Analysis: Merkel's room for maneuver on euro crisis narrows

BERLIN Mon Aug 8, 2011 10:28am EDT

BERLIN (Reuters) - Germany's Angela Merkel has vowed for months to do all in her power to save the euro zone while doggedly resisting pressure from Brussels and other capitals to move toward some form of fiscal union for the 17-nation bloc.

Now the tension between these dual pledges -- one intended for her European partners and the other for an increasingly eurosceptic domestic audience -- is building to breaking point.

In a statement issued with French President Nicolas Sarkozy Sunday, Merkel appeared to go further than she has in the past in promising support for euro zone stragglers, pledging in essence that the bloc's rescue fund would actively buy up their debt on the open market once it gets new powers this autumn.

That promise in and of itself is probably not enough to spark a rebellion in her party or the German parliament, which must approve the changes to the European Financial Stability Facility (EFSF) and the blueprint for its successor, the European Stability Mechanism (ESM), in September.

But after crossing a series of self-imposed "red lines" on euro zone policy over the past year, Merkel has moved closer to the point where new pledges of euro solidarity could spark a serious domestic backlash.

Many lawmakers in Berlin would see an increase in the size of the EFSF, for example, as a step too far in the direction of the dreaded "transfer union" Merkel herself has repeatedly warned against, although to bail out a country the size of Italy would overwhelm the fund as it stands.

The issuance of common euro zone bonds -- a solution which would allow all members of the bloc to borrow at sustainable rates but a cost to Germany's borrowing rates -- is also a taboo that Merkel can't break without serious consequences for her own political standing, German analysts and lawmakers said.

"We've entered into a limited liability union, where countries like Germany are liable for other euro zone members but only to a limited degree. This is where Berlin wants to hold the line," Thomas Mayer, chief economist at Deutsche Bank, told Reuters.

"If you increase the EFSF substantially, you're essentially talking about a Eurobond. If they do this I would expect strong grassroots opposition in Germany. A government that went down this path would probably not make it through the next election."

FROM RED TO YELLOW ... AND NOW GREEN

Aggressive buying of Spanish and Italian debt by the European Central Bank (ECB) Monday pushed down the borrowing costs of the two countries whose fate is likely to determine the future of Europe's bold 12-year old currency experiment.

The joint statement by Merkel and Sarkozy was probably crucial to the central bank's decision to wade into the bond markets again.

The German and French leaders stopped short of promising to take bonds bought by the ECB off its hands once the EFSF is fully operational in the coming months.

But they did make clear that the enhanced fund would take over the role of bond-buyer of last resort if the central bank agreed to set aside its concerns about debt purchases temporarily and step in to stem the crisis.

Just weeks ago, Merkel's advisers were telling reporters that secondary bond market purchases by the EFSF were a line they wouldn't cross. When euro zone leaders finally agreed to this step at a summit in late July, German officials downplayed it, stressing that such purchases would only be made under exceptional circumstances and could be stopped by a Berlin veto.

Pushed into a corner following worrying turbulence on euro zone bond markets in recent weeks, Merkel has now come full circle. Her red lines began to look yellow last month. Now they seem bright green.

"At the beginning, Germany refused to do anything but in the end, it has agreed to everything because it has to," said Gustav Horn, who directs the economic policy institute of the Hans-Boeckler foundation in Duesseldorf.

"Merkel has been pushed by reality into this position. Given her initial strategy, which was not very credible, it will be more difficult to get parliamentary approval."

CDU CALLS RISE

Despite increasingly vocal warnings from rebel lawmakers in her conservative camp, senior members of her Christian Democrats (CDU) and junior coalition partners the Free Democrats (FDP) scoff at the prospect of a Bundestag veto of the EFSF and ESM next month.

Volker Wissing, deputy leader for the FDP in parliament and head of the Bundestag's finance committee, told Reuters on Monday he expected a "clear majority" for the measures agreed by euro zone leaders at their summit last month.

Michael Meister, a senior finance expert in the CDU, also played down the risks of a veto. Even if some members of the ruling party refuse to back the euro zone's new anti-crisis powers, Merkel should be able to rely on the opposition Social Democrats (SPD) and Greens to see them through.

But clearly Merkel's domestic room for maneuver has narrowed significantly over the past weeks. If turmoil returns to the markets, or even if Spanish and Italian bond rates begin creeping up again to levels that are unsustainable over the long-term, it will be extremely hard for her to deliver new, bolder steps in the months ahead.

Senior CDU members called at the weekend for a special party conference to discuss euro zone policy in a sign that uneasiness with Merkel's course is spreading.

A poll last month showed her popularity dropping to its lowest level in nearly five years, and running neck-and-neck in a hypothetical battle for chancellor with Frank-Walter Steinmeier, the grey SPD politician she trounced in 2009.

(Additional reporting by Gernot Heller, writing by Noah Barkin, editing by Mike Peacock)

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