German Chancellor Angela Merkel  seems to be channeling her 19th century predecessor, Otto von Bismarck, in a striking way; engineering a diplomatic balancing act wrought with internal contradictions. Even as she seeks to placate anxious Southern European governments with bailouts, she steadfastly rejects the idea of common European debt known as Eurobonds. Her delicate strategy, like Bismarck’s, seems destined to suffer a tragic fate. Moody’s downgrade last week of Germany’s credit rating outlook signals that time is running out.
Bismarck devised an elaborate system of overlapping treaties and pacts to support Germany’s rise to power while he isolated Germany’s principal rival: France. Similarly, Merkel is committed to preserving German power through support of greater European integration, yet she is equally committed to avoiding measures that would place a permanent burden upon Germany’s economy through common European debt.
Eurobonds are a scheme worth fighting against. Their implementation would signal German support of profligate Eurozone governments in perpetuity. Proponents of a common debt argue that there would be new stringent rules, such as sovereign risk-based borrowing limits enforced by the threat of expulsion, preventing countries from running excessive deficits. But this is fantasy.
Europe has already tried making rules to keep debt under control, and failed. The European Union created the Stability and Growth Pact (SGP) in 1997 to keep annual deficits under 3 percent of GDP and debt-to-GDP below 60 percent. The agreement even called for sanctions against rule breakers. Yet when France and Germany became the first violators in the early 2000s, EU officials simply changed the rules.
A 2005 amendment to the SGP allowed deficits and debts to be in excess of the limits if the country in question were to experience “a severe economic downturn” and a “protracted period of very low annual GDP volume growth relative to its potential.” Breaking the rules was easy as long as governments could portray themselves as under-performing economically.
The threat of a Eurobond member having its bond issuing privileges revoked isn’t credible. Given the staunch support of European leaders to keep countries like Greece in the common currency, after the Greeks egregiously broke the rules and then cooked the books to cover it up, it seems highly unlikely that Eurobond rule breakers would get the boot from the common debt club. Merkel is right to tread lightly here. One small misstep could usher in the creation of another European project that Germany will end up underwriting. And it would cost much more than the threat of a credit rating downgrade.
But the Chancellor can’t just say “nein” to her southern neighbors. To preserve the euro, Merkel must offer an alternative. So far, this has meant bailouts. But with Greece still squirming after two major rescue plans and Spain having negatively revised its growth forecast just days after the German parliament authorized €100 billion in aid, it seems the bailout option is only putting off inevitable default.
Carmen Reinhart of the Peterson Institute for International Economics and Kenneth Rogoff of Harvard University  found in a 2008 study that debt in excess of revenue by 421 percent is the historical average threshold for default. Total sovereign debt exceeds central government revenue by 602 percent in Greece and 432 percent in Spain, according to Eurostat data. Meanwhile, Greece spends a whopping 25 percent of revenue on interest payments and Spain pays 16 percent. The Eurozone average is 13 percent.
Just as Balkan conflict was the bane of Bismarck’s careful diplomacy, the inevitability of default in the Eurozone periphery is the canary in Merkel’s coalmine.
Merkel and her Christian Democrat Party (CDU) face trouble on the home front too. According to a recent Infratest-ARD survey, the CDU’s coalition ally, the Free Democratic Party, has fallen below the minimum threshold to win seats in parliament. Meanwhile, the Greens, a likely coalition partner for the CDU rival Social Democrats, have soared in popularity. Elections aren’t scheduled until fall 2013, but a constructive vote of no confidence in the Bundestag could change Germany’s leadership at any time.
Bismarck’s elaborate and contradictory system of alliances was doomed to collapse from the collision course of Austria and Russia in the East. But his ouster upon the rise of Kaiser Wilhelm II catalyzed that process as the new emperor’s reckless foreign policy marched Europe toward war in 1914. Default in the Eurozone periphery—if it hasn’t already happened with the Greek bond haircut in March—is the inevitable end that Merkel futilely forestalls. But her replacement with an advocate of greater European bureaucracy and profligacy could send already jittery markets into a panic that would bring Europe to its knees.