Creating Order in the Euro Zone: Merkel's Rules for Bankruptcy

A newly established Berlin Club would serve as the "international guarantor." The German government experts see this organization as an "apolitical and legally independent entity."

The plans build on existing institutions involved in international debt settlement. While the Paris Club regulates debt restructuring among nations, the London Club specializes in liabilities between banks and countries.

The German government hopes to bridge a gap with its proposal. The Berlin Club would concentrate on government bonds and the associated derivative securities. The members of the club could be recruited from within the G-20 group of industrial and emerging nations. Another possibility would be to establish the club within the framework of the euro zone.

The International Monetary Fund (IMF) would be involved in the debt refinancing from the outset. The German experts see the IMF playing a key role. If representatives of the Washington-based organization determine that debt forgiveness and restructuring have failed, then the second phase of the procedure kicks in.

It amounts to a complete refinancing. According to the concept, "this will require restrictions on sovereign discretionary powers." In other words, the government of the affected country would no longer be able to fully dispose of its own treasury.

Institutionalized Disempowerment

It would be replaced with "an individual or group of individuals familiar with the regional characteristics of the debtor nation," which would safeguard the financial interests of the bankrupt country. The Berlin Club would have the authority to appoint these individuals.

The concept toughens the stance, particularly toward creditors, but also toward the debt-ridden country. If it is implemented, it will amount to an institutionalized disempowerment of a debtor nation's government by the IMF and the new Berlin Club, at least in its final stage. This prospect alone could have a disciplining effect on overspending governments.

But the concepts would also represent an imposition on international donors. Until now, conventional bailout programs like the one devised for Greece have been based primarily on the notion that a cash-strapped government receives public funds from other countries, while private donors are not asked to waive their claims. To put it simply, taxpayers in countries with reasonably healthy government finances, particularly Germany, have taken the place of banks and private investors that have extricated themselves from ailing economies. This would no longer be the case in the future.

This is also the way the EU's and IMF's €750 billion rescue package works. The bailout funds provide the euro zone with planning security until 2013, but it is by no means certain that the crisis will have been resolved by then. Experts predict that by that time Greece will be burdened by a debt ratio of 150 percent of its gross domestic product. The country will have an enormous need for fresh loans, but the difficulties it faces in getting those loans will probably be just as great. This suggests that the country could quite possibly stumble from one bailout program to the next.

Resistance Guaranteed

It is also completely unclear as to if, when and to what extent the new concept could even be implemented. Regardless of whether the government introduces its plans at the G-20 level or within the task force headed by European Council President Herman Van Rompuy, resistance is guaranteed.

Countries immediately or potentially threatened by insolvency, like Greece, Portugal and Spain, will be up in arms against the proposals from Berlin. Why should they agree to rules that would make it easier for the remaining euro countries to deny them aid in an emergency?

But the German government is determined not to be the paymaster for Europe's debt transgressors in the long term. Officials at the Chancellery and Finance Ministry fear that otherwise the German public's support for the euro and the EU would be undermined.

In developing their scenarios, the government experts assume that other potential donor countries share their concerns. The governments of France, Finland and the Netherlands are likely to be just as interested in private creditors and debtor nations bearing a portion of the burden.

No Way Around Emergency Planning

The concept by no means sells itself. If the project were organized under the auspices of the EU, it would face a high hurdle: The European treaties would have to be amended to establish the Berlin Club, which would require the consent of each individual member. This is not a process governments are keen to repeat after the experiences of the Lisbon Treaty.

Nevertheless, there is no way around pushing ahead with emergency planning, because the situation could come to a head more quickly than anticipated. The aid for Greece is subject to the Papandreou government fulfilling the EU and IMF requirements. The Greek prime minister is full of good intentions, but his measures have been relatively ineffective so far. Although the government is raising taxes and even introducing new taxes, revenues have fallen short of expectations. Strikes, like the one that was staged last Thursday, are constantly paralyzing public life and the economy.

In other words, it is quite possible that Greece will not fulfill the conditions and thus will receive no aid from the European fund. This could lead to a consequence that European leaders have been trying to prevent at all costs: a total national bankruptcy. And, if the reform package has not been implemented by then, it could end up being anything but an orderly process.

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• Part 1: Merkel's Rules for Bankruptcy
• Part 2: Berlin Club as 'International Guarantor'