Death of the (German) Euro: Kohl giveth, and Merkel taketh away.

• Author: Engelen, Klaus C.

For the generation of Germans characterized by European Community President Jacques Delors in 1992 with the words, "Not all Germans believe in God, but they all believe in the Bundesbank," a sense of "Gotterdammerung" has pervaded the air during the past few weeks. The threat of Greek bankruptcy has escalated into a full-blown financial crisis, severely damaging the public's confidence and trust in the single European currency--the euro--and in the European Central Bank, the Bundesbank's successor institution. Europe faces a twilight of the gods, indeed.

The death notice cover of Wirtschaftswoche, Germany's business weekly, captures the worries of important segments of the German population. The notice reads, "The Euro. Kohl gave it, Merkel took it. We say goodbye to a stable currency, anchored in solid fiscal policy," and is signed by the German Federal Republic and its taxpayers.

But those bemoaning the death of the euro are essentially reacting to the burial of the single European currency modeled as a "German euro," which the Germans thought to have secured forever by the "no bail-out" clause in the Maastricht Treaty of 1992 and by the Stability and Growth Pact, the agreement between the sixteen members of the European Union that take part in the eurozone. The "no bail-out" clause forbids the European Union or any of its members to "'be liable for or assume the commitments of" another EU country.

The Greek crisis is a defining moment for the eurozone. We can be sure about one thing: Europe's politicians, central bankers, and EU bureaucrats are meeting reality. They are now victims of their own failures and misdeeds, with considerable collateral damage to the foundations of monetary union. No longer can they have their cake and eat it, too.

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Europe's future recently hung in the balance after the most turbulent week in the history of the union. The eurozone was spared at the eleventh hour from outright collapse, but the credibility of its key institutions was left in tatters. There was a painful awakening from years of complacency, ignorance, and long-held unrealistic notions about the resilience and invulnerability of European monetary union and its member countries. For the past decade, essential deficiencies in the institutional framework and the implementation of governance roles have been disguised by extraordinarily low risk premiums in the eurozone, which led to the illusion that there was no need anymore to take into account "country risk" when investing in the euro sovereign debt asset class.

For Germany--with its traditional monetary stability culture--this amounts to a capitulation, considering the political effort that was invested into assuring that the European Central Bank would be modeled after the Bundesbank.

The capitulation was made, by coincidence, in the waning hours of May 9, 2010, exactly sixty-five years alter Germany surrendered to the Soviet Union in World War II, an event that German Chancellor Angela Merkel celebrated as guest of honor in Moscow.

Chancellor Merkel, whose bungling allowed the long-smoldering Greek sovereign debt crisis to flare into a serious threat to the survival of monetary union, is seen with a mixture of bewilderment, angst, and anger among some of Germany's EU partners. This is because when it comes to defending the stability of the euro and the cohesion of the European Union, the German government holds the key. And a German chancellor who held off on making urgent support decisions until after the May 9 state elections in North Rhine-Westphalia (which her CDU party lost) may have done a lot of damage to Europe in a world of evermore powerful and dangerous financial markets.

But the big story behind the Greek situation is not about short-term debt management tactics, but about loss allocation and the stability of the financial system going forward. Achim Dubel, a Berlin-based financial market consultant, argues that the Greek case means yet another round in the spiral of the bail-out economy which will benefit private interests while threatening public solvency. "It is unacceptable that politicians for the second time in two years nationalize or supra-nationalize all historic private exposure--before to risky banks, now to risky sovereigns. A sustainable position would be to haircut the old debt and recapitalize or unwind the banks to address solvency, while guaranteeing the new debt to restore liquidity. This was the successful strategy adopted during the debt crisis of developing countries in the 1980s. Programs like the ECB's sovereign debt purchase program as well as ECB's huge exposures towards southern European bank risk do precisely the opposite. They randomly allocate historic losses to the remainder of the eurozone while keeping investors in the dark about whether they will get repaid. This undermines the credibility of both the currency and the political system in general. This is what you might call the European version of the 'Greenspan put', where for many years, very low dollar interest rates allowed investors to take any risks and make a lot of money, knowing their central bank, Greenspan's Federal Reserve, would bail them out."

SEEDS OF A CRISIS

Beginning in October of last year, the newly elected Greek socialist government revised the estimate of its budget deficit from 6.7 percent of G DP to 12.7 percent, causing Greece's credibility in financial markets to plummet. In April 2010, Eurostat, the European Union's statistical agency, put Greece's deficit even higher, at 13.6 percent. The international investor base in Greek sovereign bonds and treasuries became increasingly nervous, and the rating agencies reacted with downgrades. Doubts spread about Greece's ability to repay its maturing debt obligations, estimated at 54 billion [euro], and the specter of Greece's debt reaching about 150 percent of GDP ignited speculation on the need for restructuring all or part of Greece's outstanding sovereign bond obligations, or worse, the first full-blown default of a eurozone debtor country.

After the situation smoldered for months without political agreement on a rescue mission, on April 20, 2010, the economists of Royal Bank of Scotland, a bank that the U.K. government rescued from bankruptcy, sent out an unhelpful message: "Europe risks biggest coordination failure in modern history." And pointing to eurozone governments, in particular to Germany as the financially strongest country in the eurozone and key to any major emergency financing package, they saw "communication and coordination failures at the core of current crisis, the extent of contagion now such that the backstop to Greece is becoming a sideshow. Europe needs to respond to the financial markets' wake-up call."

As it turned out, Europe's politicians first put together a huge "support mechanism" for Greece, worth about 110 billion [euro], including resources of the International Monetary Fund for about one-third of the credit support. This amounted to three times the level discussed a few weeks earlier.

Only days later, in order to right contagion that was spreading to other highly indebted euro members, the same European leaders...