NOVEMBER 30, 2010.

Germany Recommits to the Euro

By MARCUS WALKER

BERLIN—Germany's insistence that Ireland, Greece and the euro zone's other fiscally feeble members adopt punishing austerity regimes has fueled concern across Europe that the bloc's biggest member is souring on the euro.

But Sunday's agreement among euro-zone leaders to establish a permanent rescue facility for overly indebted members suggests that rather than turning its back on the euro, Germany is doubling its bets. Put simply, Chancellor Angela Merkel and her allies have concluded that the euro is essential for Germany's continued prosperity.

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.To appease a domestic audience deeply opposed to rescuing profligate euro-zone members, Germany's leaders have pushed for punishing both governments and investors. Yet time and again in recent months, Berlin has sacrificed its tough public demands for backroom euro-zone consensus.

The fine print of the weekend agreement commits Germany to do what its leaders insist they want to avoid—prop up the weakest countries of the euro zone in future debt crises, even after Europe's current, €750 billion ($993.21 billion) bailout facility expires in 2013.

WHEN MAKING that open-ended promise to other euro nations, Germany gave up its insistence that investors automatically share in future losses.

Instead, Berlin won a watered-down agreement that will force investors to shoulder losses only if a member state is declared insolvent by a unanimous vote of all euro-zone members.

That political concession sets a high bar for including shareholders in future restructurings. Currently, for example, euro-zone leaders insist that even Greece remains solvent, despite its massive debts and poor growth prospects.

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."The Germans have accepted that there will be more bailouts," says Simon Tilford, chief economist at the Center for European Reform, a London-based think tank. "They have compromised on their demand that haircuts for bondholders should be automatic," he says.

Berlin's readiness to compromise in order to get an agreement with France and other euro-zone countries reflects the still-strong belief of Germany's governing class that saving the common currency is a vital national interest.

The euro has allowed Germany's export-dependent industries to sell their wares in their main European markets at stable prices, free from the currency appreciations that afflicted them in the days of the Deutsche mark.

Most German business people agree that a revived mark would be too strong for comfort, jeopardizing Germany's booming trade with China and other emerging economies, and wiping out a decade of efforts to make German companies more competitive.

In addition, an unraveling of the common currency would leave Germany's banking system holding hundreds of billions in distressed assets in countries that dropped out of the euro.

That could force the German government to spend far more on propping up its banks than it must now lend to Greece, Ireland and possibly other governments.

For example, Germany is taking on roughly €12 billion in credit exposure to the Irish government through the European Union and International Monetary Fund loans to Dublin, but is thereby shoring up around €118 billion of German banks' exposure to Ireland, according to Bundesbank data.

"The idea that we might not successfully defend the common European currency would have unimaginable economic, social, and also budgetary consequences for Germany," Finance Minister Wolfgang Schäuble told reporters in Berlin on Monday.

Ms. Merkel's dilemma all year has been that the cold economic logic that underpins her government's commitment to the euro is hard to sell to German voters and lawmakers. Many ordinary Germans resent having to pay for the financial follies of other European countries, especially after years of cuts to entitlements at home.

The chancellor, whose ear is acutely tuned to German public perceptions, knows that nostalgia for the mark has grown this year.

When Ms. Merkel and her finance minister pushed the €750 billion bailout facility through Germany's parliament in May, they sold it as an emergency measure that would last only three years. In the meantime, they pledged, Berlin would impose much tougher rules on budgetary discipline on other euro members, to ensure that there would be no repeat of the Greek debt crisis.

In the face of stiff resistance from other euro-zone governments, however, Ms. Merkel backed away from her demand that euro-zone laggards face automatic sanctions last month.

On Oct. 18, Ms. Merkel stunned Europe and angered many in her own ruling coalition by agreeing to a quid-pro-quo with French President Nicolas Sarkozy.

Germany dropped its pressure for automatic sanctions. In return, France promised to support Germany's demand for a change to EU treaties, to enshrine the principle that bondholders, not just taxpayers, will pay a price if a euro member needs a bailout in future.

Germany's insistence on including bondholders spooked financial markets, pushing up the risk premiums on government bonds of Greece, Ireland and Portugal, and helping to push Ireland into a crisis, say many observers.

EU leaders including European Central Bank President Jean-Claude Trichet and Greece's Premier George Papandreou have slammed Ms. Merkel's proposal for making life even harder for euro-zone stragglers.

German officials deny sparking the past month's investor panic. But amid growing financial-market pressure on the euro and its weakest members, Ms. Merkel decided to push for a final agreement on its debt-restructuring idea. Berlin argued that clarity about Europe's future rules would help to reassure investors.

At the weekend, Mr. Sarkozy and other key EU leaders agreed—but at a price. Ms. Merkel had to accept that bondholders will only take a hit if a euro-zone government is deemed insolvent. If a government can't tap bond markets but is still solvent, then taxpayers alone will finance an international rescue. The judgment about which scenario applies will ultimately be a political one, taken by euro-zone finance ministers.

Mr. Schäuble admitted on Monday that Germany had to compromise in order to get a deal. But, he said, it was important to reach an agreement quickly, in order to reassure investors who were fleeing euro-zone assets amid the uncertainty.

Write to Marcus Walker at marcus.walker@wsj.com

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