How Germany Could Kill the Euro

By Gideon Rachman

Published: November 22 2010

“Tell me how this ends,” was the question posed by General David Petraeus about the Iraq war. European leaders are asking the same question as they contemplate the crisis in the eurozone.

Having failed to construct a firebreak in Greece, the Europeans are hoping that they can stop the euro crisis in Ireland. But, even as an Irish rescue package is put together, the bond markets are already looking with unhealthy interest at Portugal. After Portugal, Spain is assumed to be next. And, if a really big economy such as Spain needed to call the financial fire brigade, the whole future of the euro would be in serious peril.

The question of “how this ends” is therefore obvious and urgent – but also fiendishly difficult to answer. It is like watching a three-dimensional game of chess – in which the financial, economic and political levels all interact with each other.

My current best guess is that the single currency will indeed eventually break up – and that the euro’s executioner will be Germany, the most powerful country and economy inside the European Union.

The headline on one of the most-read stories in the Financial Times last week was “Anger at Germany boils over” – reporting accusations by some Europeans that the latest twist in the euro crisis had been triggered by inflexible German policies.

But Germans themselves have plenty of reasons to be cross about the way the single currency is developing. Their country has been through a painful decade of wage restraint and cuts in government services. Many voters are outraged that their tax-euros might be used to finance early retirement for Greeks, or Ireland’s super-low corporate tax.

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The German people were also promised that the euro would be as stable as the Deutschmark – and that there would be a “no bail-out clause” that would prevent the richer countries in Europe having to save the indigent. Both promises look perilously close to being violated. That, in turn, is triggering growing concern that Germany’s constitutional court could declare their government’s participation in European “bail-outs” illegal.

The German government’s fear of its own constitutional court has already been a crucial driver of the crisis. This year, the Germans were accused of acting far too slowly to organise a rescue for Greece. But official sloth was driven by a fear that speedy action would be deemed to violate the European treaties.

The immediate crisis in Ireland was triggered about a month ago when Angela Merkel suggested that, in future euro crises, private bondholders should bear more of the losses and that further European treaty changes were needed. This remark was also made under pressure from the courts.

Germany’s actions have, in turn, created political and legal pressures in bail-out nations. In Greece, we have seen deadly riots in Athens and a senior government minister evoking the Nazi occupation of the 1940s. In Ireland, there is much lamentation about the threat to national sovereignty. on Monday, the government itself was wobbling.

It is possible that the rise of nationalist and anti-capitalist parties such as Ireland’s Sinn Féin will cause recipient countries to stick two fingers up to the EU – and to see whether life might be better outside the single currency. Countries such as Greece and Portugal might be a lot more competitive if they could devalue their currencies. But quitting the euro might feel like a national humiliation for members of the southern periphery. There is also no mechanism for quitting the euro in an orderly fashion. Any obvious preparations to do so might trigger a bank run.

So if the euro is to break up, the country that sues for divorce is likely to be a strong economy – with Germany as the likeliest litigant. The Germans would not take this step quickly or lightly. A commitment to European integration has been a leitmotif of German foreign policy for half a century.

But if the Germans became convinced that their eurozone partners were simply impossible to deal with – and that therefore the whole single currency experiment could not work – they might decide to quit. There are two ways I could imagine this happening.

The first is a successive wave of financial crises across the eurozone, affecting larger countries, which gradually sap German taxpayer confidence that the “loans” that the EU is extending to its weaker members will ever be repaid. The second is if, as seems quite likely, the treaty changes that the German government is demanding to satisfy its courts fail to be ratified by some of the other 26 EU members. At that point, the Germans might throw up their hands and say, in effect, “Well, we tried our best, but the other Europeans won’t do what is necessary to save themselves.” Germany might then feel released from its historic obligation to “build Europe”.

I realise that, in setting out these scenarios, I am laying supposition upon supposition. It only takes one point in the chain of argument to be wrong and events could charge off in another direction. All I would point out is that the optimists who put together the euro – and still argue that the currency will surmount its current problems – also made a lot of suppositions. And theirs don’t seem to be working out too well.

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Are you ready for the next bubble in Asia?

Asian central bankers see a ghost from the past in the U.S. Federal Reserve’s plan to pump $600 billion into the banking system. To them it's like the rolling mid-1990s again, except that they know how this party is going to end.

Here's the scenario: This tsunami of cheap dollars would flood Asia's stock, property, commodities and other asset markets, pushing up prices, then forming bubbles that would eventually burst and result in another ruinous recession like the 1997 Asian financial crisis.

Even scarier now than 13 years ago is that options to manage this cash onslaught have come down to a hard dilemma for central bankers in Asia: If they raise interest rates to absorb excess capital, which would almost definitely be higher than the rates in the U.S. and Europe, it would only attract more of that cheap money. If they leave the markets alone, the risk of a severe shock multiplies. Hot money comes in fast, and flees just as easily.

Compounding the situation is that these economies have only just come off their own stimulus in 2008-2009. So the Fed's move is like a double stimulus for them, piling on top of the money still sloshing around.

“The launch of QE2 [this second round of quantitative easing] will definitely add pressure to the asset markets in the emerging market economies such as Hong Kong’s. As far as Hong Kong is concerned, we will take measures that are specific to the housing market,” said Norman Chan, chief executive of the Hong Kong Monetary Authority, the city’s de facto central bank.

Property prices in Hong Kong have risen to their highest since 1997, the peak of the last bubble. The Hang Seng index this week reached a two-year high in anticipation of the Fed's loose money. With a highly liquid market and no capital controls (unlike mainland China), Hong Kong is a natural proxy for investors seeking a China exposure. In the first 10 months of the year, HK$345.9 billion ($44.6 billion) was raised in Hong Kong from initial public offerings. That shows just how much money has been circulating. Hong Kong hardly needs more.

Property speculation is a major concern too in China, Malaysia and Singapore — all three already curbing mortgages. In South Korea, stocks reached their highest level in nearly three years this week. Bailed out by the International Monetary Fund in 1997 — South Korea came out with a combative tone against effect of the stimulus, signaling it will “actively” seek measures to control the flow of capital, which could include taxing foreign investments in government bonds. Thailand — another poster country of the 1997 crisis — already did that last month.

Surely, Asian authorities want to see the U.S. economy pick up – after all they sell a lot of their exports to America? However, the Fed’s intervention, although anticipated, still conjures U.S. unilateralism, an attempt by America to save itself regardless of how it would affect others.

“The main issue here is that the United States conducts monetary policy that has consequences not only on the United States. The U.S. dollar, for better or for worse, is the only serious international reserve currency,” said Uwe Parpart, chief Asia economist and strategist of Cantor Fitzgerald in Hong Kong.

The Fed’s stimulus was a de facto weakening of the dollar. Conversely, it means the Fed has just engineered for the value of Asian currencies to go up.

So how is that different from the Bank of Japan intervening in the foreign exchange market to weaken the yen? Or from China managing its exchange rate?

Whatever happened to global coordination of policies to prevent a currency war? Did the Fed just precipitate that? Only a few weeks ago, Treasury Secretary Tim Geithner said there was “no risk” of a currency war.

This only gives Beijing ammunition to counter the expected clamor at the G20 next week for the yuan’s appreciation and it allows central banks in Asia to justify future foreign exchange interventions.

Already, the currencies of big exporting economies such as Japan, South Korea and Thailand have risen to multi-year highs. This makes their products more expensive abroad and they are unsurprisingly, not happy with that (although a strong currency also makes imported components cheaper.) More foreign capital flows further raise the values of their currencies as foreign investors buy local currencies.

The Japanese yen hovers around a 15-year high against the dollar despite a massive purchase of dollars by the Japanese central bank in September to weaken the yen.

There are indications that Asian central banks may take concerted actions to control the flow of capital into their economies. Capital controls work well when done together, but a robust common policy may be hard to come by because some Asian economy stand differently today, than say, in 2008, when all agreed on stimulus measures.

Japan, for instance, has mirrored the sluggish economic recovery of the United States and may even implement its own quantitative easing (expected Friday).

China, too, attracts foreign capital, perhaps more than others, because of its expected 10-percent growth rate this year. But because the yuan is heavily managed by the central bank and because of existing capital controls and foreign investment restrictions, it has some built-in safeguard against capital inflows.

All told, Asian monetary authorities are probably reaching for their antacids now. Yes, they want the U.S. economy to grow to stabilize the global economy. But they don’t want the imported inflation and the instability risks. They didn’t survive two severe financial crises in less than 15 years to be sitting ducks for another one.

The question now is, how far would Asian leaders assert themselves at the G20 talks in Seoul next week (Nov. 11-12) against the United States and the weak dollar?