Published in Business Spectator (Melbourne), 5 July 2012

http://www.businessspectator.com.au/bs.nsf/Article/Time-to-rethink-German-risk–Germanys-slow-slide-i-pd20120704-VVB2J?OpenDocument

After last week’s decisive EU summit (the 20th of its kind), and after the German parliament’s support for the latest bailout plans, the euro is saved! Again. The usual sigh of relief was heard at bourses across the continent, and once more politicians congratulated themselves on their historic achievements.

A cynical interpretation of events would come to a different conclusion. German decision makers were effectively confronted with a choice between two evils. By blocking immediate help for Greece, Spain and Italy, they could have triggered a collapse of these countries. Without access to substantial bailout funds like the new European Stability Mechanism, governments of the struggling eurozone periphery would have been unable to finance their activities for much longer. This was the first choice – and no one was willing to risk this outcome.

So instead the Germans went for the second option: By committing themselves to potentially unlimited wealth transfers from their taxpayers to the European periphery, they may have averted an immediate catastrophe. But in doing so – and by simultaneously lifting the reform pressure off these countries – they also guaranteed that the euro crisis will now end not with the bankruptcy of Athens, Madrid or Rome. It will end with the fall of Berlin.

In the years prior to the crisis, spreads between the bonds of the healthier countries of Europe such as Germany and the less reassuring looking periphery such as Italy had narrowed to just a few basis points. The assumption behind this pricing was simple. Membership of the eurozone had made investments in Southern Europe more secure as their stability was effectively underwritten by the eurozone’s more prosperous core – i.e. Germany.

In the course of the GFC, markets became more risk aware almost overnight and also more risk averse soon afterwards. Suddenly they realised that eurozone membership was not equal to being exempt from the risk of default. The louder the Germans and their tabloid newspapers screamed and complained about their profligate southern neighbours, the more markets had to question their previous assumptions. Consequently, the spreads between German bunds and PIIGS bonds increased steadily.

More recent developments in the euro crisis should call this into question. What we have witnessed time and again is the German government drawing lines in the sand. No bailout for Greece! No European rescue package! No stability mechanism! No Spanish bailout without corresponding austerity commitments! No bond purchases by the European Central Bank! Nein! Nein! Nein!

In the event, the euro crisis has washed away every one of these German lines. Dragged kicking and screaming, Chancellor Angela Merkel and her government have always given in to demands for extended German engagement.

Ironically, hardly anyone has noticed. Not outside Germany where Frau Merkel is still regarded as a ‘Madame Non’; not in Germany either where she has thus far managed to portray herself as a lone fighter for Germany’s interests. In fact, her defence of the German purse is as effective as the German soccer team’s efforts against Italian striker Mario Balotelli. His two goals sent Germany home from the European Championships.

Given Merkel’s inability to protect her country from exponentially rising commitments to the rest of Europe, it is time to rethink the pricing of sovereign default risks. In order to sustain the now substantial spreads between Germany and the rest of Europe, there needs to be a good justification. But such a justification is nowhere in sight.

At an official debt to GDP ratio of more than 80 per cent, Germany cannot claim to be the model of fiscal prudence. Its long-term demographic challenges appear worse than those of the countries currently in crisis. And with its apparent inability to protect its interests – and its money – against claims from the eurozone periphery, Germany has burdened itself with commitments it will struggle to honour.

Not even the prospect of a German change of government after next year’s general election substantially alters the picture. On the contrary, it would only speed up Germany’s path to financial exhaustion. Where Merkel first says ‘no’ and then grudgingly commits her country to more eurozone exposure regardless, Germany’s opposition parties only differ in as much as they show greater enthusiasm in leading their country to ruin. The opposition Social Democrats openly toy with the idea of eurobonds, which Merkel has just categorically ruled out on principle.

If it is obvious that Germany has become the guarantor of all Europe’s public debts – and probably also most of Europe’s banking debt as well – then it is high time to return to capital markets’ pre-GFC assumptions about the safety of eurozone public debt. They should all be regarded as secure (or rather as insecure) as German bunds.

This could mean that the high yields on eurozone periphery debt are exaggerated and need to come down. However, it would be more appropriate that German yields go up. Once markets realise this, the days will be over when the German treasury could borrow for two years at negative interest rates. And the yields on 10 year German government debt should certainly be higher than the meagre 1.5 per cent mark around which they have been hovering recently.

To say it clearly: Although markets currently price Germany as one of the few remaining safe havens, it is actually one of the riskiest places out there. If Europe’s debt crisis cannot be solved, Germany will be in deep trouble.

Every time that a European rescue summit manages to bring down borrowing rates for countries like Spain and Italy, German yields should increase correspondingly. Otherwise markets are making a logical mistake. One cannot help a country without hurting the creditworthiness of the guarantor.

The recent bailout measures and the European Stability Mechanism all underline that in the euro crisis all members of the eurozone are now jointly liable for their debts. Once the last legal hurdles are cleared in the German Constitutional Court, there is no more escape route for Germany. The Germans will have to pay for bankrupt Spanish savings banks, Italian pensioners and Greek government officials.

Unfortunately, none of this will make the rest of Europe more German. All it will do is render Germany as bankrupt as the rest of Europe.