Deepening crisis forces Merkel to re-examine euro taboos

BERLIN: How far is Germany prepared to go to save the euro zone?

With Greece's future in the single currency bloc in doubt, Spain scrambling to get a grip on its ailing banks and the euro itself in freefall, the question that has preoccupied crisis watchers for over two years is back in focus like never before.

As in previous "crunch" moments during the crisis, coming up with a clear picture of Berlin's intentions is difficult.

Chancellor Angela Merkel, who has looked increasingly isolated since the victory of Socialist Francois Hollande in France's presidential vote, is keeping her cards close to her chest in the run-up to a pivotal EU summit one month from now.

Much will depend on the outcome of Greece's June 17 election, where a victory for the radical-left could catapult the bloc into an even deeper abyss, forcing Merkel and her partners to decide whether they can cope with a Greek exit and the contagion that would bring.

But amid the uncertainty, Merkel and her advisers have sent out signals that help to decrypt which of Berlin's "red lines" in fighting the crisis are truly red, and where Europe's reluctant paymaster may show flexibility in the crucial weeks to come.

Merkel herself indicated at a news conference in Stralsund on the Baltic Sea coast on Thursday that Europe could not afford to exclude any ideas as it struggles to avert a catastrophic breakup that would rock markets and economies worldwide.

"We have to think about how we move forward over the next five to ten-year horizon. And if we are constantly coming up with new taboos, it won't work," Merkel said.

What does seem clear is that developments over the past month have rung alarm bells in Berlin.

The euro has slumped to two-year lows, Spain was forced to nationalise its fourth biggest bank, and US President Barack Obama's administration is sending increasingly shrill appeals to Europe's policymakers to act fast.

This has forced German officials to think more openly about new steps to stem the crisis.

No longer is a "growth pact lite" that reallocates existing EU funds to new projects and gives the European Investment Bank a bigger role in fostering investment in stricken euro countries seen as sufficient to reassure jittery markets.

One senior German official who is close to Merkel told Reuters that other steps were necessary because such a pact would be largely "cosmetic" and have little impact on countries like Greece and Spain that are struggling with contracting economies and surging unemployment.

"We have growth that is higher than expected, and they have a recession that is deeper than expected," the official said. "It will all lead to them telling us, you need to provide some relief, we need more time."

FRANCO-GERMAN COMPROMISE

The European Commission said on Wednesday it stood ready to give Spain an extra year to bring its deficit down to the EU limit of 3 percent if Madrid comes up with a credible budget plan for the next two years.

Hollande will press Merkel for similar flexibility for other recession-hit euro members at the June summit, Philippe Aghion, a Harvard economist who is advising the French president, told Reuters this week.

On this issue a Franco-German compromise seems possible.

But Hollande's other big push - for joint euro zone bond issuance - seems destined to fail because of staunch opposition from Germany and its northern European allies.

Even setting out a road map for introducing so-called "euro bonds" years from now seems highly unlikely given Merkel's concerns about the level of domestic opposition to a step that would increase German borrowing costs and relax reform pressure on euro stragglers.

"If you introduce euro bonds, you will have political developments that are so unpleasant, that unleash such tensions that the likelihood of a political break-up of the euro zone only increases," a top Chancellery official said. "It's not a real option."

Another clear red line for Berlin is using funds from Europe's permanent rescue facility (ESM), set to come into force in July, to recapitalise struggling banks directly.

European Commission President Jose Manuel Barroso came out in favour of this on Wednesday. It would allow a country like Spain, where But German officials continue to rule out such a step, which would violate the statutes of the new ESM, and have been quietly urging Madrid to consider a formal request for an EU/IMF rescue, sources say on condition of anonymity.

Berlin is also lukewarm about other proposals for shoring up ailing banks.

Both the European Central Bank and European Commission have come out in favour of a "banking union" that would include a deposit guarantee fund and cross-border bank resolution system.

But while German officials support giving the ECB greater supervisory powers and Merkel herself has said it should be possible to dismantle banks across borders, steps that might expose German taxpayers to new risks are being ruled out.

Asked on Thursday in Stralsund about the calls for a banking union, Merkel dodged the question and suggested that national bodies that have already been created to shore up banks should simply cooperate more closely.

NOT ENOUGH

So Berlin appears ready to accept Hollande's demands for a loosening of fiscal targets for weakened euro members next month, and agree to a modest pact to boost growth.

The German government and central bank have also signalled a readiness to accept higher inflation rates at home to compensate for deflationary tendencies on the southern periphery -- a step that over time could help address the imbalances that got the euro zone into trouble in the first place.

But will these steps be enough to save the euro zone from stumbling deeper into crisis in the weeks and months ahead? Probably not.

People familiar with Merkel's thinking say bolder steps from Berlin may only come when Germany itself begins to feel the crisis in earnest.

And that may be sooner than the hard economic data suggests. Business sentiment surveys this month showed the crisis is beginning to unsettle German industry, hurting exporters in key European markets and crimping their readiness to invest.

Despite diversifying into fast-growing markets like China over the past decade, German companies still send nearly 60 percent of the goods they sell abroad to EU partners.

A slowing economy, weighed down by an imploding euro zone, would be poison for Merkel's re-election chances in 2013, especially if opposition parties are able to pin the blame on the chancellor and her European "red lines".

"The German economy is at once Merkel's big strength and her Achilles heel," one aide to the chancellor said. "Ultimately, she will do what she has to do to ensure this crisis doesn't come back to bite her at home."