On July 26, as traders were once again deserting Spain's government bonds, setting up the risk of a default and a deeper crisis of the euro, Mario Draghi, president of the European Central Bank surprised and delighted financial markets. Speaking off the cuff in London, he vowed to do "whatever it takes" to save the European economy.
The escalating crisis of speculative attacks on government bonds had spread from Greece to Portugal to Ireland to Spain and Italy, threatening to take down the euro and the European Union. It was a message that political leaders had been waiting for. The markets read Draghi's statement as an audacious declaration that he would begin massive bond purchases, ending the threat of a slide into European depression.
A week later, a chastened Draghi walked it all back. There would be no such purchases, he said, not until governments did their part by getting their budgets under control. Draghi made a rare disclosure of some of the infighting that led to his reversal. The president of Germany's Bundesbank, Jens Weidmann, a powerful member of Draghi's board, had strenuously objected. The policy of relentless austerity continued. The market for Spanish bonds crashed again. The lesson: Don't cross Angela Merkel.
In the nearly three years since money markets began attacking Greek government bonds, the German chancellor has become the world's enforcer of a perverse economic dogma. In a pattern that has now been repeated at least five times, she insists that European aid to... fill in the blank-Greece, Portugal, Ireland, Spain, Italy--is out of the question. The crisis then worsens. When collapse is imminent, Merkel makes a tactical repositioning and partly relents. But as penance for fiscal sin, the offending country is harnessed to deeper austerity, which sets off the next round of speculation against government bonds. As the panic spreads to ever-larger European countries, the stakes only increase.
Technically, these austerity policies are not the work of Germany. In a rescue package, the European Commission, the European Central Bank, and the International Monetary Fund--collectively known as the Troika--sign a memorandum of understanding with the supplicant country. Aid is then doled out as the country delivers on the austerity program. But behind the Troika, insisting on the hardest possible line, is Germany, the largest single provider of funds. In every case, austerity has failed to increase the target country's competitiveness and growth.
Until now, Merkel's hard line had a certain logic as unenlightened self-interest. As money flees other nations for the safety of Frankfurt, the supply of capital floods the demand and Germany benefits from low interest rates. The euro, undervalued relative to the old Deutsche mark, also provides Germany an artificial export advantage, giving Berlin bragging rights about the joys of fiscal rectitude. Germany, which invented the word schadenfreude, profits handsomely from the rest of Europe's misfortune.
But the policy of pushing other European nations deeper into depression has begun to boomerang, because the rest of Europe is Germany's prime customer base. In July, Moody's, the credit-rating agency, shocked Berlin by adding German government bonds to the credit watch list for a possible downgrade.
Germany's ultra budget hawkery is partly an ingrained fear of inflation. Twice in the 20th century the assets of the German middle class were wiped out, first by the Weimar hyperinflation of 1923 and again in 1948 when a currency reform nullified almost all Nazi-era assets. But the reality is more complex. Germany has been thrust into an urgent European leadership role--for which the nation and Chancellor Merkel are ill-equipped.
When European leaders launched the common market barely a decade after Hitler, one purpose was to nest a recovering Germany within a larger democratic European whole. …