Ambrose Evans-Pritchard: Will Germany deliver on devil's bargain of monetary union?

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, February 23, 2009

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/478274...

If Der Spiegel is correct, the German finance ministry is drafting rescue plans to prevent default on the edges of the eurozone leading to a full-blown collapse of Europe's monetary system.

This is an entirely appropriate policy in economic terms. One dreads to think what would happen if the world's twin reserve currency were to disintegrate at this stage.

But what about the solemn pledge to voters by Germany's political elites -- promiscuously given over the years -- that monetary union would never leave them on the hook for the debts of half Europe?

The vast imbalances that have been allowed to build up under the seductive protection of EMU leave German taxpayers facing bailout liabilities that exceed the cost of reparations after the First World War, in proportional terms. The political ground has not been prepared for this. EMU was foisted on the German people without a referendum, in the face of deep public scepticism and scathing criticisms by the professoriat. This failure to secure a mandate for such a revolutionary undertaking is coming back to haunt them.

Berlin is at last having to deliver on the Faustian bargain made by Germany's political class when it swapped the D-Mark for French acquiescence in reunification. It must either go the whole way towards EMU fiscal union and take responsibility for Italy's public debt (111 percent of GDP by next year), Austria's loans to Eastern Europe (70 percent of GDP), the adventures of Ireland's "Canary Dwarf" (E400 billion or so in liabilities), and Spain's housing collapse (1 million unsold homes), or jeopardize its half-century investment in the political order of post-war Europe. Letting EMU fail at this stage would have far higher costs than never having launched the project in the first place.

The alleged bailout options include "bilateral bonds" where big-brother countries agree to shoulder the credit risk for siblings -- who vouches for Italy and Spain? -- or some form of EU bond.

Finance minister Peer Steinbruck -- erstwhile Scrooge -- has become the unlikely champion of open-ended help for all. "We have a number of countries in the eurozone that are clearly getting into trouble. ... Ireland is in a very difficult situation. ... The euro-region treaties don't foresee any help for insolvent states, but in reality the others would have to rescue those running into difficulty," he said.

In case there was any misunderstanding, he upped the ante two days later with a pledge to "show ourselves to be capable of acting" if any euro member proves unable to roll over its debts. This is a radical shift in policy.

For now the bailout talk has cowed speculators. The euro has rallied after weeks of sharp descent against the dollar. Credit default swaps (CDS) on Irish debt have fallen back below the red alert level of 400 basis points. But it has not been lost on the markets that Germany's own CDS spreads have risen to a record 86. Are traders starting to ask whether Berlin is in a fit state to rescue anybody?

The German economy contracted at an 8.4 percent annual rate in the fourth quarter as exports to Eastern Europe, Club Med, and the Anglo-sphere collapsed. The GM subsidiary OPEL is running out of cash and risks going the way of Sweden's SAAB without a E3.3 billion rescue.

Mortgage lender Hypo Real Estate is imploding despite E87 billion in state guarantees and capital injections. Mr Steinbruck said nationalisation is inevitable. If Hypo collapses with E400 billion of liabilities, it would risk a "second Lehman Brothers," he said. Like Northern Rock, it relied on short-term funding to lend long. Game over.

Hypo has been infecting the E850 billion Pfandbriefe market (covered bonds), the rock core of Germany's credit system. Spreads on Postbank issues have jumped from 40 to 80 basis points. Pfandbriefe are not covered by Berlin's emergency guarantees (unlike three-year bank debt). That may need to be changed soon. Mr Steinbruck still insists that German banks are in fine fettle. The rest of us notice their leverage ratio is 52, the highest of any major country. We are assured they have good assets. Let us hope so.

Time will judge whether Mr Steinbruck's bailout rhetoric is hollow. I wonder whether any German government can in fact deliver on his pledge. He is unlikely to be finance minister after the elections in September. The Social Democrats are heading for the most crushing defeat in a free election since July 1932 -- and for the same reasons -- because they are associated with a deflationary collapse of Germany's core industry. Their left flank is peeling away to the neo-Marxist Linke party, just at it peeled away to the Communists in 1932.

There is much talk in the German and global media perpetuating the myth that it was German hyperinflation in 1923 that destroyed the Weimar Republic and led to Nazism. This is a fatal misreading of events. What led to Hitler was the Bruning deflation of the early 1930s.

What is true is that the 1923 trauma caused the Reichsbank to wait too long to ease monetary policy from 1930 to 1933, though gold standard ideology played its part. The European Central Bank has done better. At least it has followed Bagehot's advice to "lend generously" even if rates have been too high, but it has been paralysed by its own institutional hangups and its need to prove itself a hard-money successor to the Bundesbank.

Last week chief economist Jurgen Stark attempted to head off the bailout plans, reminding Berlin last week that rescues are prohibited by EU law. This is not strictly true -- Article 100.2 allows aid in "exceptional circumstances" -- but it gives powerful cover to anybody wishing to oppose the Steinbruck policy.

But whatever the legal theory, the political reality is that 700,000 Germans are going to lose their jobs this year as unemployment rises to 4.3 million (IFO Institute). Voters are not going to look kindly on any party seen to divert German savings to Ireland or Club Med.

Architects of EMU were well aware that a one-size-fits-all monetary policy for vastly disparate nations would create serious tensions over time. They gambled that this would work to their advantage. The EU would be forced to create new machinery to safeguard its investment in the euro. It would be a "beneficial crisis," bringing about the great leap forward to full union.

We are about to find out if they were right.

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