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Angela Merkel’s Pyrrhic victory


As far as Germany is concerned, the drama of the euro crisis is over. The subject was barely discussed in the country’s recent election campaign. Chancellor Angela Merkel did what was necessary to ensure the euro’s survival, and she did so at the least possible cost to Germany – a feat that earned her the support of pro-European Germans as well as those who trust her to protect German interests. Not surprisingly, she won re-election resoundingly.


But it was a Pyrrhic victory. The eurozone status quo is neither tolerable nor stable. Mainstream economists would call it an inferior equilibrium; I call it a nightmare – one that is inflicting tremendous pain and suffering that could be easily avoided if the misconceptions and taboos that sustain it were dispelled. The problem is that the debtor countries feel all the pain, while the creditors impose the misconceptions and taboos.


One example is Eurobonds, which Merkel has declared taboo. Yet they are the obvious solution to the root cause of the euro crisis, which is that joining the euro exposed member countries’ government bonds to the risk of default.


Normally, developed countries never default, because they can always print money. But, by ceding that authority to an independent central bank, the eurozone’s members put themselves in the position of a developing country that has borrowed in foreign currency. Neither the authorities nor the markets recognized this prior to the crisis, attesting to the fallibility of both.


When the euro was introduced, the authorities actually declared member states’ government bonds to be riskless. Commercial banks could hold them without setting aside any capital reserves, and the European Central Bank (ECB) accepted them on equal terms at its discount window. This created a perverse incentive for commercial banks to buy the weaker governments’ debt in order to earn what eventually became just a few basis points, as interest-rate differentials converged to practically zero.


But interest-rate convergence caused economic divergence. The weaker countries enjoyed real-estate, consumption, and investment booms, while Germany, weighed down by the fiscal burden of reunification, had to adopt austerity and implement structural reforms. That was the origin of the euro crisis, but it was not recognized at the time – and is not properly understood even today.

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