is a whiff of August 1914 in the air. That was the month when Europe’s leaders stumbled into World War I through arrogance, nationalism, entangling alliances, and myopia. The operating assumption is that Merkel will bend before the onset of a financial conflagration, but there’s no assurance of that. In calling for treaty revisions, the Chancellor referred to “construction weaknesses in the euro zone” that need fixing. She perceives herself as a builder, not a firefighter. The question is whether, by the time Merkel has perfected the blueprints for the high-class renovation of Europe she and her supporters crave, the building will have burned down.
It’s impossible to grasp Merkel’s stubborn adherence to austerity and correct procedure without knowing her past, and Germany’s. She was born in 1954, nine years after World War II ended and Adolf Hitler perished, leaving her untainted by the generational guilt that compelled those like her former mentor, Chancellor Helmut Kohl, to throw themselves into the project of European unification. What’s more, she was raised on the wrong side of the Iron Curtain, in Brandenburg. East Germans, growing up under the thumb of the Soviet Union, were more likely to view themselves as victims of totalitarianism than as aggressors with a need to atone.
Merkel is the daughter of a Lutheran pastor. She won a PhD for a thesis on quantum chemistry. She is not without a personal touch: In October she presented Sarkozy with a German-made teddy bear for his newborn daughter (which the French President proceeded to unwrap while talking on his mobile phone). Though childless, she is known as Mutti, for Mother. Those who know her speak of a quiet charm, but it has never translated into political charisma. Her signature issues prior to the current crisis were global warming and the aging of the German population—chronic problems that benefit from a methodical approach.
Above all, Merkel’s worldview reflects the German desire for stability. Chaos plagued the German-speaking people long before there was a German nation. Historians estimate that the Thirty Years’ War between Protestants and Catholics in the 17th century killed 15 percent to 40 percent of the population. The country’s defeat in World War I was preceded by an exhilarating but frightening period marked by “influential demagogues, militarists, nihilists, and racists,” historian Steven Ozment wrote in his 2004 book A Mighty Fortress: A New History of the German People. Later, the hyperinflation of the 1920s and Depression of the 1930s, both of which undermined the middle class, gave rise to Nazism.
Modern German politics continues to be influenced by a philosophy that originated at the University of Freiburg in the 1930s: ordoliberalism, a conceptual blend of free markets and strong government. It says rigorous regulation is necessary, but only to help the free market achieve its full potential.
Ordoliberals detest stimulative Keynesian policies. Jürgen Stark, a Merkel ally who has tendered his resignation from the European Central Bank’s executive board in protest against its easy-money policies, once said that ordoliberalism theoretician Walter Eucken (who died in 1950) “has been a constant source of inspiration throughout my career.” In a speech in Freiburg last February, Merkel said: “Unfortunately there aren’t Euckens in all the countries of the world.”
Sound money is the polestar of the ordoliberal tradition. West Germany’s first Chancellor, Konrad Adenauer, once said, “Safeguarding the currency forms the prime condition for maintaining a market economy and, ultimately, a free constitution for society and the state.” Germans regard the 17-nation euro currency as the descendant and inheritor of one of their most cherished symbols, the Deutschmark.
During its half-century of existence, the Deutschmark, launched in 1948, was one of the few fixtures of postwar national life that Germans allowed themselves to be proud of. Thomas Kleine-Brockhoff, who played on Germany’s national basketball team in 1980-81, recalls that he and his teammates rolled down their socks at games to hide the black, red, and gold, and wouldn’t put their hands over their hearts when the national anthem was played. “The only accepted version of nationalism was what [philosopher] Jürgen Habermas called Deutschmark nationalism,” says Kleine-Brockhoff, a former correspondent for Die Zeit who is senior strategy director for the German Marshall Fund of the United States.
It was wrenching for many Germans when the Deutschmark was lashed to the euro in 1999 and done away with entirely in 2002. Those who opposed the common currency are claiming vindication now that the pressure for money printing and bailouts is rising and the Bundesbank wields but one vote at the European Central Bank, the same as Greece and Malta. The resentment of ordinary Germans toward what they view as southern European profligacy would tie the hands of any Chancellor—and Merkel is acutely aware that she faces re-election in two years.
The problem is that deliberation is a luxury Europe can no longer afford. The risk of bank failures and sovereign defaults in the weaker euro zone countries is now measured in weeks, not months. “I will probably be the first Polish Foreign Minister in history to say so, but here it is: I fear German power less than I am beginning to fear German inactivity,” said Radoslaw Sikorski in a Nov. 28 speech in Berlin.
What Europe needs urgently is a lender of last resort, a function that Merkel and Bundesbank President Jens Weidmann insist is out of the question. Weidmann, 43, a onetime economic adviser to Merkel, has variously described euro bonds as a “sweet poison” and as “seawater” that can’t quench one’s thirst.
In their opposition, the Germans are fighting against more than a century of central banking theory and practice. No less a conservative hero than Milton Friedman chalked up the Great Depression in the U.S. to the failure of the Federal Reserve to fulfill its role as a lender of last resort. Simple deduction says that a banking system that lacks an institution with unlimited lending power will be destroyed eventually by exactly the kind of bank run that is gathering speed in Europe today. Here’s the stomach-churning sequence: A weak bank fails. Depositors begin to worry about the stronger banks. The most anxious pull out their money, knowing the banks’ assets are tied up in long-term loans and there isn’t enough cash in the vault to pay off all depositors on demand. Others quite rationally follow suit. The prediction of failure is self-fulfilling: The banks run out of cash and go under even though their businesses, absent the panic, would have been perfectly healthy. Kaputt!
Traditionally, each European nation’s central bank served as a lender of last resort to its own nation’s banks. But they can’t promise unlimited support now that they have lost the power of the printing press. Also traditionally, it was banks rather than sovereigns that needed lenders of last resort. But by giving up their currencies, euro zone governments are no longer fully sovereign. They need a backstop.
There is a pernicious, amplifying interaction going on in Europe. As banks get in worse shape, they need more help from their governments. But the added stress on governments hurts the value of their debt, which banks own. And so on.
If it had the blessing of Merkel and other monetary hawks, the ECB could arrest the panic overnight by promising to print as many euros as necessary to buy the bonds of European nations, such as Italy and Spain, that are fundamentally healthy but wilting under attack. A related idea is to issue euro bonds, for which all euro zone members would be liable. If sovereign debt regained value, the banks that own their bonds would also be restored to health. Inflationary? Perhaps in the long run. But the printing press might never be needed; its mere existence would be enough to reassure depositors and scare off speculators.
Still, Germany resists. “Markets are going up a blind alley thinking there’s going to be a common euro bond or thinking that the ECB is going to act as a lender of last resort,” said Norman Lamont, the former British Chancellor of the Exchequer, on Bloomberg Television. “I think Germany would rather leave the euro than see the ECB’s integrity affected.”
Depending on where you sit, a breakup of the euro zone would be anywhere from ugly to catastrophic. If a deficit country such as Greece dropped out and brought back the drachma as its currency, Athens would be forced to default on its €277 billion of sovereign debt. The Greek government and Greek banks and companies would be shut out of foreign borrowing, crippling the economy. If Germany, on the other hand, left the euro, its new Deutschmark would likely soar in value, causing its export economy to shrink.
Some observers believe that Merkel is allowing the crisis to fester in order to gain financial control over the rest of the euro zone. Hans Kundnani, editorial director of the European Council on Foreign Relations, quotes the Cold War theoretician Edward Luttwak, who coined the term “geo-economics” to describe the “admixture of the logic of conflict with the methods of commerce—or, as Carl von Clausewitz would have written, the logic of war in the grammar of commerce.” Germany, with its perpetual trade surplus and financial grip on the rest of the euro zone, “may be the purest example of a geo-economic power in the world today,” Kundnani wrote in the Summer 2011 issue of the Washington Quarterly.
That may be going a step too far. If Merkel were thinking strategically, she probably wouldn’t risk the European economy falling into a recession. Jeffrey Sachs, director of Columbia University’s Earth Institute, says, “I’ve come to the conclusion that they don’t understand very much of these issues. Apparently some of the key figures have strong, self-contained views and are not interested in much discussion.” Sachs concludes: “This is really a disaster.”
Merkel could learn about coping with confusion from one of Germany’s greatest thinkers, psychologist Dietrich Dörner. In research at the University of Bamberg, Dörner tested Germans’ decision-making skills with a SimCity-like game that made them benevolent dictators of a fictional West African nation. His 1989 book on the game, published in English in 1996 as The Logic of Failure, cries out to be read by everyone enmeshed in the European debt crisis. One player became absorbed in building an irrigation canal, setting all other objectives aside. “When the experiment director reported that a great famine had broken out and that many inhabitants of Lamu were suffering from malnutrition or had already died from it,” Dörner writes, “this participant’s response was, ‘Yes, yes, but how is the construction of the major side canal in the Nehutu Steppe coming along?’ And he never gave another thought to the famine.”
Dörner’s bottom line is relevant to Merkel’s righteous defense of austerity. “The conviction that our intentions are unquestionably good,” he wrote, “may sanctify the most questionable means.”
What Merkel has so far seemed unable or unwilling to grasp is that her obduracy is self-defeating. From the start, the European project has been driven by Germany; but if the euro fails, Europe fails—which means Germany has failed. Jean Monnet, the French diplomat who was one of the fathers of European unity, once stated that Europe would be “established through crises.” Faced with existential threats, postwar Europeans have always chosen to huddle closer together, surrendering bits of their sovereignty in the process. Even Merkel repeatedly says that the solution to the current crisis is “more Europe.” It’s just that she demands stronger fiscal controls—which require time-consuming negotiations, treaty revisions, and national referenda to implement—before she’ll even consider more emergency assistance.
Increasingly isolated, Merkel is forging ahead with her renovation plan for Europe. “She’s trying to actually solve the problems instead of fighting the crisis,” says Ferdinand Fichtner, chief economist at the German Institute for Economic Research in Berlin. Fichtner says there’s plenty of blame to go around for the euro mess, but argues that Merkel is making a mistake by exploiting the crisis to force discipline on the laxer nations of the euro zone. “She’s obviously using German economic traditions,” Fichtner says. “She has made the crisis much worse than it would necessarily have been.”
Merkel could save face by embracing a plan that couples the tough fiscal rules she wants with the emergency aid that the markets demand. On Nov. 29 there were reports that euro-area finance ministers were exploring greater roles for the International Monetary Fund and the European Central Bank to insulate Spain and Italy from the debt crisis. Any new plan adopted at the next euro leaders’ summit on Dec. 9 would be the fifth “comprehensive” fix since May 2010 for a continent that keeps going back to the drawing board. Whether Merkel will smile on the latest gambit remains unclear.
The paradox at the heart of the crisis in Europe is that Merkel’s fetish for stability has become deeply destabilizing. There was a telling moment last February during Merkel’s speech in Freiburg to the Stiftung Ordnungspolitik, the organization that carries the torch for ordoliberalism. According to the prepared remarks, Merkel questioned how ordoliberalism should be implemented internationally when Germany is out of step with other countries. For the sake of international order, how far should Germany adjust to the way other countries do things, and when should it stick with what it believes is best? Although Merkel was referring to differences over narrow topics like tax breaks for scientific research, the implications of her musings were far-ranging. “That’s an eternal question that plagues me,” she said, “when I wake up in the morning and when I go to bed at night.”
