Monday, November 15, 2010

Germany's euro dilemma

Germany entered the EU and then the euro for political reasons: peace with its neighbors, reunion with the GDR, and international respectability. It made clear, when it joined the euro, that it was not a fiscal union, and that it would not have to bailout other euro members.

As events on the periphery are playing out, Germany is clearly on the hook for bailout money via the EFSF mechanism. This is very unpopular in Germany.

Recently, Merkel forced the EU to agree that bondholders would have to take haircuts in the event of a rescue by the EU. This spooked the markets, which forced the EU to make a statement “clarifying” the policy, and emphasizing that the revised scheme would not take effect until 2013.

Despite the “clarification”, the markets remain spooked and peripheral government bond yields remain in deep junk territory. In other words, the EU is saying “these bonds are guaranteed” and the bond market is saying “no they’re not”. (I agree with the bond market.)

But getting back to Germany and its motives. It would be very difficult to hold the EU together if Germany left the eurozone. But what if the eurozone craters on its own?

The Germans are not stupid. They can see where events are headed: either Germany agrees to play sugar-daddy for the entire eurozone, or the eurozone breaks up. I wonder if this is what the Germans want. They would get their DM back without paying a political penalty.

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