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Rescuing the Euro: The Fatal Mistakes of Berlin's Bailout Strategy

A commentary by Wolfgang Kaden

The German parliament is set to approve the expansion of the enormous euro rescue package next week. But this will be a fatal mistake. There is only one reasonable solution to Europe's debt crisis -- and it also happens to be much cheaper.

Are Chancellor Merkel and Finance Minister Schäuble leading Germany down the wrong path? Zoom
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Are Chancellor Merkel and Finance Minister Schäuble leading Germany down the wrong path?

It was no surprise that Standard & Poor's downgraded Italy's credit rating this week. The decision made Europe's debt strategy only slightly less credible. But does the government in Berlin still believe the European debt crisis can be solved with ever bigger rescue packages?

Seldom have German politicians seemed as directionless as they do in the euro crisis. Never before has Berlin made such serious and costly mistakes, racking up as many errors as they did with their grand plans for Europe.

They want to establish the unity of the continent -- but are nurturing fear and anger in donor and recipient countries alike. They want to sustain the homogenous single currency area -- but are doing everything possible to deepen the divide in the euro zone. They want to safeguard Germany's competitive edge -- but are undermining its future financial viability with unimaginable burdens.

The first mistake begins with the terminology. The talk is and always has been of a "euro crisis." The chancellor has even made the nonsensical claim that "if the euro fails, Europe fails." It is actually possible to talk a currency into crisis and ruin.

Where, pray tell, is this supposed euro crisis? It seems that many politicians, journalists and researchers no longer distinguish between federal budgets and the money supply through issuing banks. What we are seeing is a crushing sovereign debt crisis, not a currency crisis. The intrinsic value of the euro -- despite the talk about the dangers of massive inflation -- is as stable as that of many other currencies.

The external value naturally suffers from the never-ending chatter about a crisis, though. Some EU investors have fled in panic to the supposed safety of Switzerland, thus providing for a depreciation of the euro against the Swiss franc. But compared to the dollar, still the dominant world currency, the exchange rate has remained stable. Measured in terms of purchasing power, the euro is even overvalued against the US currency.

Acts of Desperation

We are witnessing a debacle of state debt accumulation. And this is not only a European phenomenon, but a global one. For many years, one could only wonder at how private individuals and financial institutions were willing to entrust their money to governments whose debts had long been considered non-refundable. In this debt world, finance ministers were celebrated when the new debt they took on was less than the previous year. That the total debt would continue to rise was, and is, self-evident.

Now the investors -- and not sinister "speculators" -- are ready to prepare an end to this mismanagement by refusing further credit. Rightly so. We should thank them for this insight, even if it has come rather late.

But what are the self-annointed euro rescuers in the central governments doing? Mistake number two: Those countries which still enjoy good ratings think they need to rescue those with bad credit through fresh lending. They are thus violating the founding treaty of the euro zone, which excludes such aid.

So-called stability facilities are being contrived to communitarize the new debt. Then the European Central Bank jumps in. Likewise, in gross contract violations, it buys government bonds and in doing so damages its most important asset --credibility.

And what results from these desperate acts, which German politicians are actively involved with, or at least accept with a shrug?

In the case of a fundamentally competitive Ireland, they essentially want to build a bridge to better times. But with Portugal, this is already doubtful. And in the case of Greece, according to all financial calculations, it is impossible for the economically moribund country to escape bankruptcy, even with a mixture of new debt and crushing reforms. Meanwhile no one in charge wants to discuss what would happen if investors decide to shun Italy, which is at even greater risk.

Debt Haircut is the Solution

All this is supposedly being done to save the euro. Nonsense. It's not actually about the euro. Three years after the collapse of the Lehman Brothers investment bank, it is to forestall a new banking crash which would supposedly have catastrophic, difficult to control consequences. A number of important financial institutions in Europe, particularly in France, have accumulated large amounts of Greek, Italian and Portuguese bonds. And not all of them have written them off at their actual value.

Those in power repeatedly tell us there is no alternative for the bailouts when it comes to securing the euro (or, in actual fact, the financial institutions). Whether they really believe that, however, is uncertain.

Mistake number three: Of course, there is at least one other possibility. One version, which German bankers talked about more than a year ago, is urgently being recommended by researchers. It has now, indirectly, been taken up by the new head of the International Monetary Fund (IMF) Christine Lagarde and by German Economics Minister Philipp (FPD). But it has been rejected by the government's largest party, Merkel's conservative Christian Democrats, and the main opposition parties, the center-left Social Democrats and the Greens. In fact, the idea has almost become a taboo.

The solution is a so-called debt haircut, or in the words of the much maligned Rösler, an "orderly bankruptcy." The creditors who have frivolously given Greece or other states credit up to the point of an actual declaration of bankruptcy would lose so much money that the remaining losses for the debtor country would actually be manageable.

Experts estimate that this debt haircut would need to involve between 30 and 50 percent of debt, depending on the country. The second rescue plan for Greece from the summer provides a waiver of only 20 percent, but it is voluntary and so far only 75 percent of financial institutions have agreed to it.

Banking Crash Would be Easily Manageable

A haircut which mirrors the debtor's real ability to meet financial obligations could, of course, leave some banks in trouble and threaten a new banking crash. But this problem could be easier to control than one outrageously expensive bailout after another. Above all, this solution would be cheaper for the countries; indeed, the burden would be borne by the lenders.

Banks which, thanks to the stress test, are known to be in a precarious position, would have to be weatherproofed before the debt haircut with fresh capital. This "recapitalization" must take place through the state because private investors would certainly not rush to take on such a risk. In return, governments would be shareholders in the banks.

To their credit, German economists Harald Hau and Bernd Lucke have calculated what it would cost to make German and European banks crisis-proof through additional capital. Their findings: German banks would need €20 billion ($27 billion) to cope; the German contribution for banks in Greece, Portugal, Italy and Spain would be €12 billion ($16 billion).

That makes a total of €32 billion ($43 billion), or just 15 percent of the absurd €211 billion ($285 billion) that Germany has to guarantee in the future, which still won't be enough.

Largest Projects of the Postwar Period

The money which would be accrued by the banks would not be lost -- as opposed to a large portion of the state guarantees. The donors would be given shares in the banks, that is to say monetary value entitlements. According to similar situations in the past, these would likely increase in value during the course of an economic recovery and could then be sold later.

Of course, this solution does not relieve the indebted countries of the task of cleaning up their public finances and making their economies competitive. But without the heavy burden of unpayable debts, they would certainly be in a better position to balance their budgets and reinvigorate the private sector than they are now.

But Berlin's crisis managers Angela Merkel and Wolfgang Schäuble have taken up neither the economists' calculations nor the suggestions of IMF boss Lagarde. They remain undeterred in loading Germany with unprecedented, gigantic financial guarantee obligations, from which solid demands will definitely emerge. This will certainly lead to either tax increases or spending cuts -- or both.

It's no way encourage the European idea. A united Europe and the euro are the most important political projects of the postwar period. It would be a disaster if they were damaged by taking the wrong course of action.

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