Frankfurt

The summit of twenty-seven heads of government and state held in Brussels in early December was billed as “make or break” for the eurozone. But the future of the European Monetary Union, at least in the short run, now depends on decisions to be made among the ungainly skyscrapers of Frankfurt—namely, at the monolithic HQ of the European Central Bank (ECB), its pop euro logo now obscured by anti-Bank slogans scrawled on placards at a rain-swamped indignado protest camp.

No one would deny that some kind of history was made in Brussels, where Germany, enforcing its hegemony in all the wrong places, imposed changes in the European treaties that make fiscal austerity permanent and legally binding, with sanctions for slackers. It was like the Treaty of Versailles after World War I, only the other way around, with Germany now on top. As Keynes warned then, in The Economic Consequences of the Peace, forcing broken economies to pay fines never works. This time, all-out war seems avoidable in the eurozone. But depression may already be under way in Greece, Portugal and Ireland. Spain, with almost half of youth unemployed, is sliding into prolonged stagnation, along with Italy.

The strange thing about the Brussels deal is that it is irrelevant to the urgent task at hand—that is, avoiding imminent collapse in the eurozone as bond traders resume their flight from Spanish and Italian debt. The new “compact” may be a step toward eventual fiscal union, if it gives way to a European budget similar in dimensions to the US federal budget, with fiscal transfers from cyclically strong regions to cyclically weak ones. Likewise, the rift with Britain, which rejected the deal, may have historic implications for the City of London, as financial power shifts from there to Paris or Frankfurt. The compact will certainly drive a wedge between Prime Minister David Cameron and his euro-skeptic Tories, on the one side, and his coalition government partners, the euro-friendly Liberal Democrats, on the other. Ed Miliband’s Labour Party, now proven right on the danger of premature austerity in a Britain that is itself sinking into stagnation, is rubbing its hands as the Cameron government groans and cracks. There are also some potentially progressive steps in the Brussels compact, such as a Tobin-style financial transactions tax (fiercely opposed by the British) and proposals on tax harmonization, which could avoid destructive competition for multinational investment.

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But when it comes to the eurozone’s fight for survival in the next days, weeks and months, German Chancellor Angela Merkel’s drive for German-style, rules-driven fiscal masochism is entirely superfluous. The euro periphery is already buckling under market-driven fiscal discipline. Spain, Italy and Greece, all under new governments keen to prove their undying commitment to self-administered shock therapy, are stepping up austerity policies that will deepen their recessions and, in all likelihood, worsen their debt dynamics. Rules and sanctions or no rules and sanctions, no indebted eurozone country can avoid deflationary fiscal austerity at this moment—at least not without revamping the whole eurozone—since any respite would simply trigger further runs on sovereign debt. It is not clear how the European Union’s complex legal structure can make the compact work in the long run. “They will try to make it as binding as possible, but I don’t think it could stand up in European courts,” said German euro-skeptic and ECB Observer member Ansgar Belke. Nor is it clear what the sanctions would be. Taxing a government that has overrun its deficit target seems counterproductive, to say the least.

Since Italian and Spanish debt runs into the trillions, the decision to fast-forward deployment of the €500 billion European stability mechanism, succeeding the €440 billion already allotted, is of little relevance. The same applies to the commitment to channel €200 billion into the International Monetary Fund. While European leaders understand the need to ring-fence Spain and Italy before the next round of panic selling in the bond markets, only the ECB has the necessary limitless firepower of printing money, the so-called Big Bazooka. “Sovereign debt has to be entirely free of risk,” said Peter Bofinger, the only nonorthodox economist on the German Council of Economic Experts. “You need 100 percent security on government bonds; otherwise, no one will buy them,” he told me in an interview in Berlin just before the Brussels summit. “Only the ECB can give total security.”

That’s why the spotlight turned immediately to Frankfurt the Monday after the Brussels conference, when markets pushed Spanish bond rates back over an unsustainable 6 percent and the credit-default-swap market pointed to more dread in the coming days. Beyond the grandiloquent speeches on the building of a new integrated Europe, the unwritten script is the following: most economists agree that the danger of forced default on Spanish and Italian debt is real unless the ECB steps up as lender of last resort. But there is also a tacit recognition that this is not part of the ECB’s mandate, as defined in the catastrophically incomplete design of the monetary union. In fact, the more hawkish members of the ECB council, led by Bundesbank president Jens Weidmann, are fiercely opposed to the Bazooka, believing it would create “moral hazard”—that is, give countries no incentive to be fiscally responsible. Weidmann has condemned all government bond purchases by the ECB.

So, emerging in the obscure logic of European policy-making is another, hidden rationale behind the Brussels compact: by imposing a legally binding agreement, enforceable with sanctions, Merkel may be trying to give the ECB room to do what any good German orthodox economist (not to mention the parsimonious German public) knows it should not do—namely, roll out the Big Bazooka and start buying Italian and Spanish debt in aggressive quantities, perhaps even printing money to do so. Merkel cannot say as much, since any political interference by the ECB is supposedly frowned upon. Mario Draghi, the new Italian ECB president, has blown hot and cold on the Bazooka, aware that any unambiguous support would have him labeled a Mediterranean dove by the Bundesbank hawks. We shall soon find out if there really is a secret plan to deploy heavy artillery, as markets launch repeated attacks on sovereign bonds to test the ECB’s nerve.

What’s certain is that in the medium term, political pressure will build in Germany against a stopgap measure to save the eurozone. The next stage must be the creation of eurobonds, which could be swapped for the debt of troubled peripheral countries with a massive reduction of interest rates. Yet Merkel and her government reject the very mention of eurobonds, which would in effect merge all eurozone sovereign debt.

They have done U-turns before, though. The decision in Brussels to scrap plans for private sector “haircuts,” forcing investors to take losses in future debt workouts (with the exception of Greece), is the latest. In fact, the U-turn is as common a feature of the management of this crisis as the “make or break” summit, of which fifteen have been held so far.

Europe’s future depends on one more big change of mind by the German-oriented core. After a period of hefty bond buying by the central bank, leaders have to set out some good German rules for the issuance of eurobonds and the creation of a United States of Europe, with a unified debt and centralized budget. That’s the only kind of fiscal union worthy of the name.