German Chancellor Angela Merkel may need to surrender her opposition to issuing common bonds in order to stop a debt crisis that is threatening to splinter the euro region. Merkel, who calls the single currency a “work of peace” and part of Europe’s “uniting idea,” is the key holdout on so- called euro bonds. With leaders meeting in Brussels today, her stance may eventually weaken amid signs the heart of Europe is becoming infected by the 21-month debt crisis as yields on Spanish and Italian 10-year bonds reach euro-era records. “Once they look into the abyss of a major speculative attack on Italy,” Merkel will have to embrace euro bonds, Peter Bofinger, a member of the chancellor’s Council of Economic Advisers, said in a telephone interview. “That would be the turning point. There needs to be a joint guarantee for all outstanding debt.” As investors test the resolve of policy makers, Merkel is wavering between the legacy of Helmut Kohl and voters in Europe’s largest economy disgruntled with bailing out its partners. Kohl, Merkel’s political mentor, was the pro-European chancellor who sold skeptical Germans on swapping the deutsche mark for euros in the 1990s and championed his nation’s role as Europe’s paymaster as part of its post-World War II penance. “It’s a fact of life that common currency areas have subsidies from the rich to the poor,” said Marchel Alexandrovich, an economist at Jefferies International Ltd. in London. “You need euro bonds for the show to go on.” Step Too Far The summit is scheduled to start at 1 p.m. in Brussels today. Merkel and French President Nicolas Sarkozy agreed on a joint position on Greece after a seven hour meeting that ended after midnight, government statements said. Details will be announced later today. Merkel rejects issuing common debt as a step too far because it would remove pressure on governments with ballooning deficits to pursue austerity, and also risk pushing up the cost of credit for her taxpayers. Germany currently pays investors 2.77 percent to borrow for 10 years compared with Greece’s 17.34 percent. Yields on Spanish and Italian 10-year and Greek two-year bonds hit euro-era records this week as investor concerns that this week’s summit will fail to fix the crisis unsettling financial markets. The German position “remains in effect,” Steffen Seibert, Merkel’s chief spokesman, said July 15. Shared bonds would lessen the pressure for budget discipline and this “contradicts the basic structure of the European currency union,” he said. Euro Bond Yield The euro area as a whole might pay around 4.8 percent to borrow for a decade, based on current markets and debt levels, Alexandrovich and colleagues at Jefferies calculate. That suggests Germany would need to afford a yield of about 2 percentage points higher than today or the equivalent of 44 billion euros ($62 billion) more in annual interest payments. Common bonds are nevertheless gaining support elsewhere as the crisis repeatedly foils policy makers. Italian Finance Minister Giulio Tremonti, Irish Foreign Minister Eamon Gilmore and Pacific Investment Management Co., the manager of the world’s largest bond fund, have all backed the concept. Domestic politics loom large in Merkel’s rejection. Lawmakers in her governing coalition are opposed, reflecting voter anger at three European bailouts since May 2010 to which Germany is the single biggest country contributor. Euro Gravediggers Eighty-six percent of Germans are concerned about the value of their savings and 47 percent want Greece evicted from the euro area, according to a poll for ZDF public television published last week. Politicians who back measures such as common bonds “will prove to be the euro’s gravediggers,” Otmar Issing, the European Central Bank’s former chief economist, said in a July 19 interview in the Frankfurter Allgemeine Zeitung newspaper. “The consequences of this policy will strangle Germany.” A compromise proposed by the Brussels-based research group Bruegel would see countries fold debts up to 60 percent of gross domestic product into a joint “blue” bond. That would likely enjoy relative lower interest rates than even low-deficit governments now pay, in part because of the more liquid market. Any excess debt would then be sold on a national basis as a “red” bond with a higher yield. “I’m growing more sympathetic to the red-blue bond approach,” said Gilles Moec, co-chief European economist at Deutsche Bank AG in London. “You want a combination of accommodation and incentives for fiscal discipline.” Final Straw Euro bonds may become inevitable, said Frank Schaeffler, a lawmaker for Merkel’s Free Democratic Party coalition partner, who predicts Greece will succumb to a temporary exit from the euro region. They “would be the last straw and Merkel knows it,” he said in an interview. “The reality is we’re steaming ahead into eurobond land, it’s just a few stations down the line. We may not be about to create instruments that are called euro bonds but don’t be fooled by the labels.” Merkel regularly tells Germans their export-driven economy, which grew last year at the fastest pace since reunification, has benefited the most from the 12-year-old currency union that underpins a market of more than 300 million people. With the debt crisis worsening, the nation’s investor confidence fell in July to the lowest since January 2009. Kohl Angst To contain the crisis, European officials will today consider steps previously rejected by Germany, including the use of precautionary credit lines, a person close to the talks said yesterday. Other options for discussion include enabling the main 440 billion-euro rescue fund to lend to recapitalize banks, said the person, who declined to be named because the negotiations were in progress. Kohl, 81 and retired from politics, expressed concern about the euro’s future in a July 17 interview with the Bild newspaper. “What is needed now is to find sensible ways at a difficult to heal these mistakes and make Europe and the euro durable,” he said. Merkel, who saw capitalism from behind the Iron Curtain while growing up in then-communist East Germany, will be “steamrollered by events,” said Fredrik Erixon, head of the European Centre for International Political Economy in Brussels. “Germany is rejecting all kinds of proposals to deal with the debt problem but Merkel is not coming up with any real ideas on how she’d like to see the crisis resolved,” he said. To contact the reporters on this story: Tony Czuczka in Brussels at aczuczka@bloomberg.net; Simon Kennedy in Brussels at skennedy4@bloomberg.net To contact the editor responsible for this story: John Fraher at jfraher@bloomberg.net

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