EUROZONE CRISIS:

GERMANY’S RESPONSE IS LIKELY TO BE

TOO LITTLE TOO LATE

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 EUROZONE CRISIS: GERMANY’S RESPONSE IS LIKELY TO BE TOO
LITTLE TOO LATE

KEY JUDGEMENT
The German government has been trying to persuade its citizens of the importance of helping the Eurozone
and preserving the euro. But ahead of the 30 January EU Heads of Government meeting, senior politicians
in all the ruling parties have brushed aside the need for more German financial assistance for the Eurozone
in favour of more austerity by southern Europe. By the time the economic impact of the crisis creates more
urgency to respond in Germany or a new, more helpful, coalition comes into power, it will be too late to
contain the contagion from the Greek crisis to other Eurozone economies and the banking sector.

DETAILED ANALYSIS
The German government has been trying to communicate the benefits of the euro to swing public opinion in
favour of more German bailout funds for the Eurozone. But there is a high risk that further action will come
too late to provide sufficient financial buffers to avert the contagion to other Eurozone economies of
sovereign non-payments by Greece.

Rather than prioritising financial firewalls to reduce the contagion from Greece’s likely sovereign non-payments,
Germany looks set to prioritise austerity and fiscal discipline at the European Heads of Government meeting of
30 January. Announcements about how the EU is to cope with this crisis will likely include some mention of
bailout mechanisms. But these will likely be in the form of wish lists again rather than sufficient and transparent
financial resources. Germany is reluctant to increase the size of bailout mechanisms, issue joint Eurobonds or
give the ECB free reign to act as a lender of last resort to European banks.

The government is aware of the risks of contagion to Germany and the euro of this inaction. Our sources in
Berlin assess that the government is increasingly trying to make German financial support more palatable to its
population. German government communications are focusing more on examples of its benefits for Germany,
estimates of the costs of a Eurozone breakup and reports of how southern Europeans have accepted fiscal
disciplines. But this approach is too gradual; should Greece default on its sovereign debt by March, a likely
scenario, sufficient financial buffers are not in place to mitigate contagion from Greece to other heavily indebted
economies such as Portugal, Ireland, Italy and Spain.

The German population is not sufficiently alarmed about the Eurozone crisis to make the financial sacrifices
required e.g. risking its triple A rating by issuing joint bonds with other governments or risking a permanent
culture of fiscal transfers to poorer southern European countries.

Our sources in Germany report the longstanding concern among the population that permanent fiscal transfers
between northern and southern Europe should not become the norm in the Eurozone, as in German provinces.
Wealthy German states like Bavaria, Hesse, Baden and Hamburg are resentful of the fact that they transfer some
7.3bn euros per year to poorer German states. For Bavaria, the largest donor, this amounts to some 11% of its
tax revenue. Even the poorer recipients of these transfers are concerned that any similar payments to the
Eurozone will reduce what is left of German tax revenue for them. Hence, Merkel’s attempts to reinforce the
fiscal disciplines in the Eurozone to mitigate these risks and concerns.

30 January 2012 | PAGE 1

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 EUROZONE CRISIS: GERMANY’S RESPONSE IS LIKELY TO BE TOO
LITTLE TOO LATE

The sense of crisis that facilitated legislative approval of bank interventions in the US and the UK during the 2008
crisis are absent in Germany. With unemployment at its lowest in 20 years and the GfK index of consumer
sentiment showing increasing optimism about the economy, the population and politicians have insufficient fear
of impending contagion from the crisis to readily accept more costs of bailing out the Eurozone. Some concerns
about an increase in business bankruptcies are pushed to the back of most minds; in January, the Bundesbank
president called the IMF too pessimistic in response to the institution’s forecast of 0.3% GDP growth for
Germany for 2012.

The German population is likely to feel the contagion from the Eurozone crisis to the economy and banking
sector during 2012/13, but by then it will likely be too late to contain the contagion to the rest of the
Eurozone from likely Greek default.

A sense of crisis is more likely too late in the second half of 2012 when Germany’s economic outlook is likely to
deteriorate along with the purchasing power of its main export markets. In addition, the fiscal rules and austerity
measures that Merkel will be seeking approval for in the European Council meetings are likely to produce deeper
economic downturns in the Eurozone, including Germany. Banks have already started scaling back their lending
as they struggle to reduce the size of their balance sheets to achieve regulatory capital ratios.

The German government is also likely to have to bail out large and systemically important domestic banks
exposed to the risks of sovereign debt defaults by Greece, Portugal, Ireland, Italy and Spain such as
Commerzbank (19.7bn euros), Hypo Real Estate (11.1bn euros) and Deutsche Bank (12.8bn euros). The German
government has recently reinstated its bank rescue fund that intervened in these same banks (among others)
during the 2008/9 financial crisis. This is likely to spark political criticisms such as a survey in November 2011,
which found that eight in 10 German citizens were against using public funds to rescue banks.

The next elections are likely to produce a coalition government that is more supportive on financial bailouts
for the Eurozone than the CDU-CSU’s current coalition partner FDP. But new elections are unlikely until
September 2013.

The most likely outcome of elections in 2013 is a coalition between SPD and CDU-CSU, a combination that will
likely be more in favour of giving financial assistance to troubled Eurozone economies and issuing Eurobonds.
Such a “grand coalition” appears likely given the relative weakness of both parties, and the dispersal of the
remaining votes between four even smaller and weaker parties (Greens, the Left, FPD and Pirates). Merkel
would find it easier to pass policies on Eurobonds and financial guarantees with the SPD and Greens who have
voted with her all along on Eurozone policy. The leadership of the CSU and the FDP (the other two parties in
government with the CDU) are vocally in favour of more fiscal discipline and against more financial support from
Germany.

30 January 2012 | PAGE 2

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