Many European politicians lament Germany's reluctance to commit funds to resolve the Eurozone's (EZ) balance-of-payments crisis. The 'euro crisis' is indeed a balance-of-payment crisis. Such crisis indicates that several members of the EZ have lived beyond their means and thus accumulated considerable debt. Now, representatives from over-indebted periphery members ask for money to mitigate the adversities stemming from the euro crisis.
The counterparties to these periphery net debtors are the EZ core creditor economies. In this respect, Germany as a core member is currently characterized by a liquid banking sector, a still booming export sector, and low unemployment. Most notably, the price for German indebtedness at bond markets has dropped to historically low levels. Therefore, Germans can easily afford a greater risk exposure to save the EZ stragglers. We argue, however, that Germany only faces the quiet in the eye of a ‘balance-of-payment' storm. Particularly from the viewpoint of foreign investors, the perception of German bonds as a ‘safe haven' - with nominal interest rates literally zero or even negative - might be misleading. Why so?
At the outset of the balance-of-payment crisis within the EZ (say, late 2009/early 2010), European governments did not act to recapitalize their banking sectors that were suffering from the erosion of their assets due to their large holdings of government debt. Instead, consolidation was forced upon private business and households sectors of struggling EZ periphery economies. This has prompted a full-fledged deleveraging process within the periphery. The generally declining output and falling prices (which, in turn, increase the real debt burden) constantly increase risks to the lenders in the private financial sector of net creditor EZ members.
As a result, ever more bailouts and higher ‘firewalls' are put on the political agenda. In the meantime, the debt-deflation spiral slides from the periphery to the core of the EZ. The side-effect is that financial assets are moved from the periphery to the core - a phenomenon which is particularly conducive to the German bond market. However, the EZ balance-of-payment crisis will not come to a halt at the doorway of the German economy. Foreign investors will turn their back on Germany and other EZ core members as soon as they realize that Germany's perceived status as a ‘safe haven' is just that - ‘perceived'. What will happen then?
When concerns mount over future German creditworthiness - as paid-out and pledged funds may eventually overburden the financial capacities of Germany - foreign investors could turn their back on the German government bond market. At this stage, the German administration will alter its policy stance toward EZ crisis resolution. As soon as the benefits of higher expected export earnings vis-à-vis the rest of the world (because of an ailing Euro) and the advantages from declining costs of government debt are offset by foreign investor flight and thus increasing prices for German indebtedness, a policy shift in Germany will most likely occur. At this tipping point, Germany might opt for revaluation once the current benefits of undervaluation are gone. What are the implications?
At such a point, past borrowing from the future may represent a free lunch from the viewpoint of the German government. When exiting the euro by introducing a new legal tender, the new currency (either issued unilaterally or jointly with other European net creditors of the EZ) may considerably revalue against the Euro. In this case, Germany may easily be able to repay its existing external debt in a then devalued Euro. At the same time, the revaluation will be a boost - and not a sting - to the German export-oriented business sector. First, the business sector may also reap windfall profits from paying off Euro-denominated loans. Second, export earnings will rise as long as Germany gains from reduced import prices and a barely elastic external demand for tradables in the short and medium term. Although the German economy will experience some welfare losses, such problems could be outpaced by a full-fledged economic recovery at the start of a newly revalued currency.
It is certainly politics that determines the timing of a German U-turn in opting-out of the EZ as well as the scope of a subsequent economic recovery. The more open Germany is with its wallet full of euros, the faster its creditworthiness will deteriorate. We expect that foreign financial investors will make up their mind in due time and conserve their capital. In doing so, foreign investors would rather stay on the sidelines and wait for an extraordinary German recovery at the commencement of a new currency. Most notably, dismantling the euro in this way, i.e. the core leaving the periphery, may represent the cheapest way of ruling out the debt-deflation spiral, revamping European economies, and preserving the European integration process.
Christian Fahrholz is a senior researcher at the graduate school of Global Financial Markets at the Friedrich-Schiller-University Jena. Former appointments include visiting professorships in Berlin, Mannheim, and Erfurt.
Gernot Pehnelt is Director at the independent research institute GlobEcon, research partner at the Friedrich-Schiller-University of Jena, and Research Associate at ECIPE.
Update October 2012: The authors have published the GlobEcon Policy Brief
Mid- and long-term risks of German Bonds.