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Germany's unspoken plan: A smaller euro zone

There are two puzzles in the current euro zone drama. Why is tiny Ireland, a nation of fewer than five million people creating a crisis that, as Herman Van Rompuy said on Tuesday morning, threatens the survival of the euro zone and, he suggested, the EU as well. The second question is why Germany continues to frighten investors with the threat of managed defaults and "haircuts", even as Ireland's euro zone partners urge it to swallow the European Central Bank's medicinal rescue loan.

The first question is relatively easy to answer and it has to do with the big lie that underpins the euro and the behaviour of a gaggle of stupid bankers. Unlike Greece, the Irish government did not run riot, rather it was the lenders, Anglo Irish and Nationwide which stretched their balance sheets with reckless lending to homebuyers and property developers.

They were able to do this in part because of lax supervision but mainly because of the lie: that the EU can run a single economy with a single interest rate but without co-ordination of tax and spending. Inevitably, the euro zone gave Ireland the wrong interest rate. The Irish were able to borrow at the sort of low rates suitable for Germany, a slow-moving mature industrial economy where people save rather than spend. The Irish binged on cheap euros, bought loads of fancy frocks, German sports cars and ugly bungalows. The country's banks are stuffed with bad loans and the Irish government has been forced to stage an unaffordable bank rescue.

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Irish banks are now living off a drip-feed of cash from the European Central Bank's short-term lending window. They are borrowing colossal sums, up to €130-billion, equal to 80 per cent of the entire Irish economy, because they are almost shut out of the interbank lending markets. The banks are still lending cheaply to shore up the property market which is on the verge of utter collapse. Ireland now accounts for a quarter of ECB lending, but continued reliance on short-term support could lead to a banking crisis which would infect other fragile euro zone states, such as Portugal.

Ireland has lost the EU race for independent survival, even if Brian Cowen hopes to avoid the ignominy of being the Taioseach that handed over Ireland to Brussels after less than a century of freedom. Over the next few days or weeks a rescue package will be put in place and scores of European Commission beancounters will pack their bags for a long secondment in Dublin.

That sounds like an endgame, but in Berlin they know it is just the beginning of the end. That is why Angela Merkel, the German chancellor, continues to frighten markets with ambiguous talk of bond investors sharing the pain with taxpayers. Ms. Merkel insists that she is talking about a new default mechanism for sovereigns that will only come into place in 2013, but the Germans are being disingenuous.

It is clear that at the current market yields on their bonds, Greece, Ireland and Portugal cannot finance themselves without a dramatic economic recovery and bumper tax revenues. No one expects anything but pedestrian economic growth, which begs the question how Greece will raise funds in 2013 when their rescue funds mature. If Ireland takes the ECB money, how will it pay it back three years from now?

If Germany insists that investors in sovereign euro zone bonds share the pain in the future, why would these investors buy such risky bonds? Why lend to Greece, Ireland or Portugal when those sovereigns come back to the market in 2013, begging for cash like homeless drunks? The answer is that bond investors will not lend, except at unaffordable interest rates. Germany's strategy has only one outcome, the eventual ejection of the prodigal states from the euro zone. It is Berlin's strategy, unspoken but plain for all to see.

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About the Author

Carl Mortished is a Canadian financial journalist and freelance consultant based in the U.K. With a career spanning investment banking, journalism and consulting for global companies, he was for many years a financial writer and columnist for The Times of London. More

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