Over the last few days I have been visiting customers in Germany, France and Switzerland.
My task has been to assess the current European outlook particularly from the perspective of the Germans. My base case is that Angela Merkel has moved on from expecting the model of austerity and limited support to formulating a model that would allow the currency union to survive.
In its entirety that model would encompass a political, fiscal, and banking union. The reason why Merkel would be prepared to propose a framework for such a radical model is that she seems to now be convinced that such a model is the only format that will ensure long-term survival of the currency union.
In principle this model had guarded support from my German customers since it was seen by them as the only sustainable solution. Support for the currency union goes beyond economics. The currency union is seen as a national vision that is necessary to ensure that the political disasters that afflicted Europe in the 20th century can never be repeated. On another plane it is seen as the most efficient way of reforming the economic structures and practices of the periphery. Germany's responsibility to lead these reforms is keenly felt.
Germany's experience with reunification in the 1990s might be seen as a successful model for such reform although some customers pointed out that the costs of this action are still being experienced by Germany today sending a warning signal about the difficulties in managing a huge income transfer between regions.
My scepticism around this approach is that, unlike the reunification model, this strategy is expected to be achieved with limited cost to Germany. German politicians of both persuasions support the currency union and it is currently believed that any political group which opposed the principle of supporting the currency union would get little support. These positions reflect the preferences of the electorate. But the electorate would expect any new model to be structured around a very strict set of conditions. The fiscal pact that was proposed by Merkel and Nicolas Sarkozy is an example of this approach.
Conditions around a banking union where national governments are stripped of control of their banks with tax payers pooling risk with the burden of underwriting a bank being spread across Europe would represent challenges. Of course the German banks themselves are not without their difficulties, making the banking union a massive project for all of Europe.
Consider a fiscal union using the US model. The federal authorities would have specific taxing powers with associated expenditure responsibility for health, welfare, defence, some education, and interest payments. Under the political union there would be a layer of political power above national politicians with, presumably, a president elected by the whole of the union. While such a model would lead to considerable loss of power in the periphery, Germany would also have to accept a dilution of power with the real possibility that a non-German might occupy the Presidential palace.
It appeared to me that the Germans who are committed to the survival of the currency union may not be thinking through the implications of the model that would most likely be necessary to ensure that occurs.
To date Germany has done extremely well out of the euro. It has successfully driven its export led growth model with a highly competitive euro and competitiveness greatly enhanced by aggressive labour and product market reform. It is currently benefitting from near zero interest rate refinancing costs and capital inflows from the south. On the other hand it is already committed to around €1trn in guarantees that would be heavily written down in the event of the collapse of the currency union.
With the German economy prospering, public opinion towards the currency union is positive. However some recent developments around business confidence (for June the German business confidence index had its biggest fall since 1998) are signalling more troubled conditions may lie ahead.
One suspects that if a realistic assessment of the potential open-ended cost to Germany of a fiscal and banking union were explained to the German people who believe these arrangements can be sustained at a manageable cost with rigid rules, the cost of the vision would be seen to be too high.
Indeed I detected a chink in the armour of some discussants when they indicated that if other countries left the union first and history does not hold Germany responsible for the break up then that would be entirely acceptable. In that regard an attractive option for Germany might be that countries quietly leave the union when markets have found some stability and confidence.
Such a prospect is not remote. It is likely that the conditions that the German politicians would lay down for a fiscal/banking union would be unacceptable to other majors. Only Spain, which is now in dire financial straits with markets shunning their sovereign debt and domestic banks reluctant to take on further exposure to future potential losses (following a restructure of the sovereign debt), would be likely to accept the German conditions. Italy may also accept with, perhaps, limited ultimate adherence. The French are still to suffer the wrath of the markets with respect to their sovereign debt and would therefore be very reluctant to accept Germany's conditions, preferring an open-ended German commitment.
So from the German perspective we are left with a cruel dilemma. They could continue to pursue the noble vision by extending further open-ended risk (support for further LTRO/QE by the ECB) while saving face with conditions for a fiscal/banking union that are unlikely to be met. Alternatively they could abandon the vision of European Union and risk the wrath of history. Or encourage a compromise where other countries leave quietly and the union gradually dissolves without history harshly judging Germany for scuttling it. Another possibility would be to await the likely market contagion to French sovereign debt which might push France into accepting German conditions for a fiscal/banking/currency/ political union.
Only markets can determine whether contagion to France or a managed gradual dissolution are likely to provide Germany with an acceptable solution. More likely is a rapid appreciation in German public opinion of the open-ended costs of the full union.
To date no German political group is advocating leaving the currency union but politicians have a habit of adjusting policies to reflect public opinion. We may be surprised at how quickly this option becomes part of the German debate.
Bill Evans is Westpac’s chief economist