Germany may have to choose between ‘sound money’ and the euro’s survival

'Europe will be forged in crises and will be the sum of the solutions adopted from these crises." Jean Monnet's remark in his Memoirs has often been invoked during the euro zone crisis by commentators and policymakers.

Now that the euro zone’s banking problems have been addressed by ruling out debt mutualisation through a common backstop, where does that leave Germany’s leadership, largely responsible for this outcome? And how stable is that leadership as a durable solution capable of withstanding further crises?

Even though crises have played a key role in the history of European integration, it would be wrong to conclude they necessarily dictate radical solutions; minimalist ones based on the available consensus have been more typical. That is allowed for in Monnet’s formulation – but at the cost of a perpetual struggle between sub-optimal outcomes and the consequent problems thrown up by such incomplete designs.

Zone's survival
As we move this year and next from banking to fiscal, macroeconomic and then political union imperatives for the survival of the euro zone system, this pattern is bound to be repeated.

Irish and other debtor states' expectations of writing off debt burdens in a banking union have been disappointed. The creditor states led by Germany have refused to fund such a "transfer union", demanding debts be paid, albeit over a prolonged period. A sound money ideology prioritises strict rules of budgetary balance and competitiveness over economic growth. In a low-trust regime, they refuse to fund debt write-offs based on promises to behave differently in future.

All this is within an ideological framing of the euro zone crisis as a product of national turpitude in debtor states and the dangers of moral hazard if behaviour does not change.

Potential prolonged deflation in the peripheral, indebted south is discounted, as are the depressing effects of such an outcome on the whole European economy, in which Germany’s strong exports would be deprived of buoyant markets.

Germany therefore lacks some of the key attributes of regional economic and political leadership, such as the willingness to supply counter-cyclical credit, fund debt write-downs, provide a market of last resort or co-ordinate macroeconomic policy. It is rather a geoeconomic and commercial power, increasingly aware of its own interests, but reluctant to provide the political and military security normally supplied by regional hegemons and heavily constrained too by its domestic politics for which such costs of leadership are unacceptable.

Traditionally the European Union has relied on the Franco-German pair to fulfil these roles. But the euro zone crisis broke the pattern of Franco-German compromise on their different political preferences that previously drove the response to crises and their ability to innovate.

Balance of power
A growing asymmetry between their economies and emerging interests in stability and growth tilts the balance decisively in the German direction. François Hollande has been unable to deliver the structural change in France that might correct that, or to forge alliances to the south with Italy and Spain that might force another approach. The UK's gradual withdrawal from deep engagement in the EU plays into this picture of a system unbalanced between its major powers.

The coming year will clarify how it finds a new equilibrium, through European Parliament elections, a new European Commission and further work on the agenda to deepen the euro zone.

It will also test the assumption by commission president José Manuel Barroso this week that the euro zone crisis is resolved, as against the highly significant statement on Thursday by European Central Bank chairman Mario Draghi that it is too early to say.

In these circumstances, smaller EU member states such as Ireland have little option but to adhere to the new, strict euro zone rules, endeavouring to align policy with northern creditor states. That is necessary to preserve maximum options coming out of the bailout without another formal credit guarantee.

Looming crisis?
Hopes of multilateral change on debt relief are not abandoned, but now ride on whether the minimalist banking union regime will be sufficient to ward off another crisis for the euro arising from popular protest, growing illegitimacy or economic stagnation.

If that does happen, Germany will have to choose between the currency’s survival, which would involve reopening debt mutualisation, and its sound money approach to macroeconomic management, the logic of which would point to German withdrawal from and therefore disintegration of the euro zone. Successive studies show withdrawal would be far too costly for any German government to contemplate.

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