3 Reasons Why the Germans Will Allow Unconditional ECB Bond Buying

Spanish Bonds Rise in Week on ECB Faith After Italian Election – Bloomberg.

In this post, Germans Will Allow Unconditional ECB Bond Buying , we put forth the proposition that if a eurozone country was in danger of a sovereign debt default and euro exit it would not have to adhere to conditions in order to activate the ECB’s OMT program.  Germany is calling the shots, and its cost-benefit analysis favors maintaining the eurozone for as long as possible.

The tough talk emanating from Berlin, Frankfurt and Brussels is just that— talk.  Germany is bluffing.  The incompetence of PIIGS politicians is proven by their failure to call Germany’s bluff and use their leverage to extract more generous aid packages.
The biggest losers in the continued existence of the euro are the PIIGS with the winners being the FANG nations.  The reverse is true, too.  The PIIGS find themselves in the winner’s circle in a euro breakup scenario with the FANG losing out.  Germany has the most to lose from a eurozone dissolution.

Germany receives an export subsidy from its eurozone membership, because it is using a currency that is weaker than the fundamentals of its own economy dictate.  Think of the creation of the eurozone as an attempt to average the values of seventeen national currencies.  The Deutschmark was a strong currency, and Germany began using the weaker euro instead.  The lira was a weak currency, and it was replaced by a stronger euro.  This fair value chart bears this out:

Euro Fair Value

The use of the euro has revived the German export machine, which had faltered before the creation of the euro:

German Current Account to GDP Ratio The solid black line shows the trend, up and to the right since the euro replaced the Deutschmark.  Reversion to the national currencies would bestow Germany with an appreciating mark that would squelch imports.  Germany has not developed strong domestic consumer demand, and the loss of its export machine would cripple its economy, an unacceptable cost.

The German taxpayer, through the Bundesbank is owed billions of euros in Target2 balances from the rest of the eurozone.  Rather than moving money back and forth among the different national banks, credits and debits are entered on the Target2 ledger.  Since every country within the system is using the euro, this is not a problem, but what if a country leaves?

A country will exit under extreme financial duress and won’t have the money to pay back the system.  If the Eurozone breaks up, Germany would in effect be left holding the bag.  Its financial system would be owed hundreds of billions of euros.  We promised you three reasons, but here are 600 billion:


The last reason doesn’t come accompanied by a fancy, multicolored chart.  Germany accounts for 27% of the economic activity of the eurozone, so it will also bear that much in costs in case of a breakup with no offsetting benefit.  Transaction costs will rise, and it will be harder for its firms to do business throughout Europe.  This is true for all businesses, but at least the PIIGS will get an export boost and debt relief from reversion to a national currency.  What does Germany get?

A eurozone breakup will cost the German led FANG bloc hundreds of billions of euros while causing a deep economic downturn.  As such, these countries will always find a reason to keep the PIIGS afloat.  To avoid political rancor at home, they will bestow these actions with vague euphemisms to obscure what they really are— bailouts.  Keep this in mind next time you hear a German or Finnish politician intimating that some countries should exit.


Germany Current Account Balance From 1980 to Present

10 thoughts on “3 Reasons Why the Germans Will Allow Unconditional ECB Bond Buying

  1. I love your analysis. You are suggesting that the PIIGs run up the credit card bill before they declare bankruptcy. If they were to throw off the austerity yoke, it would severely challenge Germany’s commitment to monetary probity. In the end, the Germans pay the price either way; either they fund their poorer neighbors to the south until some kind of equilibrium is reached, or they take the hit when the Eurozone comes apart at the seams.

    Two questions: Why haven’t the PIIGs used their leverage more aggresively? Will the PIIGs call Merkel’s bluff?

    • Two possible explanations for why the PIIGS are not using their leverage more aggressively.

      1. They have incompetent politicians.
      2. The politicians are accepting favors we are unaware of.

  2. Hello.
    What about energy costs on the PIGGS after the break up, with the olds crushed currency. how can they afford, oil, gas, eating oil ? who is going to lend to them ? at what rate ?

    • Look to Argentina for your answer. After breaking the peso-dollar link in late 2001, it experienced high inflation for about a year with prices stabilizing.

      As to who will lend these countries money, every country that defaults eventually returns to the debt markets. Investors seem to be very forgiving perhaps more so in this age of very low interest rates.

  3. The PIIGS may have less leverage than you think – German industry has proven in the past that it can live with an appreciating currency. Production can be sourced out, and raw materials become cheaper. And for some products, there is simply no replacement, or the quality difference is too high.

    Also, there is always the danger of an exploding populist anti-European movement in Germany. This has happened at some elections in the last 20 years, mostly on state level, but now a robust nationwide infrastructure for such a movement, the “Freie Wähler” (free voters) exists, as well as a populist left wing party, “Die Linke” and the Pirate party which showed strong in some elections. Up to now, most of these movements self-destructed quickly, but that may change. They are the reason why everyone holds their breath until the federal elections in September.

    Of course, a chaotic Euro breakup will affect everyone in Europe and elsewhere. I would expect an avalanche of bank and state bancruptcies, first in Europe, then elsewhere. No way any national economy would not take a bad hit.

    • Germany makes the ne plus ultra in certain industries; however, its economy is no longer the juggernaut of the past. The reunification with the East has saddled it with a rather unproductive region that still requires transfers of 5% of GDP from the West to remain afloat after over twenty years.

      For a decade starting in 1992 (see new chart in post), Germany was unable to overcome this handicap until the advent of the euro in 2002. This made the country instantly more competitive and its current account balance soared to record levels. A return to the DM would cause similar dynamics to those of the 90’s. (By the way, the chart makes it appear that Germany may have experienced an export bubble to match the credit bubbles of the PIIGS with the peaks in 2008)

      Every country would suffer adverse consequences from a eurozone breakup, but Germany has the most to lose. I think Italy has the most to gain.

      The countries have a similar structure with a very modern industrialized core exporting very expensive, high-end goods to the rest of the world while supporting a unproductive region through transfer payments. Germany has the West-East divide, and it’s North-South in Italy.

      Italy can devalue, take the inflationary hit and then increase its foreign exchange earnings massively through well-developed tourist and export industries immediately. Moreover, the first country to leave experiences the mildest consequences, while the last is left holding the bag.

      Before elections, the German politicians’ actions are somewhat constrained, but in case of a threatened exit by one of the PIIGS they would be faced with two unpalatable choices. I think they will choose to retain the euro over the uncertainty of what happens without the euro.

      Currently, those populist parties are not polling well, but I understand your trepidation. Germans instinctively fear populism and hyperinflation in the same way Americans fear economic depression and surprise attacks. Sometimes, I think we are both lunging at ghosts.

      • Only two weeks passed since my comment, but the situation is already moving in the direction I described. A party “Alternative für Deutschland” (Alternative for Germany) is being formed, with an impressive list of supporters, centristic, not anti-European but anti-Euro. The supporters may be tilted too much towards academia, many professors, but that may also build trust. First ignored by the media, it is currently mentioned but talked down. But if you check out the comment sections of large German media, eg Spiegel Online, the Alternative für Deutschland is mentioned quite often.

        And as the general situation develops quickly, looking at Cyprus and Italy, I would bet some money that AfD will enter the Bundestag in September, which requires 5% of the votes. This 5% rule might also mean that their success would force the two major parties into a grand coalition.

      • I was thinking of your comment when I read an article on the AFD. Do you think that the new party will be able to even make it on the ballot in time? I heard that they have a lot of procedural hurdles to overcome. If they manage to make it, I agree with your assessment.

      • I think AfD can make it in time. I checked out the election law, and that states they must register about 100 days before the election. But the signatures required are only 3, from the party leadership. They need to be recognized and organized as a party, though, which may make it more difficult. But I remember parties like the Anarchic Pogo Party Germany or the Beer Drinkers Party who were able to participate in the past.

        The base organisation of the AfD is the Wahlalternative 2013, a group which thought about supporting other parties (like the Free Voters) in September 2013, but now has decided on founding the AfD. That means, in my view, a clear “yes we want to take part in the 2013 Federal elections”. The only remaining question is if they will self-destruct due to personality conflicts, like many other parties.

  4. I think your absolutely correct.
    If Germany is making 50 % but losing 30 % they will keep going.
    I also surmised the PIIGS should run up the credit card; then default.

    But I think too Merkel is not dumb.
    Merkel probably has an agreement with the IMF [US]
    that we [Germans] will continue but if it gets bad
    you IMF [US] will bail us out too. And that is when it gets bad.

    Simultaneously/currently I surmise Merkel has an agreement with US
    we will bail if you bail too, we just agree just do not tell anyone.
    The US FED therefore permits QE to favor may foreign banks.
    It is going on right now.

    Rest assured Merkel is not in this alone.
    The US citizens [and others] just do not yet know they are on the hook too.
    Merkel would never do this alone for many reasons, and yes, among them
    anti-Germany sentiment.

    The fact of the matter is, eg: Greece, as you wrote in your other post
    nothing “material” has changed [although I do mention there has been a flurry of
    arrests/convictions in Greece for tax avoidance recently published]. The Greeks
    suddenly are not manufacturing more, suddenly are not creating more wealth.

    Even if you wiped out 100 % of Greek debt, and returned them to where they
    were before the first bailout, in a few years they would still need a bailout.
    You reset the money, but not the behavior/culture.

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