Angela Merkel's Bad Medicine

On July 26, as traders were once again deserting Spain's government bonds, setting up the risk of a default and a deeper crisis of the euro, Mario Draghi, president of the European Central Bank surprised and delighted financial markets. Speaking off the cuff in London, he vowed to do "whatever it takes" to save the European economy.

Eric Palma

The escalating crisis of speculative attacks on government bonds had spread from Greece to Portugal to Ireland to Spain and Italy, threatening to take down the euro and the European Union. It was a message that political leaders had been waiting for. The markets read Draghi's statement as an audacious declaration that he would begin massive bond purchases, ending the threat of a slide into European depression.

A week later, a chastened Draghi walked it all back. There would be no such purchases, he said, not until governments did their part by getting their budgets under control. Draghi made a rare disclosure of some of the infighting that led to his reversal. The president of Germany's Bundesbank, Jens Weidmann, a powerful member of Draghi's board, had strenuously objected. The policy of relentless austerity continued. The market for Spanish bonds crashed again.

The lesson: Don't cross Angela Merkel.

In the nearly three years since money markets began attacking Greek government bonds, the German chancellor has become the world's enforcer of a perverse economic dogma. In a pattern that has now been repeated at least five times, she insists that European aid to … fill in the blank-Greece, Portugal, Ireland, Spain, Italy-is out of the question. The crisis then worsens. When collapse is imminent, Merkel makes a tactical repositioning and partly relents. But as penance for fiscal sin, the offending country is harnessed to deeper austerity, which sets off the next round of speculation against government bonds. As the panic spreads to ever-larger European countries, the stakes only increase.

Technically, these austerity policies are not the work of Germany. In a rescue package, the European Commission, the European Central Bank, and the International Monetary Fund-collectively known as the Troika-sign a memorandum of understanding with the supplicant country. Aid is then doled out as the country delivers on the austerity program. But behind the Troika, insisting on the hardest possible line, is Germany, the largest single provider of funds. In every case, austerity has failed to increase the target country's competitiveness and growth.

Until now, Merkel's hard line had a certain logic as unenlightened self-interest. As money flees other nations for the safety of Frankfurt, the supply of capital floods the demand and Germany benefits from low interest rates. The euro, undervalued relative to the old Deutsche mark, also provides Germany an artificial export advantage, giving Berlin bragging rights about the joys of fiscal rectitude. Germany, which invented the word schadenfreude, profits handsomely from the rest of Europe's misfortune.

But the policy of pushing other European nations deeper into depression has begun to boomerang, because the rest of Europe is Germany's prime customer base. In July, Moody's, the credit-rating agency, shocked Berlin by adding German government bonds to the credit watch list for a possible downgrade.

Germany's ultra budget hawkery is partly an ingrained fear of inflation. Twice in the 20th century the assets of the German middle class were wiped out, first by the Weimar hyperinflation of 1923 and again in 1948 when a currency reform nullified almost all Nazi-era assets. But the reality is more complex. Germany has been thrust into an urgent European leadership role-for which the nation and Chancellor Merkel are ill-equipped.

When European leaders launched the common market barely a decade after Hitler, one purpose was to nest a recovering Germany within a larger democratic European whole. For nearly half a century after the war, this bargain suited Germany just fine. Germany, in the cliché of the era, was an economic giant and a geopolitical dwarf. It built an exemplary full-employment economy, with an effective welfare state. After two catastrophic wars of expansion, the Germans had finally found a formula for prosperity and peace. By being inward-looking and renouncing territorial aggression, Germany as Europe's strongest economy could exert quiet external power.

This balance worked well enough for both Germany and Europe until two events late in the 20th century tipped European hegemony in favor of Berlin-reunification in 1989–1990 and the launch of the euro (with the Deutsche mark's DNA) in 1999. An enlarged Germany was now also the custodian of all of Europe's currency.

But when the time came for an empowered Germany to move beyond its self-serving stance of the postwar era, the Germans found it hard to act in the broader European interest.

That imperative grows more urgent-and more elusive-by the day.

Merkel, who is 58 and the daughter of a Lutheran minister, was raised in Brandenburg, East Germany. By temperament, history, and politics, Merkel is perfectly suited to the role of fiscal scold. She has a doctorate in chemistry and went into politics in 1989 serving as a press liaison for the short-lived East German post-Communist government. On the eve of reunification, in 1990, she joined the Christian Democratic Union, the CDU, West Germany's governing party, which had almost no presence in the East. For then-Chancellor Helmut Kohl, Merkel was heaven-sent-an East German female with no prior political baggage and a Protestant from a Catholic region. He named her to the first post-unification cabinet as minister for women and youth. That did not prevent Merkel from publicly turning against Kohl in 1999 after he was defeated by Social Democrat Gerhard Schroeder; her old patron had outlived his usefulness.

Merkel became chancellor in 2005, displacing Schroe-der. Given the cost of reunification, which eventually came to 2 trillion euros, Schroeder had ignored the deficit and debt limits that had been imposed on all of Europe-by Germany-in the 1993 Maastricht Treaty on European Union as a condition of giving up the cherished Deutsche mark. Even Germany was blowing off the limits (deficits not to exceed 3 percent of gross domestic product and debts not to exceed 60 percent); so were France, Italy, et al.

Merkel resolved to be the anti-Schroeder. She proposed a balanced-budget amendment for the German Constitution, which was approved in 2009. This is rare in Europe; Merkel got the idea from Switzerland, the epitome of an inward-looking nation. She began promoting a "fiscal pact" to enforce the Maastricht limits. The pact was eventually adopted by most EU member nations. Such fiscal discipline makes sense in good times but not during an economic crash.

On September 27, 2009, Merkel's Christian Democratic Union trounced the badly factionalized Social Democratic Party, the SPD, which was reduced to its lowest level since before Hitler, just 22 percent of the popular vote. Merkel, having governed in an awkward grand coalition with the SPD during her first term, now turned to the free-market and anti-tax Free Democratic Party as her new junior partner, moving her program to the right.

A week later, on October 5, the Greek socialist party, PASOK, won the parliamentary elections. Within days of taking office, Prime Minister George Papandreou learned that the actual Greek deficit was more than 12 percent of GDP, double what the previous conservative government had claimed and quadruple the Maastricht limits. Hedge funds began betting against Greek bonds, and Greek borrowing costs skyrocketed. Papandreou appealed to the European Commission and the European Central Bank for help. But Merkel, Europe's de facto chief executive, was adamant: Greece had made this mess, and Greece would have to clean it up. As Greek borrowing costs rose to more than 15 percent and Greece fell deeper into depression, default loomed. Because Greece owed nearly 300 billion euros to the rest of Europe, much of it to banks, default would crash Europe's financial markets and the continent's economy.

Late on the evening of May 7, 2010, at the urging of the European Central Bank, Merkel reluctantly agreed to a rescue package for Greece. This included an 80 billion euro line of credit from EU member states led by Germany and a newly created stabilization fund with a lending capacity of 440 billion euros. The International Monetary Fund contributed to the package, which totaled 780 billion euros. The sum was thought large enough to reassure investors in Greek bonds and those of other peripheral nations where interest costs were ominously rising. The financial press treated it as a major policy shift.

For Merkel, the timing could not have been worse. Two days later, her CDU faced elections in Germany's largest state, North Rhine-Westphalia. The German press, which had generally lauded Merkel as an "iron chancellor" resisting bailouts, turned on her. The tabloid Bild Zeitung declared in a headline, "Once again, we are the fools of Europe." In the state election, Merkel's center-right coalition was repudiated, a loss that in turn cost the CDU its majority in the federal upper chamber.

In exchange for the rescue, Greece was made to sign an agreement cutting its deficit by 30 billion euros in a single fiscal year, or by 5.5 percentage points of the GDP. The comparable figure for the U.S. would be a staggering $825 billion budget cut in one year (nearly double the dreaded "fiscal cliff"), a policy that no sane economist left, right, or center would recommend. As part of the deal, three new tiers of value-added taxes were included, further depressing consumption. It was the most deflationary package ever imposed on a member of the EU, sending the Greek economy into free fall and making the deficit targets illusory. Markets noticed. By September 2010, interest rates on Greek bonds were back to their early May peak that had triggered the crisis and the initial aid package.

By doling out the aid in small amounts to maintain pressure on the Greeks to deliver the cuts, the commission kept Greece on the edge of default. That created a sense of permanent crisis and whetted the appetite of speculators against Greek bonds. A second aid-for-austerity package in late 2011 doubled down on the same medicine and kicked Greece deeper into depression. "Our mistake," one of Papandreou's top advisers told me, "was to think that the European conditions would give us leverage to proceed with difficult reforms. Instead, it all associated us with insane policies."

In November 2011, facing massive resistance against the latest austerity demands and splits in his own cabinet, Papandreou resigned. A month later, as the European crisis widened, Draghi advanced three-year loans totaling about a trillion euros to Europe's commercial banks, at just 1 percent interest. Had the European Central Bank made the same deal with Greece when the run on its bonds began two years earlier, the government could have refinanced its debt at low interest rates, and the crisis would have been contained at far lower cost. But to Germany, that course was unthinkable as it would reward profligacy.

Greece can perhaps be dismissed as a special case. It was risky to admit Greece to the Eurozone in the first place. In its corruption and incompetence, Greece resembles a Third World failed state. With only a few industries, even the most stringent wage cutting, commended by the Germans as a substitute for devaluation, is unlikely to increase its exports much. What's shocking, however, is that Merkel has applied the same recipe to other countries.

If Greece under PASOK was the bad boy of fiscal policy, regularly lambasted for missing its belt-tightening targets, Portugal with a conservative government was the poster child. "We did everything they asked of us, and we even went beyond their demands," Elisa Ferreira, a former cabinet minister and now a senior member of the European Parliament, told me.

In exchange for emergency aid, Portugal privatized government assets, raised taxes, cut spending, slashed pensions. Its reduction of the public deficit for 2012 exceeded the targets. The Troika showered Portugal with praise. But austerity hasn't worked any better as a recovery strategy in well-governed Portugal than in chaotic Greece. Unemployment has risen to 15 percent. The Portuguese economy will shrink by 3.3 percent this year, one of the worst downward spirals in Europe. Reduced wages and idled workers, not surprisingly, reduce revenue collections. The debt ratio is still rising. Portugal still cannot access money markets to roll over its bonds.

In early 2012, bond traders turned against neighboring Spain, where the banks were reeling from a collapsed housing bubble. The new prime minister, conservative Mariano Rajoy, resisted delegating Spanish sovereignty to the Troika. As the financial markets battered Spain's government bonds, repeating the Greek pattern, Rajoy played a nervy game of chicken. He refused to ask the EU for help on terms anything like those inflicted on Greece or Portugal.

After marathon negotiations-with Germany playing a central role-the Spanish economics minister, Luis de Guindos, jubilantly announced on June 9 that the stability fund would advance the Spanish state a credit line of up to 100 billion euros to be used to support the banks, with no austerity required in return. Rajoy proclaimed victory, and interest rates on Spanish bonds eased, but it was another false dawn.

It soon became obvious that by lending Spain money to pass along to its banks, European leaders were repeating the same self-defeating recipe imposed on Greece and Portugal. The Spanish state would be that much deeper in debt, calling its own solvency into question. The rating agencies downgraded Spanish government bonds, and Moody's cut the ratings on 28 leading Spanish banks, noting that the country's worsening economic picture would harm both the banks and the capacity of the state to support them.

The latest deal was intended to reassure markets, but it did exactly the opposite. Interest rates rose to record levels. Speculation spilled over onto Italy. By late July, Spain was paying nearly 7 percent to sell two-year bonds, and Italy only slightly less. Once again, Merkel's medicine had proved toxic. She had given ground on the headline story but prevailed on the details. By refusing to permit direct lending to Spanish banks, Merkel managed to turn an ostensible concession-aid to Spain without explicit austerity-into a deepening of the crisis. It was a repeat of her failed Greece policy.

Last December, Helmut Schmidt, who served as chancellor from 1974 to 1982 and is still spry and witty at age 93, delivered a keynote speech to the SPD annual convention. He used words that any active German politician would find difficult to utter. Schmidt recalled that a friend had asked him when Germany would be a "normal" country: "I answered by saying that Germany would not be a 'normal' country in the foreseeable future. Standing in the path to normality is the enormous and unique burden of our history. … In almost all our neighboring countries there is a latent distrust of Germans that will probably persist for many generations to come."

Berlin's role in Europe's self-inflicted path to depression reflects multiple factors. Among Germans, widespread contempt for Greece cuts across ideological lines. The SPD is led by men almost as fiscally conservative as Merkel. Its deputies in the Bundestag voted for both the stability pact and the balanced-budget amendment to the constitution. Although Merkel plays the austerity role with particular relish, another chancellor would not be so different. Merkel, who faces re-election no later than September 2013, is declining in the opinion polls-but because Germans fear she is too soft, not too tough, on the rest of Europe. The fact that if Europe collapses, Germany collapses too, seems lost on most voters.

"Populism" is usually considered a disease of the far right or the far left, but Merkel stands for a kind of fiscal populism of the center. The more Merkel panders to public opinion on the subject of not rewarding the dissolute Mediterranean members of the EU, the more she reinforces the same public opinion and is captive to it. (If this sounds vaguely familiar, you may be thinking of the budget-discipline minuet of Erskine Bowles, Alan Simpson, Pete Peterson, The Washington Post editorial page, and Barack Obama.)

A second factor in the paralysis of Europe is the continuing indulgence of private finance. The free rein for speculation against the sovereign debt of EU member nations functions as Merkel's enforcer: Tighten your belts or the bond market will get you (and then, whoops, the bond market reacts against the belt-tightening). As Helmut Schmidt put it, "Thousands of financial traders in the USA and Europe, plus a number of rating agencies, have succeeded in turning the politically responsible governments in Europe into hostages." If the European Central Bank massively purchased government bonds, as Draghi briefly proposed-taking the other side of hedge-fund bets-the wise guys would lose their lunch and the crisis would quiet down. But the interplay of budgetary austerity and license for speculation, as enforced by Merkel, will not allow this.

A third element is the stunning dysfunction of the EU's mechanisms of governance. Under the noses of European voters, a huge amount of sovereignty has been transferred to the bureaucrats of Brussels and the central-bankers of Frankfurt. All of Europe, under the fiscal pact, now gets a report card on how well it is complying with the terms; nations that fall short are punished. In highly neoliberal ideology of the sort that the International Monetary Fund has moved away from over the past 20 years, nations are advised to cut their wages and weaken their safety nets to increase their competitiveness and reassure money markets. When their economies worsen, they are faulted for not cutting deeply enough. After the Socialist François Hollande was elected president of France last May, one of the first bouquets he received was a detailed memo from Brussels warning him to cut France's deficit or face binding sanctions. The bond market promptly attacked French bonds, and Hollande meekly agreed to the terms.

Yet while the EU's governing machinery is strong enough to countermand national leaders, it is too weak to address a deepening crisis. Under the Maastricht rules, key policy changes require unanimity. In the absence of a consensus on behalf of growth policies, the default position of the EU is for more austerity.

The European Central Bank, the one semiautonomous pan-European institution, lacks the emergency powers of the Federal Reserve and is hamstrung by the "no bailouts" clause of the Maastricht Treaty.

Merkel speaks grandly about turning the EU into a deeper "fiscal union." But the EU budget amounts to 1 percent of European GDP, and there are only trivial mechanisms of income transfer from richer regions to poorer ones. That will not change anytime soon. What Merkel means by fiscal union is German-style fiscal constraints.

Much of the press coverage of Europe's deepening crisis has been couched in terms of whether the euro will survive and whether it was all a grand mistake. By definition, the same monetary policy and exchange rate that is right for Germany can't be right for Greece, but its use of the euro precludes the usual remedy for weaker economies of devaluation. This is all true to a point, but the emphasis on the euro focuses on the wrong question.

It is often forgotten that in the fall of 2009, Europe was on the road to a slow recovery, and the euro was doing just fine, worth about 1.4 dollars. The London summit of that April had committed $5 trillion to a stimulus program. It was only when money markets were allowed to have their way with government bonds, and neither the European Central Bank nor the financial regulators interfered, that Europe's crisis entered a more calamitous second phase.

The euro may survive, or it may not. But what Europe needs now to save its economy is an emergency program to take shared responsibility for old debt, recapitalize its wounded banks, use EU–financed public investments to make up for the deepening shortfall of business and consumer demand, and intervene in money markets to block speculators from wrecking the capacity of governments to borrow.

It is unlikely to get support for any of these policies from Angela Merkel.

Europe, much less Germany, is not a good place to play with the social dynamite of prolonged depression. The whole point of the EU was to contain the dark forces of ultranationalism, but they are being loosed again, from Norway to the Netherlands, by austerity policies imposed by Germany. In Greece, which suffered a particularly brutal German occupation during the war, the fastest-growing party is neo-Nazi. Europe fought two wars to prevent the yoke of German rule. Today, affluent, smug, and democratic Germany is Europe's dominant power. It is far from a dictatorship, but it is far from benign.

Epilogue

On September 6, Draghi tried once more. After more than a month of consultations with his own board and national leaders, he declared that the ECB would make unlimited purchases of short term government bonds, to keep borrowing costs low for struggling countries. He claimed "a massive majority of the [ECB] governing council for this concept." But the council member who mattered most, Bundesbank President Jens Weidmann, remained adamantly opposed. A Bundesbank press spokesman even issued a blunt statement warning that Weidmann "regards such [bond] purchases as being tantamount to financing governments by printing banknotes."

To mollify the hawks on his own governing board, Draghi repeated the conditions of his earlier failed effort: governments that wanted help from the ECB would have to sign up for rescue funds from the EU and strict supervision of austerity budgets by the European Commission and the IMF. Nothing doing, said the leaders of Spain and Italy. Despite a temporary stock market bounce in response to Draghi's offer or increased bond purchases, the larger impasse and deepening crisis continued.

Despite suggestions in the press that the ECB was at last moving to become more like the Federal Reserve, two difference remain key. Under Ben Bernanke, the Fed has been entirely willing to pursue policies "tantamount to printing banknotes"-exactly what's needed in a deep recession to lower interest rates. And Bernanke has refused to be an agent of fiscal austerity. While Draghi was brokering his latest deal, trading more bond purchases for more fiscal restraint, Bernanke was giving an opposite speech at the Federal Reserve's annual summer conference at Jackson Hole, Wyoming, warning against too much fiscal restraint as Congress threatened to raise taxes and cut spending in a deep recession-folly that Bernanke decried as a "fiscal cliff."