Merkel Makes Euro Indispensable by Turning Crisis Into German Opportunity

Chancellor Angela Merkel is turning Europe’s sovereign-debt crisis into an opportunity to reshape the euro region in Germany’s image.

As Spain raises its retirement age, Greece cuts wages and Portugal imposes the deepest spending reductions in more than three decades, Merkel’s resolve in refusing to aid neighbors unconditionally is showing signs of working.

Seeking to erase doubts that the markets can snuff out the 12-year-old euro, which she has called the “uniting idea” of post-World War II Europe, the 56-year-old scientist who grew up in communist East Germany is set to swap stick for carrot and throw the weight of Europe’s largest and richest economy behind a plan to bolster the area’s rescue effort.

“This is the right time and these are the right ideas,” Helmut Schlesinger, Bundesbank president from 1991 to 1993 when the euro’s founding treaty took effect, said in a telephone interview. Germany, the biggest contributor to bailouts for Greece and Ireland, “has a special responsibility to come up with proposals and see them through,” he said.

By demanding stricter oversight and tougher penalties on fiscal miscreants, Merkel would complete the job begun at the start of the euro. While German leaders in the 1990s equipped the European Central Bank with the same inflation-fighting mission as its Bundesbank, they failed to impose ironclad controls on national budget policies.

The result: a crisis that has frustrated unprecedented efforts by policy makers to calm markets and stoked doubts that the euro would survive.

EU Summit

Merkel and counterparts from the 27-member European Union met in Brussels today to review progress on a package they aim to finish by late March and which may include an increase in the bailout fund’s firepower, a reduction in interest rates on rescue loans and deeper coordination of economic policies.

Her task is two-fold: protect a single currency she views as indispensible and shift the euro-region toward the model of a fiscally virtuous, hard-money, stable-growth economy that underpinned Germany’s post-war recovery.

Still, as Europe prepared to bail out Ireland in November, Merkel’s appeal to her skeptical electorate focused on the euro as a symbol of peace to a nation ravaged by two world wars.

The euro “is about everything. If the euro fails, then Europe fails, the European ideal of common values and unity will fail,” Merkel said in a Nov. 15 speech to members of her party in Karlsruhe, Germany. “This ideal has always given us strength in the face of wars and destruction in Europe for the past centuries -- to fight for peace, for prosperity and for freedom on our continent.”

Merkel’s Task

Merkel is walking a fine line. Her effort could boomerang, raising German borrowing costs and eroding political support among voters hostile to channeling their taxes to those who avoided painful policy choices on their own.

Bunds will suffer whenever “German tax revenue is drawn upon for cross-border purposes” to help weaker euro countries, said Andrew Bosomworth, a Munich-based fund manager at Pacific Investment Management Co. who previously worked for the ECB.

The yield on the benchmark 10-year German bund reached the highest in almost a year this week as euro-area inflation advanced at its fastest pace in more than two years in January.

Germany undercut its own credibility in 2005 by teaming with France to loosen budget rules after both countries overran the EU deficit limit of 3 percent of gross domestic product. No sanctions have ever been slapped on high-deficit states, not even on Greece, a country that never met the targets.

Seeking Payoff

Now Merkel, who gained a degree in physics from the Karl Marx University in Leipzig and a doctorate in quantum chemistry from the Central Institute of Physical Chemistry in East Berlin, is seeking a payoff from a year of crisis-fighting and providing the biggest share of a $1 trillion euro-region bailout package.

A fluent speaker of Russian and English, Merkel, a former aide to Lothar de Maiziere, East Germany’s only democratically elected premier, was picked for Chancellor Helmut Kohl’s post- unification Cabinet. At 36, she became the youngest minister of the post-war era.

Her message of austerity is backed by a personal style recalling life in communist East Germany.

The chancellor and her second husband, Joachim Sauer, reject the sprawling living quarters in the chancellery and instead live in her 19th-century apartment building in Berlin’s central Mitte district. She disdains the official retreat, a restored 18th century Prussian palace, spending weekends at the family country house in the village of Hohenwalde, 80 kilometers (50 miles) northeast of the capital.

Potato Soup

Merkel wheels a shopping cart through her local food store, trailed by her security detail, at least once a month. She even bags her own groceries and during her 2009 re-election campaign she boasted that she makes a “mean potato soup” and does her own laundry when time permits.

For a country where inflation weakened democracy in the 1920s and aided Adolf Hitler’s rise to power, the chancellor says the euro is a pre-requisite for an economically strong, peaceful Europe and protecting it requires the pain of budget cuts in the so-called peripheral economies.

“Indebtedness is the biggest danger for prosperity on this continent,” Merkel told the World Economic Forum’s annual meeting in Davos, Switzerland, on Jan. 28. Any country that gets aid “must receive this solidarity under certain conditions.”

Tighter control of national finances tops Germany’s list of demands. Narrowing Europe-wide differences in taxes, pay and retirement age is also on the agenda, driven by Merkel and French President Nicolas Sarkozy, a convert to her lobbying.

“Mrs. Merkel and I will never -- do you hear me? -- never let the euro fail,” Sarkozy said in Davos.

Market Gains

Merkel may have pulled ahead for now in her battle to restore policy makers’ mastery over the markets. The euro climbed to a three-month high this week and bond-risk premiums for Spain, Portugal, Italy and Belgium narrowed as investors bet that Europe will agree on ways to strengthen its crisis response.

Governments are already taking Merkel’s medicine. Spain cut public wages 5 percent last year, reduced firing costs, made it easier for firms to opt out of collective-bargaining deals and plan further changes to those pacts by March. All but the lowest pensions have been frozen and the government is increasing the retirement age to match Germany’s 67.

“In my 25 years as an economist I can’t recall another advanced economy having undertaken such an agenda of reforms in such a short period of time,” said Erik Nielsen, London-based chief European economist at Goldman Sachs Group Inc.

Loosening Strings

In return, Merkel may be willing to loosen the purse- strings by bolstering a 440 billion-euro ($600 billion) European Financial Stability Facility, whose lending ability is limited by collateral rules to about 250 billion euros.

Merkel’s bailout tactics underscore her response to previous crises. She was criticized for moving too slowly on stimulus spending as the economy sank into recession, on supporting banks after the collapse of Lehman Brothers Holdings Inc. rocked the global financial system and on extending a lifeline to Greece.

Those who know her say that represents a scientific cast that differs from most of her political counterparts who are mainly lawyers or businessmen.

“It’s policy by trial and error. She passionately takes a position, then turns 180 degrees and changes her mind,” Gerd Langguth, political scientist at University of Bonn and Merkel biographer, in a phone interview today. “She doesn’t do politics from the gut. Sure, therein lies a danger, because those politicians often have a feel for getting it right. Merkel just wants all the facts on the table.”

Debt Limits

Merkel points to constitutional debt limits adopted by Germany in 2009 as a model for the rest of Europe and views the Sweden’s revamping of its welfare state in the 1990s as another inspiration. Years of wage restraint in Germany and cuts in social programs by Gerhard Schroeder, the previous chancellor, further strengthen her hand.

European Commission statistics show unit labor costs shrank in Germany each year from 2004 through 2007 and grew less than 1 percent in each of the six previous years. In that period, the euro-area average was only lower in 1998 and never contracted.

“Germany went through a difficult and painful restructuring,” said Klaus Baader, co-chief European economist at Societe Generale SA in London. “The fruits are clear to see and that’s what Germany expects of other euro member countries.”

German Expansion

Powered by exports, Germany had its fastest economic expansion in two decades last year with gross domestic product jumping 3.6 percent. Unemployment fell to an 18-year low of 7.4 percent in January -- the second lowest among the Group of Seven economies after Japan -- and business confidence reached a record high.

Continental AG, the second-biggest tire maker in Europe, last month reported sales and earnings that beat its 2010 goals, while Siemens AG, Europe’s largest engineering company, said fiscal first-quarter profit increased more than estimated.

Since spooking markets in October by saying bondholders will have to pay in future bailouts and again in November by calling the euro’s condition “exceptionally serious,” Merkel has shifted her public stance to a come-what-may defense of the currency. “We support whatever is needed to support the euro,” she said in Berlin on Jan. 12.

She may have other aims. Merkel may nominate Bundesbank President Axel Weber to replace Jean-Claude Trichet as president of the ECB after his term ends in October, a move that would install a so-called inflation hawk to keep a lid on prices.

Roubini’s Doubts

Merkel will ultimately fail if she attempts to impose the German diet on Europe without giving more in return, said Nouriel Roubini, chairman of Roubini Global Economics LLC. Germany and other countries should slow their deficit cuts and Greece should restructure its debt now, he said.

Germany’s message is “we don’t care about pain and the only solutions are austerity and structural reforms, and anything else has to wait for 2013,” when the EU aims to have a permanent defense system for the euro in place, said Roubini. “You need a more comprehensive solution sooner.”

Most international investors predict at least one of the 17 nations will leave the euro area within five years and that Greece and Ireland will default, according to the January 2011 Bloomberg Global Poll that underscored the urgency leaders face in calming markets. The same poll ranked Merkel as the most favored of nine global policy makers.

State Elections

Constraining Merkel are elections in seven of Germany’s 16 states this year -- with Baden-Württemberg’s on March 27 -- and public resistance to putting more taxpayer money on the line for bailouts, tinged with nostalgia for the deutsche mark. Within her governing coalition, the Free Democratic Party in January rejected any increase in the bailout fund.

Greater financial support for indebted euro-area countries was opposed by 64 percent of German respondents in a Jan. 28 FG Wahlen poll. About half of Germans would ditch the euro and return to the deutsche mark, a Dec. 26 YouGov survey for the Bild newspaper showed.

That underscores the need for her to keep both euro-region neighbors and her own voters on side, said Harvard University historian Niall Ferguson, who has written about Germany’s economy and yesterday met Merkel and Spanish Prime Minister Jose Luis Rodriguez Zapatero in Madrid.

“The euro has to survive because it’s in Germany’s interest and the German voters are gradually coming to see they can’t afford to see this fall apart,” Ferguson told Bloomberg Television. Merkel’s strategy means the “outlook for the euro has definitely improved.”

To contact the reporters on this story: Tony Czuczka in Berlin at aczuczka@bloomberg.net; Simon Kennedy in London at skennedy4@bloomberg.net

To contact the editor responsible for this story: James Hertling at jhertling@bloomberg.net