MERKEL CAVES IN TO SARKOZY / DER SPIEGEL ( VERY HIGHLY RECOMMENDED READING )

10/25/2010 04:03 PM

Merkel Caves in to Sarkozy

Germany's Allies Shocked by Euro Zone Backdown

By Peter Müller, Christian Reiermann and Christoph Schult

German Chancellor Angela Merkel has disappointed her allies in the fight for stricter stability rules for the euro. She gave in again to French demands, in exchange for concessions that may not be realized. Will her lack of a backbone weaken Europe's currency?


As a physicist, German Chancellor Angela Merkel likes to think in terms of rules, natural laws and the principles of classification. Anyone who violates these parameters reaps chaos and confusion.


Greece's narrowly averted bankruptcy has often served the chancellor as evidence of this wisdom. Years ago, the governments of the euro-zone member states watered down the stability pact and replaced systematic stringency in sanctioning budget transgressions with political arbitrariness. And what occurred as a result? The entire currency system began to totter.


In the wake of the euro crisis earlier this year, the chancellor decided that this should not -- and must not -- happen again. She urged the introduction of a strict monitoring and sanctioning mechanism that would leave very little wiggle room for discretionary decisions. "We favor the highest possible degree of automatism," she said as recently as late September in reaction to an European Commission reform plan, which proposed precisely this approach.


Yielding to French Pressure


But on Monday of last week, the chancellor threw her policies into reverse and yielded, once again, to pressure from French President Nicolas Sarkozy. The French have always had an entirely different vision of a common currency than the Germans. France has always tended to side with the southern Europeans who tend to see Germany's demands for strict stability criteria as a nuisance. Up until now, the Germans have headed the group of northern countries which favor a hard currency and severe penalties for everyone who doesn't respect the rules.


But all this seems to have been thrown out the window now that Merkel has agreed with Sarkozy that, in the future, European finance ministers -- and not the European Commission -- should continue to decide on sanctions for nations that break European Union rules regulating national budget deficits. This political wheeling and dealing lends credence to all the critics who doubt that Europe is capable of drawing the right conclusions from its currency's existential crisis.


Right from the beginning, the euro suffered from a severe birth defect: The euro-zone members did not commit themselves to a joint economic and financial policy. Indeed, the economies of the euro zone continued to drift apart and tensions increased.


Not The First Change of Course


In order to make the euro more crisis-proof, the shortcomings of its founding phase now have to be addressed. The euro-zone countries have to relinquish authority to Brussels, even if that infringes upon their national sovereignty. Furthermore, a mechanism is required to ensure that they abide by the rules.


This is the only way to win back trust in the European common currency. Currently, the euro is buoyed by the weak dollar, but that could quickly change if mistrust returns to the currency markets and investors once again target the euro and its weakest member states.


Then the euro zone would be back where it was this past spring -- on the verge of being torn apart.


This is not the first time that the German chancellor has displayed an elastic loyalty to principles when the European common currency experiences turbulence. Each time she changes course, she sows renewed doubt and confusion.


She initially spent weeks balking at the idea of aiding Greece. In the end, Germany wound up shouldering the largest share of the bailout.


As the euro crisis became increasingly dangerous, and additional countries ran into difficulties, she resisted a bailout package for the entire euro zone. In the end, though, Germany once again had to pay the largest contribution.


Now Merkel has once again caved in -- this time during her meeting with Sarkozy at the seaside resort of Deauville. Her latest U-turn certainly does nothing to instill confidence in the embattled euro. In fact, it doesn't bode well at all for the next meeting focusing on saving the monetary union.


An Italian Proposal


This Thursday, the European Council will meet in Brussels to discuss the work of the task force under European Council President Herman Van Rompuy. It remains to be seen whether the heads of state and government will further undermine the proposed changes or be able to agree on a genuine reform of the monetary union after all.


Last week, Italian Finance Minister Giulio Tremonti demonstrated what the governments of some countries are capable of doing, and thus showed to what extent the concerns of Europe's citizens -- especially the Germans -- are justified. In all seriousness, he called for citizens' debts to be taken into account when calculating the government debt of member states.


His reasoning: Italy, the country with the second highest government debt in Europe, would then enjoy a relatively respectable ranking within the EU -- and wouldn't have to worry about sanctions. But Tremonti, an expert in fiscal law, has made a logical error with his creative bookkeeping idea. Only borrowers themselves are responsible for private debts. They do not pose a risk to anyone else.


Shocked Allies at Home And Abroad


In light of such notions, supporters of a strong euro, both at home and abroad, were astonished and dismayed by the way the chancellor yielded on the issue.


In Germany, Merkel's coalition partner, the pro-business Free Democratic Party (FDP), was especially up in arms. FDP General Secretary Christian Lindner was perplexed; party leader Guido Westerwelle was taken aback. The FDP were just as unprepared for Merkel's about-face as her allies on a European level.


EU finance ministers had gathered on that same Monday in Luxembourg to prepare the European Council for this coming Thursday. The three northern states of Sweden, the Netherlands and Finland had steadfastly stood by Germany; now their leader was leaving them in the lurch. Swedish Finance Minister Anders Borg said he was "a little bit surprised that we did not have the full 100 percent backing for fiscal discipline from Germany."


Two options were on the table. The first entails the European Commission under President José Manuel Barroso automatically imposing sanctions when a state violates the stability criteria. Such a decision can only be overruled by a qualified majority on the Economic and Financial Affairs Council (ECOFIN), which is composed of the economic and finance ministers of the 27 member states. The second option does not call for such an automatic mechanism. In this scenario, ECOFIN has to explicitly approve the introduction of sanctions with a qualified majority.


Germany was represented in Luxembourg by Jörg Asmussen, a senior official in the German Finance Ministry who was standing in for the bed-ridden Finance Minister Wolfgang Schäuble. When it was Asmussen's turn to speak, he said that Germany has always favored strict and severe sanctions. "That's why we are voting for option II." A low murmur filled the room, say participants who attended the meeting.


Missing Teeth


The first to break the awkward silence that followed was Luxembourg Prime Minister Jean-Claude Juncker, who also chairs meetings of euro-zone finance ministers. "Jörg, considering how you started, you should have finished differently," he commented mockingly. Later, he jokingly quipped: "The Stability Pact may now have more teeth, but it's still not a complete set."


Others took the German reversal with less humor. European Central Bank President Jean-Claude Trichet was visibly furious. He dealt head-on with Asmussen and his French colleague Ramon Fernandez, who was representing French Finance Minister Christine Lagarde, after she had to quickly return to Paris.


"You don't understand the seriousness of the situation," the ECB head fulminated. Germany and France were endangering the continued existence of the monetary union, he said. The regulations still have to be made "much, much stricter" so the euro can return to a secure course, Trichet demanded.


The two government officials defended themselves by saying that they were only carrying out the objectives of their political leaders. This made Trichet positively livid. Contrary to the usual custom, he then switched from English to French and showered his compatriot Fernandez with verbal insults.


EU Economic and Monetary Affairs


Commissioner Olli Rehn also left the meeting feeling angry. The Finn, who had proposed stringent mechanisms for sanctions, remained obstinate. "The legislative process is solely based on the proposals of the Commission," he said. He is now setting his hopes on the many EU parliamentarians who condemned the pact of Deauville and Luxembourg. After all, the European Parliament is the "co-legislator," according to Rehn.


Meeting The French in The Middle


Even if Merkel and Sarkozy manage to bring the finance ministers into line, they will still have to convince the parliament to agree. Ever since the Lisbon Treaty, EU legislators have had co-determination rights for amendments to the Stability Pact. "All factions in the parliament endorse the automatic sanctions," says Alexander Graf Lambsdorff (FDP), a representative for Germany at the European Parliament. "If the Council comes with the deal from Deauville, it won't get anywhere in parliament," Lambsdorff predicts. From a purely legal standpoint, Merkel und Sarkozy's agreement is nothing more than a "contribution to the debate," he added.


What was announced in Luxembourg and celebrated in Deauville is something that Merkel and Schäuble already came up with two weeks ago. After several phone conversations, the two agreed that they would have to meet the French halfway on the issue of automatic sanctions. They were afraid that otherwise no joint solution whatsoever would be reached in Luxembourg. French President Sarkozy and his finance minister Lagarde were simply too intransigent in their positions.


Furthermore, Merkel and Schäuble had to recognize that they were hopelessly in the minority. Only Sweden, the Netherlands and Finland supported the German course.


Selfish Reasons for Merkel's Decision


There were also selfish reasons for the about-face. Over the past few weeks, the chancellor and her finance minister have been increasingly in doubt about the merits of a fully automatic penalty mechanism. Their thinking was that no one could guarantee that such a mechanism would not one day be used against the current model student and champion of stability: Germany.


Furthermore, experts in the Finance Ministry and the Chancellery reminded the politicians that a fully automatic mechanism would usurp the power of the German parliament, the Bundestag, which is not in the country's interest.


Many members of parliament have different views, however. In a bid to win them over, Asmussen spoke to the members of the Bundestag's financial and European committees shortly before he took off for the summit of G-20 finance ministers in South Korea.


The curtailments to the sanctioning mechanism were not so serious, Asmussen argued. Once the council of finance ministers has decided to impose sanctions on a country, the subsequent process proceeds "more or less automatically." In contrast to the current regulations, sanctions would be imposed earlier, would take effect more rapidly, and would be more incisive.


Backroom Bargaining And Horse Trading


So much for the official interpretation. Actually there is a fundamental difference between whether the Commission decides on the sanctions or whether this is done by the member states, where possible transgressors decide what to do with the transgressors. In the council of finance ministers, a delinquent could still use backroom bargaining and horse trading to avoid punishment, even though this would become more difficult than under existing law.


Indeed, there is a danger that political considerations could undermine the foundations of the monetary union and that spendthrift governments would revamp their finances at the cost of others. Dramatic consequences cannot be ruled out: Over the long term, aid payments made by countries that are still financially sound could end up ruining even their healthy public finances.


Rapidly spreading debts could prevent the ECB from raising interest rates to the required extent. This could conjure up the specter of inflation. Such a development would transform the euro into a soft currency, both in terms of its exchange rate and price stability. It doesn't have to work out this way, but it is a definite possibility.


French Concessions


In exchange for their concessions, Merkel and Schäuble give themselves credit for winning over the French as allies in two important German causes that are intended to avert this horror scenario. For instance, Sarkozy agreed that delinquent countries would lose their voting rights in the future. But an even greater victory for Berlin is that France has agreed to support Germany in creating a sustainable crisis mechanism for countries in financial trouble. The Germans have observed with concern that a large majority of member states would prefer to indefinitely extend the recently created bailout package for the euro, which is currently limited to three years.


Since Germany has the largest and most powerful economy in the EU, and the highest degree of creditworthiness, the government is afraid that it will end up having to foot the bill for helping all countries whose finances have been thrown out of balance. This would mark the final transition to a European "transfer union," in which poorer countries become semi-permanently dependent on massive subsidies -- a development that Germany wants to prevent.


For months now, Schäuble's team has been working on a crisis mechanism designed to prevent healthy states -- primarily Germany -- from having to assume responsibility for the financial obligations of foundering countries.


Instead, the governments of ailing countries would have the option of commencing a kind of orderly insolvency proceeding. During this process, a certain amount of debt restructuring would be possible, in which creditors would waive part of their claims. The idea here is that taxpayers would no longer bear the risk alone of a country going bankrupt, but would share this burden instead with private investors.


A Hope for Treaty Reforms Next Year


Introducing such an official bankruptcy policy for EU countries would require amendments to existing EU treaties, but that doesn't seem to daunt Merkel and her finance minister. Surprisingly enough, they are receiving support from one of their pro-business coalition partners: Economics Minister Rainer Brüderle (FDP), who represented Schäuble last weekend at the G-20 summit for finance ministers in South Korea.


Brüderle agrees that it would certainly be desirable to install a system of automatic sanctions. "But we also have to face the realities of the situation," says the economics minister. "If the French are prepared to accept a contractual mechanism for financially ailing countries, then that is a big step." The German government now has to see to it that such a step is also taken, he says.


Acording to the chancellor and her finance minister, a favorable opportunity for treaty reforms will present itself when Croatia joins the EU next year. Merkel and Schäuble think that the necessary modifications can be made in the wake of this process.


However, this is precisely where critics of Merkel's turnaround have their doubts: They don't believe that the planned treaty amendments can actually be pushed through. If not all of the 25 remaining member states approve the withdrawal of voting rights and the crisis mechanism, Sarkozy's concessions will be worthless. "Time will tell whether the Germans have exchanged a bird in the hand for two on the roof," says Otmar Issing, the former head economist of the ECB.


Some Support from Economists


Merkel is receiving support, though, from some economists who see automatic sanctions as relatively ineffective. "Experience has shown that automatic mechanisms are overturned, again and again, by arbitrary political acts," says Kai Konrad, an economics professor at the Max Planck Institute for Intellectual Property, Competition and Tax Law in Munich. As an example, he cites the past policy of issuing stern warnings to deficit delinquents according to a precisely determined procedure. In a number of cases, this mechanism was suspended following a political intervention.


Far more important than the issue of an automatic mechanism is whether "the rules are credible and actually applied," says Konrad. According to the economist, a control mechanism only ultimately gains credibility if a country's insolvency can go through, including debt refinancing. Then the market assumes part of the job of administering the punishment, because bankruptcy candidates have to pay higher interest rates.


Clemens Fuest, a public finance expert at Oxford University, also sees insolvency regulations for countries as much more important than sanctions: "There is no point in threatening to impose financial sanctions on a country that is already drowning in debt."


Translated from the German by Paul Cohen