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Germany Must Defend the Euro

 Financial markets abhor uncertainty; that is why they are now in crisis mode. The governments of the euro zone have taken some significant steps in the right direction to resolve the euro crisis but, obviously, they did not go far enough to reassure the markets.

At their meeting on July 21, the European authorities enacted a set of half-measures. They established the principle that their new fiscal agency, the European Financial Stability Fund (EFSF), should be responsible for solvency problems, but they failed to increase the EFSF’s size. This stopped short of establishing a credible fiscal authority for the euro zone. And the new mechanism will not be operative until September at the earliest. In the meantime, liquidity provision by the European Central Bank is the only way to prevent a collapse in the price of bonds issued by several European countries.

Likewise, euro zone leaders extended the EFSF’s competence to deal with banks’ solvency, but stopped short of transferring banking supervision from national agencies to a European body. And they offered an extended aid package toGreecewithout building a convincing case that the rescue can succeed: they arranged for the participation of bondholders in the Greek rescue package, but the arrangement benefited the banks more thanGreece.

Perhaps most worryingly,Europefinally recognized the principle – long followed by the IMF – that countries in bailout programs should not be penalized on interest rates, but the same principle was not extended to countries that are not yet in bailout programs. As a result,SpainandItalyhave had to pay much more on their own borrowing than they receive fromGreece. This gives them the right to opt out of the Greek rescue, raising the prospect that the package may unravel. Financial markets, recognizing this possibility, raised the risk premium on Spanish and Italian bonds to unsustainable levels. ECB intervention helped, but it did not cure the problem.

The situation is becoming intolerable. The authorities are trying to buy time, but time is running out. The crisis is rapidly reaching a climax.

Germanyand the other euro zone members with AAA ratings will have to decide whether they are willing to risk their own credit to permitSpainandItalyto refinance their bonds at reasonable interest rates. Alternatively,SpainandItalywill be driven inexorably into bailout programs. In short,Germanyand the other countries with AAA bond ratings must agree to a euro bond regime of one kind or another. Otherwise, the euro will break down.

It should be recognized that a disorderly default or exit from the euro zone, even by a small country likeGreece, would precipitate a banking crisis comparable to the one that caused the Great Depression. It is no longer a question whether it is worthwhile to have a common currency. The euro exists, and its collapse would cause incalculable losses to the banking system. So the choice thatGermanyfaces are more apparent than real – and it is a choice whose cost will rise the longerGermanydelays making it.

The euro crisis had its origin in German Chancellor Angela Merkel’s decision, taken in the aftermath of Lehman Brothers’ default in September 2008, which the guarantee against further defaults should come not from the European Union, but from each country separately. And it was German procrastination that aggravated the Greek crisis and caused the contagion that turned it into an existential crisis forEurope.

OnlyGermanycan reverse the dynamic of disintegration inEurope. That will not come easily: Merkel, after all, read the German public’s mood correctly when she made her fateful decision, and the domestic political atmosphere has since become even more inhospitable to extending credit to the rest ofEurope.

Merkel can overcome political resistance only in a crisis atmosphere, and only in small steps. The next step will likely be to enlarge the EFSF; but, by the time that step is taken,France’s AAA rating may be endangered. Indeed, by the timeGermanyagrees to a eurobond regime, its own AAA standing may be at risk.

The only way thatEuropecan escape from this trap is by acting in anticipation of financial markets’ reactions, rather than yielding to their pressure after the fact. This would require intense debate and soul-searching, particularly inGermany, which, as the EU’s largest and best-rated economy, has been thrust into the position of deciding the future ofEurope.

That is a role thatGermanyhas been eager to avoid and remains unwilling to accept. ButGermanyhas no real choice. A breakdown of the euro would precipitate a banking crisis that would be beyond the global financial authorities’ ability to control. The longerGermanytakes to recognize this, the higher the price it will have to pay.

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