Germany, the economic vanguard of the EU

angela_merkel.gi.top.jpg By Katie Benner, writer


(Fortune) -- Ever since the Greek crisis came into focus, German Chancellor Angela Merkel has been accused of exacerbating it by refusing to commit straightaway to a Greek bailout. As Greece's uncertain economic picturepummeled global markets that accusation gained steam. But Germany may have gained an economic advantage in dragging its feet, and even now that it has agreed to the nearly $1 trillion bailout, the country stands to reinforce its position as the strongest player in the eurozone.

Germany's export-based economy has likely already been helped by the prolonged weakness in the euro. The euro's dwindling value has made its high-end goods -- think Krups espresso makers and BMW (BMWG) SUVs -- more competitive in the global economy. The government recently announced that German industrial production jumped by 4% in March, beating analyst estimates that it would gain 1.7%, a huge uptick after a slow start to the year. German factory orders beat expectations with a 5% rise in March. And unemployment there fell for a fifth consecutive month in April, dropping faster than analysts' estimates.

Sebastian Galy, a currency strategist at BNP Paribas, adds that prolonged weakness in the euro will actually help the crisis pass, and not just for Germany. "The countries that are less efficient than Germany also need to deflate and be competitive in terms of the rest of the world," says Galy. "It's a good scenario from a purely economic viewpoint."

Is Merkel the Greek word for austerity?

Problems in Greece and fear of economic contagion have given Germany the political cover it needs to force fiscal austerity on its more profligate neighbors. Member states were supposed to meet strict deficit and debt standards to gain entry, but fiscal rectitude among countries has varied broadly over the 12-year history of the eurozone. Germany has been unable to impose its Teutonic discipline on other governments until the crisis reached a fever pitch and it wrung concessions from Greece.

The recently passed bailout measures will likely allow Germany to push other countries, like Portugal and Spain, to fall in line as well. If these countries can't convince the market that they are belt tightening and strong enough to pay their debts, they'll be forced to accept austerity measures in exchange for aid. Now even larger, healthier economies are exempt from pressure to have their houses in order. The EU's monetary affairs chief Olli Rehn has also publicly said that Italy and France must tighten their fiscal belts, too.

Much like America's bailout of Wall Street, Europe's decision to throw money at the problem doesn't address the core problem that sparked the crisis: spending that far outweighs income. But attaching the strings of forced fiscal responsibility to financial aid does curb profligate behavior. No doubt Greece's economy will deflate now that it can't abuse credit, but Germany realizes that the country and eurozone will never return to health unless runaway spending ends. Countries that can't pay their debts could threaten Germany, whose banks are large lenders. While Germany committed to a bailout of Greece to stave off the contagion among other debt-ridden countries, it was also preserving itself. To quote Germany's draft bill of the bailout proposal: "A further acceleration of the situation would not only risk the default of these states but also result in a serious threat to the financial stability of the monetary union as a whole."

Investors still bet on Germany

There is little doubt that uncertainty will hang over aid to Greece. The country is still stymied by popular unrest over proposed austerity measures, and no one is sure how long it will take for the country to get its fiscal house in order.

But the crisis has made completely clear to investors that Germany is the true economic powerhouse of the eurozone. That means its the most influential country on the Continent, but more importantly, it's the nation most worthy of foreign investment as well.

Investors who have not sought the safety of Treasuries are moving out of peripheral European government debt and into German sovereign bonds. John Higgins, a senior markets economist at Capital Economics, wrote in a recent note that he sees continued support for highly rated German government bonds. "With core inflation in the euro-zone also set to remain very subdued, we think 10-year German Bund yields could fall even further over the summer, to around 2.5%, and stay low through the remainder of this year and next," he writes.

Eventually, the smoke will clear, and stability is likely to return to Europe as a whole. But what will that Europe look like, and what role will the country that bridges east, west, north and south, look like?

There is an understanding that the eurozone can't get into this situation again, says RBS chief forex strategist Alan Ruskin. So Germany may be able to push other countries to agree to create new parameters that keep deficits from increasing to these levels.

More radically, Germany and the EU may realize that they are trying to hold together a system with too many structural problems. "At some stage, Germany may well opt for a different approach," says PIMCO chief executive Mohamed El-Erian. "Should this happen, and it is not guaranteed, Germany could opt for a smaller [eurozone] consisting mainly of countries with similar approaches to Germany when it comes to economic policy formulation and implementation."

In other words, even though Germany will help the PIIGS now, it may not be willing to tolerate them forever. Chances are that when that day comes, no other country in Europe will have the economic clout to say otherwise. To top of page

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