Challenges for Europe's Economic Core: Germany

5 MINS READMar 22, 2012 | 12:27 GMT

Editor's Note: This is the first installment of a series on domestic political challenges facing Germany, France and the Netherlands. These countries, which make up the geographic and economic core of the eurozone, have united to press for austerity in the currency bloc, backing financial assistance to struggling economies in exchange for agreements over tighter surveillance and control of national budgets. They have acted more or less together in the past two years, but in the coming months, domestic obstacles for each will weaken their unity.

Among the core economies of the eurozone, Germany is the most important member, but it — as well as France and the Netherlands, the other core countries — will face strong political challenges in the coming months. The signing of the European Union's fiscal compact and a decision on an increase of the bailout funds are of wider European importance and will show how strong Germany's coalition government is. While Berlin demands greater fiscal responsibility from other countries, support for such measures within Germany will be tested in regional elections.

Germany is the eurozone's largest economy and the most important to the stability of the euro. Germany is one of the four remaining AAA-rated countries in the eurozone (the others being the Netherlands, Finland and Luxembourg) and the largest guarantor in the two European bailout funds. In the European Financial Stability Facility (EFSF), Germany guarantees nearly 30 percent of the total 726 billion euros ($957 billion). Berlin will guarantee 27 percent of the paid-in capital (80 billion euros) and guarantees (620 billion euros) in the new European Stability Mechanism (ESM). By spreading its economic influence across the rest of Europe through the common market and common currency, Germany creates more domestic wealth and weakens less-competitive European economies.

Germany needs the rest of Europe as an export market for its industrial base. Ensuring the continuity of the European Union and the euro is a top priority, and so Germany must continue supporting the periphery financially — by serving as a destination for workers and goods and by stabilizing the common currency through its economic heft — in order to allow peripheral countries to continue consuming German goods.

Since the start of the European sovereign debt crisis in 2010, when Greece received its first bailout, Germany has tied financial assistance for ailing economies to fiscal responsibility and tighter control over government finances. Germany's pushes for more austerity measures in exchange for assistance can be politically controversial, especially if Germany is seen as making these demands unilaterally.

EU-Wide Measures and Domestic Politics

The three-party coalition government led by German Chancellor Angela Merkel will need two-thirds of both parliamentary chambers to ratify the fiscal compact that 25 of the European Union's leaders signed March 2. The compact, which calls for greater fiscal responsibility for governments, can be considered a German initiative. Germany's parliament is expected to vote on the issue by the end of May. The opposition in Germany will not derail the ratification process, but questions remain about how much the opposition will be able to weaken Merkel's coalition and get concessions from the government in exchange for support for the fiscal compact.

Merkel will also have to decide on whether the EFSF and ESM should be combined. This would also require parliamentary support. So far, Germany's standpoint has been that the new ESM, with a funding volume of 500 billion euros, is sufficient. However, the pressure on Germany to combine the two funds has increased. The International Monetary Fund (IMF) and countries outside Europe have said they would only be willing to support the Europeans if they show greater financial commitment to ending the crisis.

Austerity and Germany's Regional Elections

The last challenge facing Merkel's government this quarter will be domestic regional elections. After a collapse of the minority government led by the Social Democratic Party and the Green Party, the Bundesland of North Rhine-Westphalia — the most populous Bundesland in Germany — called for early elections. The elections must be held within the next 60 days. Furthermore, Laender elections will be held in Saarland (March 25) and Schleswig-Holstein (May 6).

The outcomes of these elections will not directly affect Merkel's government. However, as she prepares for national elections in late 2013, she will be considering how to attract voters from the left and how to accommodate opposition parties in order to preserve the possibility of finding a new coalition partner to replace the Free Democratic Party, which is expected to weaken further in the upcoming regional elections and might not even be included in regional parliaments after the votes. In making concessions to the opposition parties, Merkel likely will have to re-evaluate her stance on austerity, at least domestically.

Germany's demands for austerity in peripheral countries serve a domestic purpose, making the use of German funds to bail out other countries more palatable for German voters. The strategy has worked so far, as Merkel's high popularity levels have shown. But this does not mean Germans want to choose austerity for themselves. The regional elections likely will show increasing popularity for parties that do not favor as much austerity as Merkel's government has been pushing for so far.

The Response in Wider Europe

The peripheral European countries probably will relax their implementation of austerity measures while Germany's government deals with domestic issues. Because Germany needs to prevent the collapse of the European Union and eurozone, Merkel cannot afford to withhold aid or fail to increase the European bailout funds as a means of pressuring troubled countries to tighten their budgets.

Merkel's best argument for austerity in Germany and the rest of Europe will be market pressure. The rise in bond yields in 2010 and 2011 was so extreme that it became too costly for Greece, Ireland and Portugal to borrow on international markets. The countries had to seek assistance from the IMF and European Union and, in doing so, were forced to implement reforms and austerity measures dictated from abroad. The fear of being locked out of international markets led countries across Europe to announce austerity measures and implement economic reforms in an attempt to highlight their ability to bring their deficits and debt levels down and regain market confidence.

However, since December 2011, the European Central Bank has provided the European financial sector with two rounds of long-term lending. Banks have used this fresh money to buy European sovereign debt, bringing down bond yields. This trend is likely to persist in the coming months.

Merkel's government will be occupied with domestic politics in the coming months. As elections test the popularity of austerity measures within Germany and lower market pressure makes economic reform seem less urgent elsewhere in Europe, Merkel's government will have less credibility in its calls for fiscal responsibility abroad.

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