Economic Insights

Economic Insights: A European Vacation from Austerity?

Mon, 20 May 2013 00:00 EDT

Europe of late seems to have developed doubts about the desirability of fiscal austerity. Up until recently, a tenuous consensus had formed around the need for budget restraint and deficit reduction. But now, some look to moderate the severity of the program while others would reverse policy altogether. This new turn does, though, have virtues. It would, after all, lift the threat of a vicious downward economic cycle in which austerity depresses economic activity that causes worse deficits that only invite more austerity. But at the same time, the shift in fiscal emphasis carries its own ills. For one, it threatens to bring the Continent back to its old profligate ways. Even worse, this new turn from austerity seems to have distracted policy makers from their former embrace of structural reforms and the promise they have to ease the Continent’s fundamental fiscal-financial woes.

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The austerity consensus, of course, never had complete support. French president Francois Hollande, after all, ran for office last year on a platform of fiscal relaxation. Because the preference for austerity was still dominant at the time, he glossed over specifics enough to allow voters to see him simultaneously as both for and against austerity. But the signs were there. The first major cracks in the austerity consensus emerged in Italy's February election. The electorate there, enraged by the economy's decline, returned an inconclusive vote that clearly threatened the fiscal and regulatory reforms set in motion by the outgoing prime minister, Mario Monti. For a while, Italy could not even form a government. When recently it did, the new prime minister, Enrico Letta, was clearly constrained. Though his Democratic Party had endorsed the previous fiscal program, he could hold power only by making concessions to the contrary positions of his powerful opposition.¹

Since then, policy fissures have grown even wider. Hollande has seized on the changing environment to climb off the fence he had made for himself. He has reneged on his former promise to bring down the budget deficit to 3.0% of the nation's gross domestic product (GDP) this year, and instead now talks of a target closer to 4.5%. Spanish prime minister Mariano Rajoy, having endorsed rigid austerity for the entire 16 months since his election, recently outlined new policies that would allow less pressing deficit targets. Portugal has actually decided on a policy of fiscal stimulus, including corporate tax cuts. It has promised to bring its budget deficit, presently at 6.4% of GDP, down to the promised 3% by 2015, but many question the prospect given the government's new policy posture. Prime Minister Letta, even though he recently announced in Berlin that he would continue ongoing budget rigor, had already softened policy, proposing, almost on taking office, to cut taxes on sales and property and widen Italy's welfare net, including jobless benefits.²

European Commission president José Manuel Barroso joined the chorus, bluntly telling the media that austerity had "reached its limits," having lost the public support it needed to work. He, too, now wants more latitude for countries to run deficits wider than 3% of GDP.³ Even the International Monetary Fund (IMF) has changed. Having long promoted strict budget discipline, the IMF's managing director, Christine Lagard, in just the last month or so, has begun questioning the value of such a harsh policy. Also acknowledging the change is European Commission economic chief Olli Rehn. He has embraced a "smoother pace to fiscal consolidation," telling the United States and others who argue against austerity: "Can I tell you a secret? We have already slowed down fiscal consolidation." Of course, Greece and Cyprus, desperate for aid from the rest of the eurozone and the IMF and bound by past agreements, continue austerity measures, but the cracks in the former consensus are apparent.⁴

On the positive side, this new tone does relieve some of the downside risk implicit in strict austerity. Because severe budget restraint slows and often halts economic activity, it also stems the flow of tax revenues while it increases demands for government services, such as unemployment relief and welfare. If severe enough, the net effect can enlarge budget deficits, even as governments increase taxes and trim government spending. But since a single-minded austerity approach only then demands more restraint, it can set an economy into a vicious cycle of decline in which austerity creates recession that only evokes more austerity. Part of the recent policy change no doubt reflects fears that just such a cycle is developing. After all, business activity has fallen steeply across Europe, and especially in those countries that have pursued the most aggressive austerity programs. Unemployment has risen to 26.7% of the work force in Spain, for instance, 25.7% in France, 17.5% in Portugal, 27% in Greece, and 12.1% for the eurozone as a whole.⁵

But if the policy rethink helps alleviate such risks, it carries problems of its own. One is obvious: Europe really does need budgetary reform. The profligate fiscal policies of the past were clearly unsustainable. A realization of that fact brought on this crisis in the first place, when lenders refused to advance more credit to the Continent's periphery. Approaching fiscal sanity along a gentler, less demanding path might seem reasonable in the face of Europe's present intense economic pain, but the best these nations practically can do is reduce the intensity of restraint. Were they to go any further to, say, something openly stimulative, they might relieve the symptoms of economic illness for a time, but the relief would run its course very quickly. Soon, the renewed profligacy would prompt lenders again to withhold credit, shutting down these economies even more severely than would a regime of austerity.

The policy turn carries political risks as well. Germany has an election in September 2012. Many Germans still resist their country's prominent role in the financial rescues. Chancellor Angela Merkel has until now placated these elements by insisting on budget austerity as a quid pro quo for the aid. But the fiscal softening in France, Italy, and elsewhere will likely fortify this internal opposition to Merkel's approach. Germans will ask, not without justice, why German taxpayers should bear such burdens when Italians, Spaniards, and others who benefit from the funds refuse to cooperate fully. The fear of throwing good money after bad might have an answer in a gentler path to budgetary reform, but such fine points could easily get lost in the cut and thrust of the election campaign, especially since polls show German citizens very concerned about the use of their taxes. Those same polls do, though, also show little support for a German departure from the eurozone—and the polls reveal that Merkel is still popular enough to retain her office.⁶ But if the opposition can gain enough ground to limit her ability to help Europe, credit markets will almost surely become less responsive to eurozone reassurances about its weaker members.

The biggest problem with this changing tone, however, is that it seems to have distracted policymakers from the important structural reforms on which they had embarked. These started in Italy under Monti. He understood the downside risks of a single-minded focus on austerity, however necessary budget reform was. Impressed by the success of German labor market and regulatory reforms under former chancellor Gerhard Schröder, Monti pushed a similar agenda in Italy as a growth antidote to the depressing effects of austerity. He also saw structural reform as a way to improve the economy's underlying growth potential and so offer a fundamental answer to the country's fiscal-financial dilemma. He made remarkable strides easing Italy's rigid labor regulations, allowing firms more flexibility on hiring, firing, and setting work rules. He was looking to produce regulatory reform as well as additional labor market reforms when he exited office. Seeing his reasoning and his progress, Spain, Greece, Portugal, and others in Europe's troubled periphery also began to make similar changes. But in this latest discussion of easing the severity of budget restraint, such structural reform efforts seem to have taken a back seat.⁷

To be sure, European leaders still pay lip service to such fundamental changes. Prime Minister Rajoy alluded to "new structural reforms" when he announced less stringent deficit targets. But, disappointingly, his comments lacked specifics. President Hollande has overseen efforts to allow employers more flexibility in hiring, firing, and work rules, and has spoken of renewed entrepreneurial effort. But his solutions have lacked breadth and, in fact, are a very limited, controlling, and highly selective series of tax breaks. More troubling, he has said little about any such reform since he announced his eased deficit targets. The only strong French voice for structural change is that of Christian Noyer, governor of the Bank of France, and he, notably, is outside the government. Perhaps this neglect is simply a matter of timing, that structural reform will wait until Europe's leaders can sort out how much general fiscal restraint is optimal. Perhaps Berlin, which realizes how much of Germany's own economic success grew from its past structural reforms, will insist going forward that Europe's periphery continue along a similar path. But for now, the relative silence on such matters from Italy, Spain, and others raises questions about Europe's ability to promote lasting growth and, thus, a fundamental solution to its fiscal-financial failings.⁸

Economic Insights: Consumers: The Great Sobriety

Mon, 13 May 2013 00:00 EDT

It looks as though American households have reached a kind of financial inflection point. The great de-leveraging that they began in the aftermath of 2008–09 financial crisis seems to have run its course and stabilized. Consumers, fortunately, have not returned to their old habit of heavy spending and borrowing. They remain cautious, but seem to have settled on a moderate path, sustaining reasonable savings flows by keeping their spending more or less in line with income growth. Such a pattern going forward should allow still modest improvements in their finances, generating spending growth sufficient to propel the overall economic recovery, sluggish as it will likely remain, and stand as proof against another recessionary dip.

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In many respects, the de-leveraging that has been occurring in the household sector since 2008 stands as a truly remarkable economic event, especially given the American consumer's well-entrenched, spendthrift habits. Prior to the crisis, households hardly saved at all. In late 2007, for example, they set aside a mere 2.1% of their disposable income,¹ significantly weakening their overall finances. But as the crisis hit, consumers changed dramatically. Even as the economic decline from mid-2008 to late 2009 reduced incomes 5.6%, households began to repair their finances. They cut back on spending so substantially that savings rates soared, at times to more than 6% of disposable income and averaged more than 5% into 2011—a rate not seen on a sustainable basis for decades. Considering that many people had lost their jobs and, by necessity, were dipping into their savings, the jump in overall savings rates underscored the extent of the unfolding behavioral change.

The shift in behavior yielded dramatic improvements in household finances. Between 2008 and 2011, their debt burden fell by more than 6%, or almost $850 billion.² Much of this decline, of course, was due to foreclosures, for the debt disappears when the bank seizes the property. But it was not all owing to foreclosures. Consumer credit fell as well during much of this time, including credit card, auto, and home improvement debt. The debt retirement (plus the improvement in financial markets after 2009) produced a remarkable recovery in household net worth, even as the economic recovery proceeded at what can only be described as an anemic rate. From lows in 2008, net worth expanded more than 23% to the end of 2012 (the last available measure). Net worth, now, is almost back to the all-time highs of 2007; it stands at an impressive 5.6 times disposable income—quite an improvement over the low of 4.9 times in 2008, but, admittedly, still well below the all-time high of 6.6 times registered in 2005.

In 2012, however, another change began to take shape. Households apparently have decided to slow their financial rebuilding. Thankfully, they are not returning to their spendthrift ways of 2005, 2006, and 2007. Such a move—though it would create a surge in consumer spending and, consequently, in the economy—would hurt household finances and, consequently, would lose momentum quickly. The resulting need to rebuild balance sheets would then cut into spending and likely prompt another bout of recession. It might seem on the surface that people have returned to their old, unsustainable ways. After all, savings rates early this year fell toward a mere 2.5% of disposable income. But this dip is likely only temporary, a reaction to the savings surge to over a 6% rate that accompanied an equally temporary income surge late in 2012. In this context, this latest drop in savings rates looks like an effort to even the savings rates out to the 3.5% on which households had settled earlier in 2012.³

To sustain their savings rate, households should expand their spending going forward about in tandem with their income growth. Still, their balance sheets should continue to improve. Savings at 3.5% of disposable income would still go toward debt reduction and asset acquisition, just at a slower pace than occurred between 2009 and 2011. The pace of income and spending growth could, of course, pick up if hiring trends accelerate, but even if hiring growth remains at the slow 1.6% annual rate of the past couple of years, income can expand faster than the simple head count would imply. Growth in labor compensation—about 2% a year for the past couple of years, according to the Department of Commerce—would enlarge incomes above and beyond the rate of jobs creation. Business's tendency to use overtime more than in the past (probably to avoid additional hiring) would do the same. The average workweek, already up almost 3% from its lows, suggests that many hourly workers are already getting time and a half. That figure could rise still further.

Such factors have allowed wage and salary income to rise annually by 4–4.5% during the past couple of years,⁴ even as employment growth has disappointed. Though hardly a boom, spending growth in tandem with that income expansion could keep the economy on its admittedly modest expansion path. But there is more that might actually permit spending to outpace income growth, at least marginally, and still avoid a deterioration in household finances. Past de-leveraging, as well as declining interest rates, has reduced the burden of debt service. According to the Federal Reserve, the average American household presently dedicates just a bit more than 15% of its aftertax income to debt service, interest, and principal, including mortgages. That burden has fallen from about 20% in 2007. What is more, the burden will likely continue to fall, since the Fed also reports that more than a third of the country's mortgages have a rate above 5%. With this extra fillip to spendable income, nominal consumption could expand at about 4.5–5% a year, even as households sustain their 3.5% savings rate, modestly improve their finances, and sustain the recovery such as it is.

Economic Insights: Dispelling Dollar Doubts

Mon, 6 May 2013 00:00 EDT

It seems to happen every other year, sometimes more frequently. Some matter or other reminds people of the dollar's weak underpinnings, and headlines look for its imminent demise as the world's reserve currency. Usually such claims associate the event with economic and financial calamities. This time, however, the concerns arise from continued frustrations with Washington's fiscal mismanagement set against the Chinese yuan's rise to prominence, particularly in the oil trade. Unlike many past such alarms, these have some substance. The yuan's growing prominence is a matter to consider. But the dollar, for all its troubles, still looks secure in its reserve status, at least for the foreseeable future.

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Underlying this latest round of dollar fretting is a long list of chronic domestic American disappointments. The economic recovery, never strong, has of late shown signs of still greater weakness, and Washington, never well organized, seems incapable of even beginning to get its fiscal house in order. Meanwhile, the Federal Reserve's decision to finance much of the huge federal deficit has raised fears of future inflationary pressures and an erosion of the dollar's value, as well as its prestige. Of course, such concerns have existed for a long while. Until now, the response to all, as far as the dollar's reserve status was concerned, pointed to the absence of a viable replacement currency. For a while, the euro looked like a candidate, but the eurozone's ongoing fiscal/financial crisis has disqualified it for the time being. Of late, however, three answers to this standard response about alternatives have presented themselves.

The first of these gained traction when Beijing formally proposed to the major developed economies known as the Group of Eight (G8) that countries diversify reserve currencies away from the U.S. dollar. Many have enlarged on this suggestion, suggesting that the world use a set basket of currencies as a reserve. Some look to the International Monetary Fund's (IMF) special drawing rights (SDRs) as an example. The second response notes how regional powers have begun to establish trade-settlement arrangements in currencies other than the dollar. Most recently, China and Australia have made such arrangements for their bilateral trade. Brazil and China have arranged yuan-real swap arrangements for their central banks. The Shanghai Cooperation Organization (SCO), a group of Asian nations that includes China and Russia, has begun to investigate ways of holding reserves in each other's currencies instead of the dollar. Third and last, China, soon to become the world's biggest oil importer, has expanded its arrangements to bypass the dollar in its purchases from Iran, Saudi Arabia, and other members of the Organization of Petroleum Exporting Countries (OPEC).

Though, as mentioned, there is some substance in these concerns, much of present and past fears about the dollar's status miss the true character of a reserve currency. The notion of diversifying reserves has, for instance, existed for a long time. SDRs were created in the 1960s. Most central banks have long held reserves in currencies other than the dollar. But such diversifications have never really challenged the dollar's status. The SDR basket of currencies, for instance, has a large dollar component. SDRs have a further drawback in that central banks holding them cannot readily present them to their business community, as they can dollars, to support the payments required by trade. Much other reserve diversification links non-dollar holdings to the currencies of major trading partners. It is done to support needs of each nation's major importers and exporters. On that basis, a diversification of the sort proposed by China to the G8 has already occurred, and is ongoing. But this diversification, tied as it almost always is to existing bilateral trade relationships, has always left the dollar as the more general reserve, the store of value, and the general source of exchange liquidity.

No doubt, as those bilateral trade relationships grow over time, they will come to dominate reserve holdings more and more and, accordingly, reduce the dollar's relative weight in the equation. China looms large as a leader in this trend, especially where oil is concerned, but also in other aspects of trade. Someday, perhaps, the Chinese presence will grow so large that the yuan first supplants the dollar on bilateral reserve holdings and then more generally as the failsafe currency to back general global dealings—in other words, as the world's reserve currency. But as fast as Chinese trade is growing, such a turn is far from imminent. The United States, for all the slippage in its once supremely dominant position, still accounts for more than twice the percentage of the world's gross domestic product (GDP) as does China. What is more, the dollar still plays a role in more than 80% of the world's international transactions, whether an American firm or individual is involved or not. It will take a long time to erode such a position and the practices that have grown out of it.

In all probability, even as the yuan gains prominence, the dollar will relinquish its status only slowly. During that time, the world could function round two reserve currencies. That certainly is what happened when the dollar replaced the British sterling. The process began in the 1920s and was not complete until the 1960s. During that whole time, the world had two reserves currencies and transactions easily flowed between them. Conceivably, the same thing could occur with the yuan and the dollar. Even if the change this time were to happen twice as fast as with the dollar and sterling, it likely would not reach completion until the 2030s. Meanwhile, there is much in today's situation to suggest that it might take even longer to occur than the dollar-sterling change did.

Unlike the United States when its dollar challenged sterling as the global reserve, it's notable to point out that China today lacks a financial system capable of supporting a world reserve currency. The home financial markets of a reserve currency must be broad, deep, active, and, critically, open enough to offer all, domestic and foreign players, quick, easy conversions into and out of all currencies. Those markets must also offer all who hold the reserve, domestic players and foreign, an array of investment opportunities for their holdings and sufficient liquidity to exit and enter them quickly and freely. Right now, China's financial markets have no such advantages. On the contrary, they are cumbersome, controlled, if not effectively closed, and bereft of the necessary array of investment opportunities. Indeed, China's financial structure is so limited that even today that country's exporters and importers must funnel much of their trade finance through Hong Kong dollars. China could change all this, of course, but it would take time, even with the greatest commitment in the world, and so far, Beijing has rather shown a commitment to closed and controlled financial markets that parallel Beijing's equally controlled, top-down approach to economic management.

Meanwhile, it is far from clear that China really wants its yuan to supplant the dollar as the global reserve. Reserve status certainly would thwart Beijing's ongoing efforts to promote exports by holding down the foreign exchange value of its yuan. If the yuan were to become a reserve currency, central banks and international business would hold yuan in amounts far in excess of those required for simple trade needs. Such additional demands would drive the yuan's value (as the reserve role has the value of the dollar) far above the fair market values connected to trade, much less the advantageous low exchange rate Beijing has long preferred. Of late, Beijing has talked about deemphasizing exports in favor of domestic development and, accordingly, has allowed the yuan to rise in value against other currencies. Just recently, it announced that it would widen the range over which it will allow the yuan to fluctuate on foreign exchange markets. But China, for all the change Beijing contemplates, still depends heavily on exports for growth and employment, making the country's leadership highly reluctant to embrace the high valuations that would inevitably come with reserve status.

Beijing clearly likes the prestige of the yuan's greater stature, as well as the bragging rights it gives over Washington. But the adverse effect on the country's long-standing currency policy and exports will likely keep China from pushing matters too far too fast. (American exporters, of course, would be delighted, as it would relieve them of the disadvantages of an expensive currency with which the dollar's reserve status has long confronted them.) Even if Beijing were willing to accept the associated trade disadvantages and the need to open its financial markets in ways that it clearly still finds uncomfortable, the transition would take a long time, freeing global markets and the world’s economies from the shocks about which the alarmists speak and write.

Economic Insights: Is the U.S. Housing Recovery Built to Last?

Mon, 29 Apr 2013 00:00 EDT

Housing is back. It has added to overall economic growth since the middle of 2012. Sales and building activity both have picked up, as, importantly, have residential real estate prices. The growth will likely continue for the foreseeable future. It will, however, almost certainly proceed at a slower pace going forward. It not only is natural for the initial bounce after a turn to slow as it progresses but also much in the fundamental credit and economic backdrop suggests only a modest pace of advance. Still, even a more restrained contribution to growth constitutes a vast improvement over the free fall of past years and stands as another bulwark against a recessionary dip any time soon.

The recovery certainly looks secure. Signs of growth register across a broad front. Sales of both new and existing homes have risen, the former 10.2% during the last 12 months, the latter, more directly linked to new construction, up 10%.¹ In response, the pace of home construction has picked up. The Commerce Department reports a jump of more than 30% in new housing starts during this time. The turn in sales has reduced outstanding inventories of unsold properties and, accordingly, has arrested the slide in real estate prices. Median prices for new houses nationwide have risen 3% during this same time. As is typical of cyclical turns, especially after such a dramatic correction, the greatest gains have occurred in the regions that were most hard hit. Sales in the west, for instance, have shown the greatest gains, up 55% during this 12-month stretch, mostly in Southern California, Arizona, and Nevada. Sales in the Midwest have jumped by more than 18%. Sales elsewhere have remained subdued.²

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The overall picture is nonetheless encouraging, especially after the real estate disaster through which the country passed not too long ago. And fundamentals suggest that it will continue to improve. One crucial supporting factor is the Federal Reserve’s commitment to keep short- and long-term interest rates low. Even today, after a modest rise in longer-term Treasury yields, 30-year fixed mortgages remain on average at historically low levels of 3.74%, barely above recent and expected rates of inflation.³ More fundamental is the housing demand that has emerged and will likely continue to emerge from new household formation across the country, at a pace of just under a million a year, according to last measures by the Commerce Department. An additional positive factor is the fading memory of past losses and how recent real estate price increases, by raising house values above existing mortgages, have increasingly enabled people to sell and move and so offer real estate markets a dynamism that they lacked until recently. These last are, of course, unmeasurable, but influential nonetheless.

A different group of influences, however, point to moderation in the growth pace going forward. Primary among these are continued tight credit conditions. Of course, the Fed has poured liquidity into financial markets and institutions, driving down mortgage rates and inducing greater demands for credit in the process. But at the same time, banks and other mortgage lenders, still hurting from past losses, have maintained tight lending standards so that many who want credit cannot get it. According to the Fed, those standards have begun to ease of late, but they remain stringent by historical standards. Indeed, Fed data show continued stagnation in bank lending for any real estate venture.⁴ The modest relaxation in lending strictures was sufficient to finance the sales surge from the extremely low levels of last year, but it is not yet sufficient to sustain continued rapid advances now that activity levels have risen. No doubt, lending restraints will ease in time and real estate lending will expand concomitantly, but bank behavior suggests that the change will unfold only slowly.

As this bank behavior keeps a lid on this pace of sales growth, building activity will likely grow at a slower pace as well. Indeed, builders seem to be so far ahead of sales that they may need to pause. After all, starts of new homes leaped up almost three times faster than sales during the past year, and though the existing inventory of new houses has returned to historically manageable levels, it seems likely to expand again as this surge in starts reaches completion and comes onto the market. The difference will hardly halt the overall pattern of growth, but it should, at the very least, point to a slowdown in the growth pace of new construction. Certainly, just such a pattern was evident in the mid-1980s, which was the last time that the economy recovered from a burst housing bubble. Then, it took five years from the trough before sales and activity returned to their old highs.5 If there were a literal repeat of that pattern, it would imply the year 2015 before a full recovery—but, of course, this bust was more severe than that last one.

Economic Insights: Murkier Prospects for Merkel

Mon, 22 Apr 2013 00:00 EDT

As last month's Italian elections and, more recently, a misguided levy on Cyprian bank deposits add ambiguity to Europe's future, still more uncertainty will likely emerge as Germany approaches its September elections. Especially because Italy's ambivalent vote may make that country less likely to cooperate with the rest of Europe going forward, questions will increasingly arise about Chancellor Angela Merkel's own cooperative, European approach to dealing with the Continent's fiscal-financial crisis. At the very least, it will make her more vulnerable to her opposition. Her personal popularity will almost surely secure her another term as Germany's chancellor, but she may, as a result of these developments, face new constraints that likely will force her to consider German interests more narrowly than she has to date. Germany and Europe will lose as a consequence.¹

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Though the average German seems to like Merkel, people are far from being entirely satisfied with the chancellor's approach. Pollsters record concern that Merkel's cooperation in Europe has cost Germany influence within the eurozone and the European Union (EU). People were particularly struck, it seems, when last year the Governing Council of the European Central Bank (ECB) simply outvoted German representatives, ignored their concerns about purchases of the sovereign debt issued by Europe's periphery, and launched into a buying program. More serious is the German public's vague sense that cooperation with other eurozone members has siphoned off German wealth and income. Since some 84% of the German people expect the crisis to become worse, they connect the losses that they believe have already occurred to a frightening and open-ended claim on their taxes, their incomes, and, they have emphasized, their pensions as well. Few, of course, connect the dots between Merkel's cooperative approach and these fears, but no one seems to feel a need to do so either. Indeed, the sense of loss and vulnerability is that much more politically potent because it is vague. Data and economic logic would circumscribe the possibilities and render them less troubling.²

The German financial and political elite seem particularly concerned with the decision to house eurozone-wide bank supervision in the ECB. Merkel's own finance minister, Wolfgang Schäuble, has, more than once, pointed to what he considers an "inherent conflict of interest with the bank's monetary policy tools." Peer Steinbrück, former finance minister and a challenger for the chancellor's office, has gone so far as to question the ECB's ability to shoulder supervisory responsibilities. He points out that there are 6,000 banks in Europe, and the ECB has no staff with any supervisory experience. Others in German financial circles have asked what will become of the London-based European Banking Authority when the ECB takes over bank supervision. German banks, for their own narrow purposes, have resisted the ECB in this role, as has Jens Weidmann, head of the Bundesbank, which would clearly lose authority under the new arrangements.³

It seems most upsetting to these commentators that last June's decision to give supervisory responsibility to the ECB ignored the recommendations of that bank's own commission on the subject. Referred to as the Larosière Commission (after its head, former Banque of France governor and managing director at the International Monetary Fund [IMF], Jacques de Larosière), it warned on several levels against giving bank supervision to the ECB. In addition to all the complaints already voiced in the German debate, the commission also worried over a politicalization of the ECB, as it tried to maneuver among the different rules of the eurozone's 17 members. The commission even doubted whether the EU treaty permits the ECB to operate in a supervisory capacity. Though such criticisms take a technical turn, they, at base, really question the wisdom and coherence behind the June summit's and Merkel's decision. Summarizing that sense, Finance Minister Schäuble concluded, dryly, that it is hard to endorse a decision that is "anything but thought through."⁴

If none of this is especially flattering to Merkel, neither does it necessarily get to the nub of Germany's interests, at least as she and many in her government see them. Implicitly, if not explicitly, they see the need for a much broader perspective. Germans may object to particular arrangements, but, Merkel clearly recognizes, it can no longer simply pull back from the eurozone to protect itself and its own. Its financial markets and institutions have become too integrated into European finance for that to occur. German industry and business have long since adjusted to the euro and would suffer horribly from its dissolution. If Berlin, ostensibly to save its taxpayers, were to abandon rescue negotiations and leave Greece, Spain, and the others to their own devices, German finance, and the economy overall, would find itself in a precarious situation indeed, no doubt requiring tax resources to save both its own financial institutions and very likely many major German industrial employers as well. Germans would suffer more than they now imagine they do from the eurozone's rescue arrangements. Merkel has proceeded with this broader threat in mind.

German banks are especially vulnerable. A recent report, compiled by the banking community itself, reveals that banks have about €400 billion exposed to Greek, Spanish, Portuguese, and Irish debt. This figure amounts to 260% of German banks' primary capital, and it is more than 16% of the German economy. And it does not even include holdings of Italian debt, which in all likelihood dwarf those of others. Should European support arrangements fail and these nations default or, more likely, engage in a unilateral rescheduling, confidence in German banks would almost surely collapse. A panic and recession would ensue. Even if only the smallest of those debtors were to fail, German banks would remain highly vulnerable to all, since markets, anticipating other failures, would surely mark down the value of all the eurozone periphery's outstanding debt, destroying asset values in German banks in the process and their capital base and public confidence. Certainly, a broad European solution that heads off such a panic would offer a cheaper and easier answer to Berlin.⁵

But that is not all. Berlin also realizes that the euro serves German industry well. Because Germany joined the euro when its deutschmark stood at lows relative to both the country's own economic fundaments and the rates at which other nations joined, it effectively enshrined a pricing edge for German producers within the common currency. According to IMF calculations, that advantage amounts to 10-25% opposite Greece, Spain, and the rest of Europe's periphery. The euro also gives German industry global pricing advantages it would not otherwise enjoy. Had there never been a currency union and Germany operated separately, there can be little doubt that its deutschemark by now would have risen high enough to price German industry out of the global marketplace. But because the weaker members of the eurozone keep the euro lower than a separate German currency would trade at, German industry retains more competitive pricing. The nation's industrialists no doubt have made these points clear to Berlin, reinforcing Merkel's conviction that fundamental German interests lie within the larger union and common currency.

Merkel can count on retaining her office. For all the anxiety in Germany, recent polls indicate that 42% of the public still backs either her conservative Christian Democratic Union or its Bavarian sister, the Christian Social Union. But the opposition is gaining. Merkel's current coalition partner, the Free Democratic Party, has seen its support fall to only 2% of the electorate. Since the opposition of all stripes will be able to play on voters' evident fears, especially after the ambiguous Italian vote, Merkel may reenter the chancellor's office much more constrained than heretofore. Even now, before the election, the Bundestag has a bill before it to keep German taxpayers free of liability from older, "legacy" debt issued by periphery governments. Merkel's current coalition, even with its comfortable majority, already shows a pointed reluctance to bring any additional bailout legislation to the Bundestag, and Germany's constitutional court, when it established the legality of German contributions to Europe's Stability Mechanism, stipulated that future contributions would require more legislation.⁶

A constrained Merkel clearly raises the risks for Europe and so for Germany. Markets, fearing the loss of German support, could take control of the situation away from the authorities, marking down the debt of periphery governments, straining existing support mechanisms, and perhaps forcing the failures that investors and the authorities fear. Merkel's clear political abilities may allow her to maneuver around even a constrained, partisan situation and calm markets in the process. Still, that might require more of her then even she may have to offer. At the very least, Europe will likely face rough sledding up through the German vote and very likely for some time afterward.