WASHINGTON — If the euro fails, the blame will not be on Greece, but on Germany. Europe’s economic powerhouse is now seen as the only force that can prevent a continental meltdown that would result in defaults, disintegration, and decline. As the Bundestag, Germany’s parliament, prepares for Thursday’s crucial vote on more guarantees for the expanded European Financial Stability Facility (EFSF), concern is mounting: is Germany ready to provide bold leadership? The question is not simply whether the Germans will cut another check to save Europe. A fundamental transatlantic and transcontinental divide about prudent economics informs and infests the debate about crisis resolution. And it threatens to create a standoff during this most dangerous of moments.
Most German economists doubt the proposed strategy first outlined by former U.S. Treasury Secretary Hank Paulson: “If you have a bazooka in your pocket and people know it, you probably won’t have to use it.” He referred to a weapon potent enough to force financial markets into submission. All subsequent bailout packages and guarantee programs followed that bazooka logic. But nearly every time, the loan and guarantee amounts needed to be revised upward as market pressures continued. This week is no different. While the Bundestag is being asked to increase German liability in a euro bailout to €211 billion (up from €123 billion), the debate in financial markets is whether the rescue fund’s capacity of €440 billion is sufficient. Many American economists suggest it should be doubled, tripled, or — through leveraging — quintupled. German parlamentarians chafe at the suggestion. Hadn’t they been told this was the last and final rescue package on which they would have to vote? Wouldn’t limitless bailouts and guarantees endanger the savior rather than help the countries in need?
In the end, the debate boils down to philosophical alternatives; it’s Keynes vs. Hayek, contagion vs. moral hazard, expansion vs. austerity. The German side bases its conviction on a domestically dominant school of thought called ordoliberalism, developed at the University of Freiburg by Walter Eucken and, to some degree, by Friedrich Hayek. The theory holds that the state must establish a proper legal environment for the economy. It creates order by setting rules on how market forces ought to work — and then sticks to them. Therefore, discretionary government interference in the market should be limited. The central bank’s mission should be confined to fighting inflation, thus avoiding the politicization of the institution.
On German insistence, the framework for the European Monetary Union was modeled on these principles. Each member state would comply with a set of rules, especially on debt and deficits. If the rules were broken, it meant that there were not enough rules. And they needed to be armed with punitive sanctions against violators. Moral hazard should be avoided at all cost. A debt crisis, in the German mind, is therefore best addressed by rooting out the underlying problem. A debt crisis is certainly not resolved by piling on more debt. Instead, a state should engage in structural reforms, reducing the deficit by spending cuts and tax increases. In short: austerity.
An orthodox ordoliberal would understandably think the devil has descended onto earth in the guise of Larry Summers, U.S. President Barack Obama’s former economic advisor. Consider his recipe for crisis resolution that continues to represent the mainstream thinking within the Obama administration: “It is the central irony of the financial crisis — caused by too much confidence, borrowing and lending, and spending — that it cannot be resolved without more confidence, more borrowing and lending, and more spending.” From this vantage point, the German response to the crisis has been tepid and government incrementalism futile.
Indeed, the central contradiction of the German crisis response is its insistence on the long-term at the expense of the short-term. In fact, some German recipes have made crisis resolution more difficult. Punitive interest rates for loans to Ireland, Portugal, and Greece may avoid moral hazard, but will increase rather than lower these countries’ debt burden.
This contradiction is best represented by Angela Merkel. The chancellor is anything but an ideologue. She has combined a moderate bailout strategy with German economic principles. Her incrementalism is more than just muddling through. Buying time for Greece has made sense, to a degree — it has allowed her to bring doubters around to support the previously unthinkable, it has allowed southern Europeans to lock in structural reforms, and it has allowed banks to sell off or partially write off southern European bonds. At the same time, the strategy has fallen short. Time was wasted by not sufficiently reforming the banking system and increasing its liquidity, not properly building firewalls to avoid contagion in the event of an eventual Greek default, and not aggressively focusing on growth.
Now Merkel is approaching the ultimate decision point. It’s bazooka or default. The problem with the bazooka is that it could destabilize the core of the six European triple-A-rated countries, thus becoming the ultimate path of contagion. The problem with default is that it currently ensures contagion. So far, Germany’s economic establishment has predictably responded by saying nein to the bond-buying program of the European Central bank, nein to Eurobonds, nein to a banking license for the EFSF, and nein to an insurance scheme to leverage the rescue pool. But a simple no is not a sufficient answer when Europe is hovering on the edge of the abyss. A German plan is needed, and now. This is the hour for leadership. History is calling, Madam Chancellor. Will you answer?
Thomas Kleine-Brockhoff is a Senior Transatlantic Fellow with the German Marshall Fund of the United States in Washington, DC.