German court approves plan to save Europe. But is it a good plan?

September 12, 2012

At long last, the shiny new plan to save Europe is coming together. On Wednesday, Germany's constitutional court gave its much-awaited okay to the European Stability Mechanism (ESM), a newly created €500 billion ($640 billion) rescue fund for indebted euro zone governments. Until now, that was the big question mark—an unfavorable court ruling would have brought Angela Merkel's plan to salvage the euro crashing down.


Merkel can breathe easy... for now. (Markus Schreiber/Associated Press)

So we can now see how this plan will work. If a country like Spain or Italy sees its borrowing costs rise to unsustainable levels, risking a bond yield death spiral, then its government can go ask for help from Europe's bailout fund (with the new ESM, the euro zone will have about $830 billion for rescuing purposes). The country will most likely have to abide by new terms and conditions imposed by the rest of Europe, much like Greece and Portugal did when they got bailed out. They'll have to limit deficits to 3 percent of GDP. Once that happens, Mario Draghi will crank up the European Central Bank's printing presses, buy up bonds, and bring the troubled nation's borrowing costs under control. Crisis averted!

So is this a decisive solution? That's still not clear. There are plenty of potential hitches. For one, struggling countries like Italy and Spain would actually have to go request help first. They might not. Italy's leaders are still hoping they can rein in their debts without aid from the rest of Europe. Spanish Prime Minister Mariano Rajoy, meanwhile, has said he doesn't want to apply for a bailout until he knows what the conditions will be. After all, German-imposed supervision isn't likely to go over well with Spanish voters.

This tension could prove problematic over the long run. Mario Draghi and the European Central Bank have said they'd only act to quell the sovereign debt crisis under certain conditions. But what if those conditions aren't met? Say Spain applies for aid and agrees to open its books to Germany and liberalize its labor-market regulations. But then protests ensue, and Spanish voters usher in a new government that reverses the austerity agreement. At this point, either Draghi stops buying Spanish bonds — and risks letting the crisis flare up again — or he starts supporting Spain unconditionally. The former is risky. The latter would make Germany awfully irate.

This might all sound like a weird hypothetical. But as long as the grand euro zone rescue plan relies on grinding austerity to bring down public debts, there will always be some risk of political brinksmanship. As Martin Wolf points out, this newest plan doesn't alter the most intractable dynamics within the euro zone: "[T]he risks of a breakup cannot be eliminated. If these are to disappear, citizens of debtor countries must see a credible path to growth, while citizens of creditor countries must believe they are not throwing money down a bottomless pit. What the ECB has done is win some time. It has not won the game."

As always, economic growth would help. Europe's perpetual recession is making everything harder — even the poster child for austerity, Portugal, is having a tough time reining in its deficits. But it's tough to see where further growth will come from. The European Central Bank can't just start "stepping harder on the monetary accelerator" to boost inflation and growth in the euro area, as Wolf says, because German officials are adamantly opposed. "The difficulty for the ECB," Wolf notes, "is that relevant and appropriate measures are viewed, in Germany, as a giant step on the dismal path to hyperinflationary ruin."

So, instead, Europe's leaders have devised a compromise plan that's supposed to quell the immediate financial panic, bring down leaping bond yields, and at the same time placate German voters who are tired of bailing out their neighbors. (Although, as Gavyn Davies points out, the German private sector has about $1 trillion invested in Portugal, Italy, Ireland, Greece, and Spain, so the Germans have a lot to lose from a euro collapse, too.) Remember, Merkel is facing a tough re-election fight in 2013. The plan might not fix all the problems with the euro zone. But it could at least enable Europe to muddle through its crisis for a bit longer.

Related: From Krugmania to Draghia: Five ways to save the euro zone

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Ezra Klein · September 12, 2012