Why Germany Must Ultimately Write the Check

The eurozone saga (it isn’t a crisis as the Greek word implies a short time-frame) could end happily today – and that has been the case since the whole sorry affair began. All that is necessary is for the European Central Bank to announce that is it willing to back all the debt issued in the eurozone. Just as the Fed does for US debt and the Bank of England for British debt. Printing euros will take care of the problem; the market will only win if the ECB runs out of paper and ink, or more accurately, electrons and silicon chips to store data on. But the German government declines to let it do so because the German electorate refuses to back that move. We are rapidly approaching the point where the government will be forced to do the right thing for Germany despite wishes of its people.

The whole debt matter is rife with arguments about justice and fairness and economic ideology. Free-marketeers believe that Greece should just default, reintroduce the drachma and live within its means. The average German in the strasse wants to know why he or she should work hard to the age of 67 just so the Mediterraneans can lounge around at unproductive jobs from which they retire at 50. The matter of “moral hazard” arises; that is, those who borrow should be forced to pay up or they will be encouraged to be irresponsible.

All of these arguments are interesting and make for fine dining table discussions, but the ugly truth is that Germany is going to have to write that check because it is in its long-term interests to do so. Anything that undermines the euro as it stands also undermines Germany’s economy. What is going on in Europe right now is the German political elite trying to find a way to sell their one and only option. Punishing its spendthrift neighbors may be morally gratifying, but it will also damage Germany.

The case against the unlimited purchases of bonds by the ECB is a simple monetarist one. If the ECB does that, the money supply surges, and that results in inflation. The folklore is that Germany’s hyperinflation was one of the causes of Hitler’s rise to power.

This argument has more than a few holes in it. First, an increase in the money supply is probably inflationary presuming a constant or rising velocity of money – velocity here meaning how frequently a single euro changes hands. That is a presumption one cannot make if the economy is slowing. Second, European officialdom has more or less admitted that recession is ahead; put another way, deflation is the big problem that Europe faces, not short-term inflation caused by seasonal effects and minor market dislocations. Third, inflation at 5% or even 10% is not going to bring about the Fourth Reich. As a matter of historical fact, Germany’s hyperinflation did not lead to the National Socialist victory in 1933. It had run its course by 1924, the year Hitler went to jail for the Beer Hall Putsch. And no German under the age of 90 was old enough at the time to have any memory of it.

Instead, the facts are that Germany loses out it if the eurozone loses a single member, enough to hurt. Stephane Deo, Paul Donovan and Larry Hatheway of UBS recently sent out a research note that suggested if a weaker country like Greece left, it “would incur a cost of around EUR9,500 to EUR11,500 per person in the exiting country during the first year. That cost would then probably amount to EUR3,000 to EUR4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.” However, there would also be a ripple effect that hit the stronger countries including Germany.

Germany is currently the largest exporter in Europe and is second behind China globally. The reason is that its markets in Portugal, Italy, Ireland, Greece and Spain (the unflatteringly labeled PIIGS) along with France, Benelux, and others use a common currency. This means that the competition is direct, and Germany has most of the advantages due to its location, infrastructure, work ethic and so on.

If one or more of the PIIGS left the monetary union, its new currency would plummet in value relative to the euro. German goods would become prohibitively expensive in those countries. That means, Germany companies, shareholders and workers who export are worse off. Imports from the departing economy would flood the eurozone undermining the euro-based economies further (remember the EU is not the same thing as the eurozone; tariffs and the like would remain off the table, and no member can be forced out without its consent because that’s the way the treaties are written).

If Germany were to throw up its hands and reintroduce the Deutschmark, the same thing happens. The UBS analysts wrote, ““If Germany were to leave [the euro], we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR1,000 per person, in a single hit.” By way of comparison, the American GDP fell 26.5% between 1929 and 1933 – roughly at one fourth the pace.

Right and wrong, free-market vs. statism, these don’t really enter into it. Germany’s national interest is to keep the eurozone afloat. If that means lifting its veto on the ECB buying an unlimited amount of euro-debt, that will happen to keep Germany’s place in the world intact.

Today is the anniversary of the World War I armistice. Twenty years after the War to End All Wars came to a halt, Europe was at war again. It is hard to believe that Europeans want to go back to that kind of world. Surely, that is worth a trillion or two among friends.