Angela Merkel's nightmare: the markets test the German Chancellor's approach of trial-and-error. Is there an end game in sight?

• Author: Engelen, Klaus C.

As we go to press, German Chancellor Angela Merkel continues to display her characteristic political technique, a mixture of trial-and-error with "unilateral instincts," plus a hefty dose of nicht regieren, or non-governing. But sitting things out in a globalized world while managing the largest European economy m times of crisis can be damaging and very costly. This year, she faces seven state elections. There is a lawmaker revolt over pledges to defend the euro by providing more rescue financing, especially among the ranks of her weakened coalition partner, the liberal Free Democratic Party. Making matters worse, the newest opinion polls show that more than four out of five Germans oppose increasing the bail-out fund for the euro. Add to that the jolt that Bundesbank head Axel Weber, the German frontrunner to head the European Central Bank, has withdrawn his candidacy by announcing that he would not serve a second term as Bundesbank president.

Merkel has experienced a rapidly changing political environment since the eurozone crisis started early last year with the threatened default of Greece. She seems to realize that important segments of Germany's elite and a large part of the general population no longer want to serve as Europe's paymaster without more say in what is done with their money. Ill-feeling is growing against an ever-more-encroaching bureaucracy in Brussels telling Germany what to do. And there is resentment that the so-called "Club Med" countries along with a banking and corporate tax haven like Ireland now expect to be bailed out with German money on the grounds of European solidarity. Germans worry that their trusted Bundesbank is being taken over by Club Med central bankers who are ganging together to soften the euro.

As the international pressures mount on Berlin to do more to solve the euro crisis, Germany and France seem to be moving closer together, with not one but two odd couples: French President Nicolas Sarkozy and Merkel, and also their finance ministers, Christine Lagarde and Wolfgang Schauble. Lagarde is a renowned global corporate and banking lawyer by profession, and Schauble was former Chancellor Kohl's point man in organizing German reunification. The German-French cooperation comes from economic and financial necessity. Sarkozy has strong incentives to keep Merkel on his side, such as the high exposure of French banks in Greece and other peripheral eurozone economies, France's failure to keep up economically with global export machine Germany, the specter of a lost decade for la Grande Nation, and fear that France may soon lose its triple-A bond rating.

UNDER ATTACK FROM THE EU BIGGIES

Since late last year, ECB President Jean-Claude Trichet has called for a substantial increase in "quantity and quality" of the Luxemburg-based European Financial Stability Facility established in May last year. Its headline figure is 440 billion [euro] ($600 billion), but due to cash buffers and a guarantee cap, its lending capacity so far is only around 250 billion [euro]. In the meantime, EU finance ministers decided that the European Stability Mechanism, which will replace the present EFSF after 2013, will have a lending capacity of 500 billion [euro] ($675 billion).

The European Central Bank wants to rescue the euro by doling out easy money in order to keep weak eurozone sovereigns and banks with zero or reduced market access afloat. Trichet and his colleagues are eager to transfer much of the rescue job to where it belongs: the governments and their fiscal resources.

Under what was intended as a stopgap measure in May of last year, the European Central Bank has bought through its Securities Market Programme 76.5 billion [euro] worth of sovereign bonds of countries such as Greece, Ireland, and Portugal in an effort to keep down their borrowing costs. This much-debated program came on top of 60 billion [euro] purchased in the form of implicitly government-guaranteed covered bonds between July 2009 and June 2010.

Based on ECB data, Deutsche Bank Global Market Research computes ECB net lending to banks in peripheral countries as of December 2010 at stunning levels. The ECB's net lending to Greece reached 97.8 billion [euro], or 37 percent of the country's GDP. The net lending figures for Ireland: 94.6 billion [euro], or 68 percent of GDP; for Portugal, 42 billion [euro], or 24 percent GDP, for Spain, 61.6 billion [euro], or 4 percent of GDP. Additional liquidity is provided by individual central banks of the Eurosystem against relaxed or zero collateral requirements. According the latest figures, at the end of 2010, banks in Portugal, Ireland, Greece, and Spain had obtained 300 billion [euro] in liquidity through their national central banks. This means that one-quarter of the eurozone banks obtained three-quarters of the total liquidity provided through the ECB system.

This high exposure in the financially weak eurozone countries makes clear that the European Central Bank is moving further towards becoming Europe's "bad bank," thereby damaging its independence. Jean-Claude Juncker, prime minister of Luxembourg and an old friend of the governing German Christian Democrats, has become a sharp critic of Merkel's response to the crisis and has lost his traditional position as mediator, especially between France and Germany. Merkel and Schauble had made clear that Germany would not accept--with exception of backing bonds issued by the EFSF--a broader scheme of community-guaranteed bond issuance. In spite of this, Juncker, together with Italy's economic and finance minister Giulio Tremonti, came up with an ambitious plan for "eurobonds" guaranteed by EU community member states. For Germany, the eurozone's largest creditor, this was a political provocation. Juncker and Tremonti urged the establishment of a European Debt Agency with a mandate to gradually issue outstanding community debt equal to 40 percent of the GDP of the European Union and of each member state. When Berlin sharply rejected Juncker's idea, Juncker accused Merkel of "un-European behavior" and "simplistic thinking."

EU Commission President Jose Manuel Barroso, the former conservative prime minister of Portugal, whom Merkel had helped to get his Brussels job, stood up against Merkel by insisting on a speedy expansion of the European rescue facility and supporting the introduction of eurobonds. His action damaged further an already strained relationship. The news magazine Der Spiegel ran an article titled: "Waning Influence in Brussels: Euro Crisis Leaves Germany Increasingly Isolated." So Merkel is under pressure from all sides.

FIGHTING BACK BY ASKING FOR MORE

What does an fifty-six-year-old scientist who grew up in communist East Germany do to get out of this corner?

Holding on to power is what Merkel knows best. After a period of sitting, she moves forward with a new agenda to dominate the media and catch the attention of voters.

Merkel is treading a fine line as she seeks to balance her solemn pledge to save the euro with the increasing worries in her governing coalition about the escalating resentment of taxpayers against beefing up the "rescue umbrellas" for Greece and other struggling states.

Merkel tried to regain the initiative by shocking the European Union with a much broader call for eurozone reform--a comprehensive "pact for competitiveness" in line with Sarkozy's concept of an "economic government" for the eurozone. Merkel's "grand bargain" proposals ranged from common corporate rates to pension system reform, and include the abolition of wage indexation, constitutional amendments on debt limits, mutual recognition of education credentials, measures to promote cross-border labor mobility, and the establishment of national crisis management regimes for troubled banks. Her call for a eurozone-wide rise in the retirement age to sixty-seven was met by some EU leaders with hostility.

As a reflection of Merkel's lack of confidence in the Brussels bureaucracy, she pushes--with...