Angela Merkel at the heart of Ireland's bailout

The international bailout of Ireland’s economy is another epic moment in the crisis of the eurozone. Angela Merkel’s government in Berlin is, as ever, at the heart of events. Katinka Barysch maps the political logic that guides Germany’s current strategy. By Katinka Barysch, deputy director of the Centre for European Reform writing for OpenDemocracy.org 

A dramatic week of negotiation and political manoeuvring over the fate of Ireland's banking sector ended late on 21 November 2010 with the announcement that the government led by taoiseach (prime minister) Brian Cowen and finance minister Brian Lenihan had submitted a request for financial aid from the European Union and the International Monetary Fund (IMF).

The outcome, when the details of the agreement are finally reached, is likely to mean that a large-scale funds - perhaps up to €100 billion ($136 bn) - will be made available over three years to prevent the collapse of Ireland's debt-drenched financial system and defend the stability of the euro and the sixteen-member eurozone. This follows the bailout of Greece in May 2010 when the same three institutions as were involved in Ireland - the IMF, the European Central Bank (ECB), and the European Commission - pledged €110 billion ($146 bn) to support the tottering Greek economy.

Germany's finance minister Wolfgang Schäuble, in emphasising that the conditions of the agreement would be "tough", highlighted the connection between Ireland and other vulnerable eurozone states: "If we now find the right answer to the Irish problem, then the chances are great that there will be no contagion effects".

Indeed, Germany - its political, economic, and institutional leadership - has been at the decisive centre of the eurozone's financial troubles in this dangerous year, in ways that deserve a closer look. Why has German policy followed the determined course it has, even at the cost of alienating some of its European partners; and what is its endgame? The beginnings of an answer can be found a month before the Irish bailout, against the unlikely backdrop of a trilateral French-German-Russian summit on 18-19 October 2010 in the Normandy resort of Deauville.

The institutional drive

The leaders of two of the European Union's most powerful states stunned their European partners - and most of their officials at home - by announcing in Deauville that the EU should change the Lisbon treaty and establish a permanent crisis-management mechanism. This mechanism, said Angela Merkel and Nicolas Sarkozy, should include provisions for an "adequate participation of private creditors". In plain English: future rescue-packages might involve a write-down of existing debt. Ten days later, the summit of EU leaders in Brussels made the idea the official policy of the union. The plan has caused political consternation and market panic.

Even before the Deauville deal, bond-holders were well aware of the possibility that any struggling eurozone government may not be fully bailed out. Since the early autumn of 2010, the "spreads" on Greek, Irish and Portuguese bonds - that is, the difference between the borrowing costs of Germany and other countries - had suggested that investors thought a default quite likely. Since Deauville, these spreads have widened even more dramatically, to the point where Ireland has now been driven towards a variation of the three-year rescue-fund that the eurozone states cobbled together in May 2010 - the European Financial Stability Facility (EFSF).

European Central Bank officials have long warned against the idea of setting up an insolvency procedure at a time when markets are so nervous. George Papandreou, the Greek premier, argued that Germany's insistence on an insolvency mechanism could drive some eurozone countries into bankruptcy. The Financial Times reported "increasing accusations that Ms Merkel has put many of her fellow eurozone leaders in untenable positions to reinforce her own standing with German taxpayers" (see Peter Spiegel & Gerrit Wiesmann, "Anger at Germany boils over", Financial Times, 16 November 2010). Many senior economists and policy-makers have been calling on the German government to drop the plan and instead prolong the life of the EFSF beyond its designated expiry-date of June 2013. There are three reasons why it is unlikely to do so: legal, economic, and political.

The legal framework

Germany's mighty constitutional court is still examining whether the EFSF is compatible both with the German constitution and with European Union law. Lawyers in Brussels say that the EFSF (and the Greek rescue-package) do not contravene the no-bailout clause of the Lisbon treaty; they also cite that treaty's Article 125, which says that individual EU governments should not be liable for any other's debt - but if they choose to help each other voluntarily, that's fine. German politicians and the country's constitutional court disagree. They think almost any budgetary assistance from one country to another could contravene EU rules.

The court is unlikely to declare the EFSF illegal: the latter can plausibly be portrayed as an emergency measure. But the judges will probably tell the government that it must not stage similar rescues in the future unless the EU treaty is changed to build a solid legal base that allows this to happen.

Germany's finance ministry initially aimed at changing Article 125 itself. But it has since shifted its focus to other articles that look easier to amend, notably Article 122 (which allows EU governments to help each other in case of natural disasters or "exceptional occurrences") or Article 136 (which allows eurozone members to set up new procedures and mechanisms among themselves to make the euro function better).

The economic context

Politicians and officials in Berlin tend to play down potential pressure from the constitutional court. They insist that there are sound economic reasons why eurozone governance needs "a new pillar". The Germans no longer seem to believe that EU fiscal rules and sanctions - even if they are made tougher - will be enough to impose discipline on all eurozone members.

The logic of this view is that future crises are possible, even likely. If and when they happen, they will be a problem for the eurozone as a whole. Today, contagion spreads quickly from one troubled country to another. German, French, Dutch and Belgian banks sit on billions of euros worth of Greek, Portuguese and Irish debt. If the even bigger debt-piles of Italy and Spain are added, it becomes clear that the solvent "core" eurozone countries have little choice but to help their more highly indebted neighbours in a crisis. The Germans, in other words, have accepted that the Greek and now Irish bailouts are unlikely to be the last. Hence their determination to set up a permanent rescue-fund.

However, the existence of such a fund could itself encourage fiscal recklessness, a problem economists call "moral hazard". Some politicians, safe in the knowledge that help is available, may be tempted to promise tax-cuts or generous welfare cheques that their national budget cannot afford. Investors would buy that debt, relying on other eurozone governments to bail them out in the event the borrowing country can no longer repay them. Even the remote risk of a country being unable to service its debt could make investors pay more attention to the sustainability of its public finances. Although current borrowing costs for Ireland (and others in a comparable position) are driven by panic, some differentiation between eurozone countries with sound budgets and those with shaky ones will be welcome in the future.

The political logic

German officials still shudder at the memory of the tense days in May 2010, when Angela Merkel's government faced a tough job in getting the Greek bailout and the EFSF through the Bundestag (national parliament). The opposition threatened to vote against the rescue and demanded that the government ensure that "speculators" would never again be allowed to benefit from eurozone turbulence. To placate the critics, Merkel called for an international financial-transaction tax and announced a unilateral ban on naked short-selling of certain stocks and bonds. The opposition abstained and the package was passed. But Merkel thinks that she cannot return to the Bundestag with another bailout package unless it foresees the possibility that private investors, and not only taxpayers, are involved.

The European Commission and many EU governments urged the Germans to delay the new mechanism until the EFSF has proven its worth, Greece and the other troubled countries had some time to restore fiscal stability, and markets have calmed down.

But the Germans are in a hurry, for two reasons. First, they want to forge agreement on the mechanism while the crisis instils a sense of urgency in their EU colleagues. Second, they want the mechanism in place by the time the EFSF expires in June 2013, and well before the German parliamentary election in October that year. Even changes adopted under the "simplified" procedure that the EU intends to use for this will have to be ratified in all twenty-seven member-states, which may take a year or longer.

Moreover, parliaments will only agree to a treaty amendment if they can fathom what the new mechanism will look like. That question is still wide open. For now, the German finance ministry seems to have decided only that the new mechanism, like the EFSF, will rest on an intergovernmental agreement rather than create a new EU institution; that the International Monetary Fund will be involved somehow; that "restructuring" clauses will apply to new - and not outstanding - debt; and that an insolvent country will first get a grace period of a few years before any debt write-downs become possible.

The hard work on creating this new "pillar" of the eurozone has barely begun. It will be technically complex and politically divisive.

Nevertheless, the Germans appear to be determined to see it through. "We are begging our neighbours to help us build a mechanism so we can help them", says one German official with a sigh. But he then tellingly adds: "If the other euro countries want to set up their own rescue fund without us, that's fine by us too".