For much of the past two years, Germany has endured a lot of criticism for its approach to the euro-zone crisis, not all of it fair. Some say it is guilty of ingratitude, failing to acknowledge how much of its own economic success is due to membership of the euro zone; many believe it has misused its political and economic power to impose ill-judged austerity policies on its European neighbors, worsening their economic crises; and it is accused of a lack of solidarity for refusing to allow policies that might end the crisis, such as greater European Central Bank intervention and the creation of common euro-zone bonds. The result is that Chancellor Angela Merkel can expect to receive much of the blame if, as some now expect, the common currency breaks up.
There is an element of truth to these criticisms. Germany has certainly often been slow to appreciate the consequences of its actions. It underestimated the speed and severity of the contagion that arose after it insisted on imposing losses on private-sector owners of government bonds as a condition of future bailouts; it failed to anticipate the devastating impact on confidence of Ms. Merkel's statement that Greece could leave the euro; and even now, Germany may be underestimating the seriousness of the current crisis—in particular how far the sovereign-debt crisis reflects a loss of confidence in the wider market rather than a lack of credibility in national fiscal policies.
Even so, Germany can't be faulted for its clear-sighted analysis of the euro's failings and what must be done to eliminate them. It has recognized that this is, above all, a governance crisis. Too many European governments had become the prisoners of vast, unproductive public sectors and over-mighty trade unions, buying electoral support with lavish entitlements that destroyed competitiveness and ran up unsustainable debts. At the same time, Germany recognized that the euro zone's institutional arrangements, including the Stability and Growth Pact that was supposed to guarantee fiscal discipline, had proved woefully inadequate. Finally, it recognized that only market forces, no matter how painful, could exert the necessary pressure on governments to reform.
Whatever the current market turmoil, Germany's approach has certainly yielded results: Greece, Ireland, Portugal, Italy, Spain and now Belgium have new governments committed to far-reaching fiscal and structural reform. Meanwhile, Germany's campaign to reform euro-zone governance is also bearing fruit. European Commission President José Manuel Barroso and the president of the European Council, Herman Van Rompuy, are both working on proposals to improve fiscal scrutiny and discipline. Ms. Merkel and French President Nicolas Sarkozy have also discussed fast-track reform ideas that could be implemented without an EU treaty change. A European Council summit on Dec. 9 will consider these proposals amid hopes they will pave the way for a "Grand Bargain," in which a clear commitment from euro-zone leaders to improve discipline and minimize moral hazard will pave the way for a major ECB intervention.
Indeed, the biggest obstacle to a resolution of the crisis may now be France rather than Germany. Unlike Germany, a federal state that has always been comfortable with ceding power to the European Commission, France is a highly centralized state whose own European vision has historically been based on political agreements between nation states. This division has long dogged the European project: France rejected former German Chancellor Helmut Kohl's plans for deeper political and fiscal integration at the creation of the euro; it broke the rules of the Stability and Growth Pact, flouted single-market rules and consistently resisted the kind of structural reforms now being demanded of euro-zone member states; more recently, it held up the "six-pack" reforms designed to increase economic policy coordination, only backing down as the price of securing Germany's support for this year's July 21 summit deal.
But French resistance to greater fiscal and political union may be crumbling under the intensity of the crisis. President Sarkozy is due to give a speech Thursday in which he will set out his plans for improving economic integration, increasing fiscal harmonization, guaranteeing discipline, ensuring solidarity and improving euro-zone governance, according to someone familiar with the situation. Whether these proposals will be far-reaching enough to win over Germany remains to be seen. Germany is determined that the euro zone must be based on the rule of law, not political deals. But it may have to give ground, too: Mr. Sarkozy may find it politically impossible to sell any deal to French voters that involves a loss of sovereignty unless Germany is prepared to commit to policies that lead to increased solidarity.
Nonetheless, for the first time since the crisis began two years ago, the outline of a possible long-term solution to save the euro is emerging; after two years of incremental solutions that only undermined market confidence, there is a growing realization that only much deeper fiscal and political union can create the conditions in which the ECB can act and member states might ultimately pool their tax bases to create euro bonds. The ECB, for its part, seems ready to act: It is actively considering a range of options to intervene in what it now considers is a real threat to monetary stability, including yield targeting and funding other bailout vehicles, such as the International Monetary Fund and European Financial Stability Facility, according to someone familiar with its thinking.
Sure, enormous execution risks remain. Any deal will need to be accepted and then ratified by all 17 members of the euro zone—and all 27 members of the European Union if treaty changes are required. And the euro zone is engaged in a race against time: Banks are hemorrhaging funding and parts of Europe already face a severe credit crunch; doubts will persist about the sustainability of some countries' debts. Many countries will take years to restore their competitiveness; further debt relief and possibly fiscal transfers may be needed to keep the euro zone together.
Further dark days are inevitable. But if Mr. Sarkozy can show the political leadership and imagination that has so far been conspicuously lacking throughout this crisis and put forward workable euro-zone governance proposals, he may yet start to draw a line under the crisis—and boost his chances of re-election next year.
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