In an ongoing drama with no shortage of characters, two pairs of powerful individuals have emerged as the potential saviours of the euro. First, of course, there’s been the twinning of Mario Draghi, the newly-appointed president of the European Central Bank (ECB), with Mario Monti, the former EU Commissioner and the new Italian prime minister who has been tasked with sorting out the diabolical finances left by the departing Silvio Berlusconi.

But, while the two Marios might have a lot on their plates, it is the other pair – Angela Merkel and Nicolas Sarkozy – who must ultimately make the hard decisions that will determine the future of the Eurozone.

“Nicolas wooed Angela with his vision for a unified Europe led by France and Germany, but she mainly shied away from his advances.”

The Angela and Nico show has been in the makings for a while. As the heavyweight seaanchors of the Eurozone, the French and Germans have long been seen as leaders in the European Union. So, when crisis struck, these two countries with their large, stable economies were also the place most people looked to for solution. And so the unlikely pairing of Angela and Nico was cemented.

The Family Doesn’t Approve

And yet, in order to stay together, the two leaders have had to convince the people back home of the necessity of their alliance. Merkel, in particular, has faced opposition at home. The Eurozone debt crisis represents her coalition’s toughest challenge, and she looks to be reaching the limits of what she can obtain from it. That would be bad enough, but unfortunately the current resolution mechanisms look unlikely to solve the crisis, and it seems that further domestic legislation will be needed.

While Mrs Merkel won support for policies that include a further cut for Greek public debt held by banks, EU bank recapitalisations and an attempted leveraging of the firepower of the EFSF, the euro area rescue fund, as well as an increase in the EFSF’s size, German’s voters and politicians are hesitant to give Merkel the full authority she needs to take decisive action. Indeed, the German leader barely managed to scrape together the necessary majorities from her own ruling coalition.

German voters fear that if extraordinary measures should become necessary to save the euro, monetary stability and central bank independence could be compromised. (They’re also worried about how Europe’s new bond issuances might spark severe inflation – a concern that won’t be properly understood by any country that doesn’t have the terrifying hyperinflation of the 1920s and 1930s embedded in its cultural memory.) Either way, there’s a real risk that the short-term fix for the euro might result in the long-term loss of German public support for the EU – and for the government that supported the fix.

“The German economy has been a rock through the financial crisis, the recession, the incipient recovery and now the sovereign debt crisis.”

But why is the fate of the euro resting on the political mood in one member country? Why is Germany in this position of power? The short answer is that its economy has been a rock through the financial crisis, the recession, the incipient recovery and now the sovereign debt crisis.

A Remarkable Economic Recovery

Germany was in a position of strength because it had already dealt with many of the tough economic issues that had been dogging it since its reunification in 1990. The previous Social Democrat government, led by Gerhard Schröder, had courageously cut social benefits and persuaded the trade unions to reduce their demands, so that efficiency had been improved and a resurgence of export activity had begun.

Between 1994 and 2009, Germany’s unit labour costs fell about 20% compared to the rest of the EU. But the immediate effect was not nice – unemployment rose to a peak of 12.1% in 2005 – and in that year Schröder’s government was forced into an awkward coalition with Merkel’s Christian Democrats and their Christian Social Union allies. Further elections in 2009 gave the boot to Mr Schröder, whereupon Merkel launched a centre-right coalition with the liberal Free Democrats.

The rest, so far, is history. Unemployment is at a 20-year low, and workers are starting to see the rewards for their past sacrifices. Wages are expected to rise by 5% this year and by about 3% next year. Disposable income, adjusted for inflation, is expected to increase by 1% in 2012. Germany, for so long an export-led economy, is now seeing domestic consumption contributing to growth as well.

But it wasn’t just austerity that has helped the German economy to grow. Since the introduction of the euro in 1999, Germanyhas gained competitiveness not only against other major industrial nations, but against all other members of the euro zone. Indeed, it was the relatively poor performance of all those other Eurozone members that held down the appreciation of the euro against international currencies – thus increasing Germany’s industrial competitiveness against the rest of the world.

This currency advantage has increased still further since the start of the debt crisis. Between mid-2009 and mid-2011, German exports jumped by 18% – but economic studies have shown that would only have been 10% without that currency advantage. But it all looked rather different from the perspective of many other Eurozone countries, which lost competitiveness because their own unit labour costs had risen more rapidly, but which had been unable to devalue their currencies because of their euro club membership. For Greece, Ireland and Portugal especially, the single currency morphed from a blessing to a curse in barely half a decade.

There were more reasons why Germany moved forward while others were falling back. German companies were able to take advantage of government subsidies that helped them to keep skilled workers working at reduced hours during difficult times – a policy which allowed them to respond quickly when demand eventually returned in 2010. More recently, they have also benefited from increased access to financing, as domestic investors have pulled their money out of ailing economies such as Greece and Italy, and looked for safer areas to park their cash.

Can It Continue?

But the good times may be coming to an end. German consumption might be picking up, but the economy is still dependent on strong exports, and those are expected to decelerate from the high growth rates of 2010 and 2011. Many forward-looking indicators have worsened recently – such as the influential business confidence index from the Ifo Institute, which covers 7,000 companies in manufacturing, construction, retail and wholesale trade.The confidence index reached a record high of 115.4 points in February, but since June it has dropped sharply, falling to 106.4 points in October.

The decline points to a sharp deceleration in economic growth. Indeed, the Economist Intelligence Unit predicts that the German economy will return to recession in late 2011 or early 2012, with a contraction of 0.2% in 2012, before growth returns in 2013 at 1.1% and an average of 1.6% in 2014-16.

The hope is that Germany’s downturn will be short and shallow – but that depends largely on the outcome of the euro crisis. Germans seem hesitant to contain the crisis, feeling that if they step in to bail out countries such as Greece and Italy, they are condoning the reckless behaviour that got those countries in trouble. They seem not to realise how they have benefited from the effects of that behaviour – and how intertwined their own prosperity is with the rest of the Eurozone. The question is, how much of this does Merkel understand?

Angela Takes the Lead

It has often seemed as if it is Sarkozy who has been pushing a reluctant Merkel towards stepping up the EU’s powers and the Eurozone’s monetary union. Nico wooed Angela with his vision for a unified Europe led by France and Germany, but she mainly shied away from his advances. Now, with France looking next in line as a target of a paranoid bond market, Nico is losing his position of strength and it is Angela who must take the lead.

“The good times may be coming to an end.”

It’s being predicted that the German economy will return to recession in late 2012 or early 2013.

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