Wednesday, April 04, 2012

Germany Supports Increase in Funds to Combat the Debt Crisis Contagion

Chicago Tribune: Merkel Signals Readiness to Compromise on Firewall
Nine News Australia: Merkel Gives Ground on Higher Firewall
San Fransisco Chronicle: Merkel Backs Firewall Increase for First Time Amid Spanish Concerns
WSJ: Euro Zone Raises Ceiling on its 'Firewall'

To limit the spread of the negative effects of a potential default in Greece, Portugal, or Ireland, European leadership has created a permanent rescue fund named the European Stability Mechanism (“ESM”) with a maximum value of €500 billion that will come into effect in July 2012. A current temporary fund with the same goal, the European Financial Stability Facility (“ESFS”), has already disbursed €200 billion and has €240 billion in unused capacity.

Having the necessary funds to combat default is vitally important because one country’s default can create a domino effect that causes enormous problems in other countries. This spread of economic harm based on one country’s default is called “contagion.” A simplified example of this problem is as follows. Suppose that country A (“A”), which is barely able to make its debt payments, holds €100 billion in debt from country B (“B”) and receives annual interest payments of €6 billion on that debt from B. A also owes €5 billion in interest payments each year to a number of other countries. If B defaults, A will no longer receive its €6 billion in interest payments that it counts on to be able to meet its own obligations. In this simplified example, the default of B could force A to default. Additionally, a default in one country could cause panic throughout Europe, leading banks to greatly reduce the amount of money they are willing to lend. Both of these problems could be devastating to the world economy.

Germany, one of the most economically powerful countries in the EU, previously believed that funds to combat the debt crisis contagion should be limited to the €500 billion maximum of the ESM. However, on March 26, in response to concerns that the economies of Spain and Portugal are in serious economic danger and pressure from the IMF and the governments of top global economies, Germany agreed that €500 billion may not be sufficient to combat the debt crisis contagion. Germany then agreed with other Eurozone members that the ESM and ESFS could run in parallel. Germany’s new position is that the permanent ESM will remain capped at €500 billion, but the €200 billion already distributed by the ESFS will not be included in that total, giving the Eurozone a total of €700 billion to combat the debt crisis. The increased availability of funds will allow countries nearing default to meet their current debt obligations, which will give these countries the additional time needed to implement economic changes that will allow them to meet future debt obligations.

On Friday, March 30, 2012, Eurozone finance ministers agreed to increase the bailout limit to €700 billion, but many in the euro-zone are concerned that it will not be enough. For example, the European Commission (the EU’s executive arm) argued that the ESM needs €940 billion to adequately contain the crisis. Germany however, believes that €700 billion is sufficient and was successful in defeating those lobbying for an even higher debt ceiling. The option chosen by the finance ministers still must be ratified by the 17 euro-zone member parliaments.

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