Mohamed El-Erian On Germany's Lose-Lose Position

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Germany in a lose-lose situation,
Posted in the FT and soon to appear in PIMCO's website

Germany. It goes to Thursday’s two-day European summit in Brussels in a
visible lose-lose situation, and with no easy way out of a complex
dilemma that pits good politics against bad economics. Its hard-fought
economic gains, earned over many years through restructuring and fiscal
discipline, are threatened by the crisis in peripheral eurozone economies
that adopted a different policy approach. To add to the irony, these
challenged countries (and indeed the zone as a whole) now look to
Germany to fund one rescue package after another.
Up to now,
Germany has co-operated. It has been the biggest contributor to the
bail-outs for Greece and Ireland. It has also supported the European Central Bank’s decisions to buy peripheral government bonds,
and to provide unlimited liquidity to struggling banks. In doing so
Germany has sought to buy time for the weaker members (and European
banks) to get their houses in order – as well as to reduce pressure on
the integrity of the zone as a whole.

course Germany’s support has not been unconditional. It has insisted on
serious policy corrections from profligate peripheral European
countries. It has also pushed for a sovereign debt resolution mechanism that,
starting in 2013, would ensure that the burden of adjustment is not
carried just by taxpayers but also by creditors and shareholders. And it
has resisted multiple calls to stimulate its internal demand and thus
act as an economic locomotive for the eurozone as a whole.

problem is that this approach – centred on dealing with liquidity
problems now and solvency issues later – is not working. On Wednesday,
credit ratings agency Moody’s threatened further to downgrade Spanish government bonds,
because of problems associated with raising funds in 2011, along with
difficulties with its banks. More generally, rather than being reassured
by the provision of liquidity to peripheral countries, existing
depositors and creditors have used the rescue funds to exit their
holdings. Meanwhile, new money remains sidelined by concerns about these
countries’ debt overhang and their lack of competitiveness.

investment in peripheral Europe means fewer jobs and deeper economic
contractions, making it even harder to deliver austerity plans that are
already contributing to social unrest, including Wedneday’s disturbances in Athens.
So the pressures on Germany to do more are rising. In the last week,
Germany has been called upon to back even more ambitious bailout
initiatives, with proposals to create a unified European bond
and double the size of the emergency funding facility for peripheral
countries. In the process, the country also finds itself in a growing
standoff with an ECB that now wants to limit the weakening of its own
balance sheet.

Sensing the risk that Germany’s balance sheet (and
that of the ECB) may continue to be contaminated by someone else’s
problems, the markets have started to signal some initial concerns about
the country’s fiscal robustness. In addition to some jitters at a
recent government bond auction, German interest rates have followed
American ones sharply higher even though the two countries’ fiscal paths
diverge dramatically.

All this highlights the dilemma facing a
Germany that feels politically compelled to support a liquidity approach
for peripheral Europe’s solvency problem, but knows the economics of
the situation are wrong and, ultimately, harmful. A liquidity approach
that delays the day of reckoning may be good regional politics, but its
bad economics. It does not restore sustainable growth to the periphery,
and it exposes the core to contamination – be it through peripheral
liabilities being transferred to the German tax payer or the ECB’s
balance sheet coping with by purchases and repos of peripheral bonds.

is not the first time that Germany faces such a dilemma. After the fall
of the Berlin wall, West Germany judged that good politics trumped bad
economics, and agreed to reunify with much-weaker East Germany at a
one-to-one exchange rate. It took years to overcome the costs of this

The situation this time suggests good economics should
play a greater role. Rather than simply doubling up on a faltering
liquidity approach, the time has come for Germany to lead a more
holistic solution focused on addressing the periphery’s debt overhang
and competitiveness problems.