It's becoming clear that there is only one sensible solution ahead of us as the Eurozone’s problems evolve: Germany and the other countries suited to a strong currency should leave. If they do, the European Central Bank (ECB) will be free to pursue the easy money policies recommended by Keynesians and monetarists alike. It's increasingly clear that Germany has no option but to behave like any creditor seeking to protect its interests – and do its best to defuse the growing resentment against her from the Eurozone’s debtors.
However, leaving the Eurozone is a political and legal, even seismic wrench, reversing decades of historical progression towards political and economic union.
The saga of the Eurozone reads like an old-fashioned novel – with a beginning, a middle, and presumably an end. In the beginning we are introduced to the characters, the middle is where the action is, and the end is plainly predictable. There are two broad types of story: fairy tale and murder mystery. A fairy tale starts with a handsome prince, who meets and conquers evil and woos the princess, and at the end they marry and live happily ever after. A murder mystery starts with a murder, the middle is littered with clues (many of which are designed to put the reader off the scent), and the perpetrator of the crime is revealed at the end. The starry-eyed visionaries behind the Eurozone embarked on a fairy tale and instead have found themselves as characters in a murder plot. The difference is not the outcome, but how many pages we have left to turn to the end of the story.
The victim, of course, is the great European ideal, the political project that was meant to unite the European nations. The murderer is sound economic theory, which has been ignored, even trampled underfoot, but has resurfaced in the guise of reality. None of the actors foresaw (let alone can accept) this turn of events, and to get a flavour of the current mood we only have to listen to Manuel Barroso, President of the European Commission, whose response is to retreat into yet more regulation and statist control in denial of all reality.
Germany and France are centre-stage; in the post-war years they were partners in forming an economic and political block on Soviet Russia’s western boundary, containing the spread of communism. And by uniting the nations of Continental Europe, the reasons for war between them would be neutralised. These objectives were achieved, not so much by the formation of the European Union, but because the USSR’s communist model ensured the eventual economic collapse and disintegration of Russia and her satellites. And after the Franco-Prussian War and the First and Second World Wars, Germany lost all appetite for belligerence anyway.
France, with a little help from her Anglo-Saxon friends, was cock-of-the-roost after the two world wars, so much so that De Gaulle, France’s post-WW2 leader, was confident enough to refuse to join NATO, building France’s own arms capability instead. This sharply contrasted with Germany, who disavowed any military capability of her own and submitted completely to the military jurisdiction of NATO. This was reflected in post-war politics, with Germany quietly rebuilding her shattered economy, basing it on the preservation of savings, while France sought to build the state. The background to our story is one involving neighbours presenting a common front, but with very different attitudes toward life.
It is tempting to think that none of this matters, but it does. Politics, and not economics, are centre-stage. The German establishment is fundamentally reluctant to lead the Eurozone, being more interested in protecting Germany’s commercial interests. The French retain perhaps a sense of insecurity expressed in their jingoism. The former president, Sarkozy, visibly epitomised this. The new president, Hollande, expresses his nationalism by promoting French socialism. While Frau Merkel and M. Sarkozy were able on the surface to rub along together, Hollande’s denial of fiscal austerity exposes Germany’s underlying problem: As the rich and successful partner, it is now expected to subsidise the rest of the Eurozone for as long as it takes.
Germany is now in the unhappy position of a lender who has committed large amounts of money to a number of borrowers, who find themselves unable to repay and require further finance. Does it dig deep and find more money in the hope that it does not have to write its investments off, or does it say enough is enough? But it is worse than that; it hasn’t enough money itself to throw at these debtors, with the likely costs certain to exceed all its tax revenues. To give you a sense of the problem, in very round figures Germany’s tax revenues are €1.2 trillion, while the estimated costs of keeping defaults in the Eurozone at bay stand at close to €4 trillion.
But it gets worse still; it has no control over the money flowing through its own central bank. The chart below is of the money the Bundesbank automatically has to lend the other Eurozone central banks under the TARGET2 settlement system. Some of this figure, by the way, is included the in the total estimated €4 trillion.
This balance, which reflects private sector capital fleeing from the Eurozone debtor nations and being lent back to their central banks, stood at €751bn ($975bn) at the end of August, representing perhaps one sixth of all Eurozone deposits. On top of this, Germany and a few others are being asked to bankroll these nations’ governments. You only have to look at the rate of increase to get a sense of the banking runs being suffered in the weaker states and to understand the scale of the underlying crisis.
Germany’s electorate is becoming acutely aware of the enormity of the task. In theory, under the European Stability Mechanism (ESM), which is the vehicle for bailing out debtor nations unable to fund themselves, each Eurozone nation has to contribute. While one can understand the case for a nation being bailed out not having to contribute, does this mean that Italy, for example, must contribute to a bailout for Spain, and if so, how is it going to come up with the money? Obviously it cannot. And what about France, with its inward-looking economic model and with its own budget deficit running at over 6% and rising? It's silent on this matter, but it is a reasonable guess that it will make diplomatic excuses. This is the background to the German Constitutional Court’s judgment delivered on September 12, 2012.
German Constitutional Court’s Judgment
Last month on behalf of GoldMoney, I spoke to Professor Markus Kerber, who is one of the German academics that led the action placed before the Court on behalf of about 37,000 citizens. The Constitutional Court was asked to block presidential ratification of the German parliament’s approval of the ESM. Central to his case was the rapid increase in the bailout costs faced by Germany. Kerber told me that in the deposition to the court, the estimated costs for which Germany would be liable and that can be substantiated are in the order of €2 trillion, with further commitments of €1.7 trillion in the pipeline. This is in stark contrast with a similar action bought before the court a year ago, where the costs appeared to be only €170 billion. That action was rejected on the grounds that Germany could effectively afford it, in the view of the judges. So it was entirely logical that they ruled that the German President could ratify parliamentary approval of the ESM, so long as Germany’s contribution is capped at the level authorised by parliament at €190 billion.
This is small change in the scheme of things, and the ESM will require considerably larger contributions from Germany, assuming that an immediate and miraculous economic recovery doesn’t happen for the debtor nations. It doesn’t even begin to tackle Spain’s problems, let alone Italy’s. The larger contributions required for these debtors can only be obtained by going back to parliament and asking for an increase; something that is getting progressively more difficult as the general election approaches. But the Court went further, by ruling that the ESM can only use funds directly contributed to it and cannot borrow by issuing bonds in its own right or operating as a bank. This eliminates any hope that the ESM can be levered up.
Even more startling is its ruling with respect to the ECB and its recently announced Outright Monetary Transactions (OMT), and I quote from an English translation:
For an acquisition of government bonds on the secondary market by the European Central Bank aiming at financing the Members’ budgets independently of the capital markets is prohibited as well, as it would circumvent the prohibition of monetary financing (see also Recital 7 of Council Regulation (EC) No 3603/93 of 13 December 1993 (OJ L 332 of 31 December 1993, p. 1)).
The Court ruling therefore appears to put a straitjacket on the ECB as well as the ESM, together with all the bail-out plans cobbled together so far. The Court has basically made it impossible for unelected officials to commit German citizens’ funds without parliamentary approval and for the Bundesbank to condone the ECB’s actions.
The immediate response from German politicians has been supportive of the judgment, because it does not seek to overturn the Bundestag (the German parliament), and frankly, what else can they say without disrespecting the law? Privately, they must be reflecting on not only the difficulties or even the impossibility of going back to the Bundestag for ratification of even greater contributions to the ESM, but also they must be wondering where on earth they go from here.
The alternative, assuming attempts to rescue indebted nations are not to be abandoned, is for the ECB to ignore the German Constitutional Court on the basis that the GCC has no jurisdiction over it, confront the Bundesbank, and accelerate its lending through the banking system, which of course is likely to eventually undermine the euro itself. The question then arises as to whether or not Germany will voice its objections to such a policy. It makes no sense for Germany, which has seen its own currency destroyed twice in the last ninety years and has experienced a period of national prosperity based on sound money before the creation of the euro, to be a party to the rapid expansion of money by the ECB.
This monetary expansion has to happen, however, if widespread sovereign defaults are to be averted. Its Constitutional Court has effectively made Germany’s decision. It can only with the greatest political difficulty raise more than €190bn from its own citizens to support debtors, and it cannot condone the monetisation of government debt. There is now only one alternative: Germany must leave the Eurozone and allow the member states, who happen to believe in the Keynesian salvation of a weak currency, to pursue their favoured solution with a weak euro. Germany’s politicians can now demonstrate that their hands are well and truly tied by their own constitution, which is getting in the way of co-ordinated solutions.
What does Germany get out of the euro?
Not as much as you would think. It is a common fallacy that Germany has benefited by anchoring its terms of trade with its neighbours through a common currency; this is an error born from neoclassical economic suppositions. Germany’s original supporters of Eurozone membership were its large industrial companies, which were looking forward to a trading environment made easier by a weaker currency. However, it was not long before these benefits were lost, because companies naturally felt less pressure to control their costs. The result is that German companies have (if anything) lost their competitive edge as a result of the single currency, and gains in productivity have been disappointing as a result.
The biggest losers have been the ordinary workers, whose wages continued to rise at a very pedestrian pace, if at all. Whereas in the past, a wage-packet bought more as the Deutsche mark rose in value against other paper currencies, that is no longer true. Instead, static wages have lost purchasing power over time, and the result is that growth in real disposable income per capita is virtually non-existent. Workers have been squeezed between a legacy of past wage-bargaining assumptions and a change from a strong to a weaker currency.
In short, it has become obvious to many people from all walks of life in Germany that the euro has done them no good, and, far from reaping benefits, they are actually less wealthy as a result of it. Therefore, the brash assumption fostered by the debtor nations that Germany can and will pay is simply incorrect, even if we stick to the headline numbers. But we all know that a government budget deficit is only the tip of an iceberg. For Spain and Italy, we must also consider rapidly escalating off-balance-sheet liabilities, the financial difficulties of local governments, and central government guarantees for nationalised and other supported industries. Government liabilities can be doubled or even tripled – who knows? Our experience of Greece’s troubles has confirmed that an initial few tens of billions, which Deo volente was enough, turned out to be only the first of a series of ever-increasing demands. If Greece is to be regarded as a learning experience, Spain will certainly be impossible to support, given that she shows no sign or even any prospect of economic recovery.
Germany’s politicians know this. For the moment they are frozen in a state of inaction, but there is a general election to concentrate their minds in about a year’s time. So irrespective of the timing imperative from Eurozone countries facing financial disaster, Germany is running out of time as well. It is make-your-mind-up-time for everyone.
If Germany is to abandon the euro, it has to do so as quickly and elegantly as possible. It must be able to demonstrate that it has no alternative and that it is the best solution for all parties involved. It must gain international support for its actions and the support of other key Eurozone members. There will also be legal difficulties to surmount – because, put simply, leaving the Eurozone is against the law.
In Part II: The Implications of a German Exit from the Eurozone, we explore the most likely strategy the main players will take to achieve these ends. And we ask, What does a German exit actually mean? What are the most probable impacts to expect?