Two-thirds of the country's stock of foreign direct investment (FDI) is in eurozone countries. The value of these assets is already being depressed by the crisis and would fall dramatically if the currency union collapses. And then there is the Bundesbank's exposure to other eurozone central banks. As capital flight from the struggling member-states has got underway, banks in these economies have become dependent on funds from their central banks, which have turned to the Bundesbank for financing. At the end of 2006 the difference between the Bundesbank's claims on other eurozone central banks and the latter's claims on the German central bank was negligible, but by May 2012 stood at €700bn. This will not pose problems so long as the euro system holds together, but it is far from clear what would happen if it falls apart.
Record low government borrowing costs have fuelled Germany's sense of invulnerability. Investors have pulled out of struggling eurozone economies in favour of German bunds, pushing yields down to unprecedentedly low levels. But there are signs that this is now changing as Germany's burgeoning exposure to the rest of the eurozone raises fears for the country's own fiscal stability. A declining group of countries are being called upon to underwrite ever larger sums of money, eroding their own creditworthiness. For example, a full bail-out of Spain would further erode confidence in Italy which would have to underwrite 23 per cent of the funds or around €100bn (on the assumption that a Spanish bail-out totalled around €400bn). This, in turn, would increase the likelihood of Italy itself needing a bail-out. At this point, only Germany, France, the Benelux, Austria and Finland would be in a position to underwrite bail-out funds. As a result, France's share of a bail-out of Italy would be around 35 per cent of the total, and would inevitably prompt a steep rise in French borrowing costs. Indeed, there is real risk that France would not be able to underwrite its share, leaving German (and a group of small economies) back-stopping the whole edifice. With each new country forced to seek a bail-out from the EU's rescue funds, the more vulnerable Germany becomes.
The current strategy for dealing with the eurozone crisis is largely a German one. But far from limiting the risks to Germany, it is maximising them. The German economy is not immune to the economic slump enveloping a growing swath of Europe. One country after another will need bailing out, with Germany ultimately providing the back-stop. Much of this debt will not be repaid, leading to a dramatic rise in Germany's public indebtedness. Without a mutualisation of risk, the euro will collapse, with devastating implications for German exports (to EU and non-EU markets alike as a euro collapse would hit the global economy hard), the value of Germany's foreign investments, and the stability of its banking sector. These are just some of the direct economic costs; the political fall-out would be grave for Germany. Isolated and blamed for the collapse, it would be poorly placed to pursue its interests through whatever is left of the EU.
By contrast, the reforms needed to stabilise the eurozone pose far fewer risks to Germany. Debt mutualisation need not be open-ended, so moral hazard could be limited. And it is far from clear that mutualising debt would boost Germany's borrowing costs compared to the current approach, which threatens to undermine the country's creditworthiness without doing anything to address the underlying reasons for the eurozone crisis. The arguments for a banking union are equally compelling. If the eurozone banking crisis is left to fester, banks will collapse, which in turn will hit German banks (and hence German taxpayers) very hard. In return for agreeing to mutualise debt and to introduce a eurozone back-stop to the economy's banking sector, Germany could demand a host of concessions. The political union needed to give legitimacy to these institutional reforms would be cast in Germany's image. Berlin would cement its influence over Europe's economy and its politics but in a benign and hence sustainable fashion.
Five years ago Germany was plagued by self-doubt and even self-flagellation. Now the political debate, media coverage and national mood generally are marked by hubris and self-righteousness. Germany's strength is exaggerated and its weaknesses downplayed. The German authorities are underestimating how much they have to lose from the eurozone crisis and the damage it is inflicting on the European economy as a whole. Germany should agree to big institutional reforms of the currency union, not out of charity, but as a way of containing the risks to itself. A deepening crisis, culminating in defaults, a rupturing of the eurozone and most probably the single market are all but inevitable under the current strategy. This will not only do huge economic damage to Germany but leave the country isolated and mistrusted by a region from which it derives its strength. With the German economy slowing rapidly and investors starting to question the safety of German debt, it is possible the country will change course. But at present it appears that Germany is not for turning.
