Editorial Board

Saving the Euro or the Next Election Is Merkel’s Dilemma: View

German Chancellor Angela Merkel faces a big choice in deciding how to handle the European debt crisis: Do what is politically expedient, or do what is best for her country, the European Union and the global economy.

Events across the Atlantic are overshadowing the pomp and ceremony of Merkel’s visit to the U.S. this week. If European officials don’t come up with a credible plan to contain the financial troubles in Greece, Ireland and Portugal, the U.S. recovery could be among the casualties.

As leader of the euro area’s largest and wealthiest member state, Merkel has the power to stem the crisis. Given the politics in Germany, though, she has little incentive to take the bold moves needed.

Life is good for Germans at the moment. The country’s exports are booming, thanks in part to the crisis-weakened euro, and in part to the concessions German workers have made in recent years. Unemployment is falling, the economy is growing and business confidence is near a 20-year high. The benchmark DAX stock index has gained 21 percent in the last 12 months. Such strong performance tends to dull any sense of urgency.

With Merkel’s Christian Democratic Union party struggling to regain momentum ahead of federal elections in 2013, asking Germans to bail out the euro area’s more profligate members would be politically fraught. On the other hand, a debt restructuring that involves big losses for German banks -- with $22.7 billion in loans outstanding, they are the Greek government’s single biggest lender -- might trigger another financial crisis.

Vienna Initiative

Expediency would suggest Merkel find a middle way. She could, for example, endorse a version of the Vienna Initiative, in which private creditors agree to purchase new Greek bonds when existing ones mature. Used in Eastern Europe in 2009, the approach has drawn the support of European Central Bank President Jean-Claude Trichet and the European Union’s economic and monetary affairs commissioner, Olli Rehn.

The proposal would give Greece more time to get its debt burden on a sustainable trajectory, and banks more time to prepare for a restructuring that may prove inevitable. To give it teeth, Merkel could propose that the ECB automatically stop accepting as collateral the bonds of Greece, Portugal or any other member state that failed to meet specific fiscal targets within three years.

Such a deal, however, is unlikely to calm markets. Investors would still worry about the impact on banks if Greece failed to fulfill its promises. More importantly, Merkel would be wasting an opportunity to fix the flaws in the euro area that the crisis exposed.

Fiscal Union

Without some sort of fiscal union in which tax revenue can flow across borders, the common currency puts too much of a burden on economies that fall out of sync. The massive public and private debts of Greece and Portugal arose in part as a result of large trade deficits -- deficits that exchange-rate adjustments could have alleviated if they had their own currencies. Now, they must undertake the difficult task of restoring competitiveness by lowering wages, even as they cut government spending and struggle with stagnating or shrinking economies.

In what could be viewed as the world’s largest currency union, the U.S., automatic federal transfers such as unemployment insurance and tax credits for low-wage earners help the states get through hard times. A supra-national finance ministry could make similar fiscal transfers in Europe, helping to ease the cyclical part of the pain as countries undertake structural reforms.

Fiscal Transfers

Fiscal transfers in Europe might not be as expensive as they seem. In the U.S., money from Washington generally covers about 30 percent of states’ income shortfalls. Using that rule-of-thumb, a similar fiscal cushion for Greece would cost about 7.5 billion euros, or about $11 billion, in 2011. That’s 0.3 percent of Germany’s projected economic output and less than 0.1 percent of the entire euro zone’s.

Tellingly, Trichet, one of the few officials involved who doesn’t have to worry about re-election, suggested last week that the euro area consider creating a unified finance ministry, a precursor to a fiscal union.

Without a fiscal union, the euro area will see more crises and could ultimately fail as a currency union. That would be a loss for all its members, Germany included. Hence, as President Barack Obama hosts Merkel at tonight’s state dinner, he might want to pose a question: How do you want to be remembered, as the politician who saved her party’s chances in the 2013 elections, or as the politician who saved the euro?

    To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net .

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