Why Germany needs the euro by Megan Barnett @FortuneMagazine November 14, 2011, 10:48 AM EST E-mail Tweet Facebook Google Plus Linkedin Share icons By Cyrus Sanati, contributor FORTUNE — Booting out the weak members of the eurozone won’t solve the continent’s economic problems. Such a bold move would cause more harm than good for core members of the euro, most notably, export-driven Germany. A coordinated effort to share the pain seems to be the best option out there, but it’s unclear how much pain the core eurozone countries are willing to take. The integrity of the eurozone has been considered sacrosanct by its core members throughout the long running European sovereign debt crisis. The idea that a profligate member of the zone, like Greece, would need to be kicked out of the 17- member common currency was quickly dismissed by mainstream politicians of core member states, like Germany and France. But cracks in that resolve have started to form. Two weeks ago, the leaders of Germany and France hinted that they could envision a scenario in which Greece would be allowed to leave the common currency. French President Nicholas Sarkozy took the issue a bit further last week when he said he could envision a “two-speed” Europe, where strong members of the European Union would grow closer while weak members would be left to putter in the background. Traders have interpreted this to mean that a smaller eurozone may be on the horizon, one where the core members of the euro unite to form a strong fiscal and monetary union, while the peripheral nations exit the common currency and drown in debt. On the surface this seems like the best solution to a growing European economic crisis that shows no signs of abating. The core members have been good stewards of their money and shouldn’t have to bail out the periphery just to save a 10-year-old common currency. The Eurozone crisis will not go away until banks face reality Of course, things aren’t that simple. Most of the debt that the periphery has racked up over the past decade has been financed by banks that are headquartered in the core countries. There has been a lot of discussion surrounding what a hard default could do to the region’s fragile banking system. If the sovereign debt didn’t crush them, then the trillions of euros in private loans that were extended to people living in the periphery would do the trick. To the average German citizen this probably seems very unfair. Why should they have to shoulder the heavy burdens of not only bailing out whole countries, like Greece, but also big rich banks headquartered in places like Paris and Amsterdam? Given this stark reality, some may question why there isn’t a larger “Occupy Wall Street”-like movement made up of angry and unemployed young Germans camping out in Frankfurt parks. Germany relies on the weakest members It’s probably because of a truth that no one likes to talk about: Germans have benefitted greatly from the euro — it’s given them an artificially weak currency. Normally, one would hate to be paid in a weak currency — among other things, it makes their vacations abroad more expensive. But for Germany, a weak currency has been its ticket to prosperity. If the Germans would leave the euro, they would actually be shooting themselves in the foot. Consider that Germany, which has a generous social safety net, relatively high wages and just 80 million people, is the world’s second-largest exporting country. The euro has played a significant part in this. German exports have more than doubled since they went on the euro in 1999, going from around 469 billion euros to well over a trillion euros in 2010. The rate of growth was also twice as fast as other nations in the zone. While there is no doubt that the Germans make quality stuff, the reason they are able to export so much at competitive price points is because they are operating with a relatively cheap currency. Italy’s problems are bigger than Berlusconi Germany’s export engine works two ways. First, it exports more to non-eurozone countries because the exchange rate of the euro is weaker than it would be, all things being equal, if it had stayed on the Deutsche Mark. That’s because the euro encompasses 17 nations, many of which are “weak,” therefore bringing down the value of the currency relative to the dollar and the pound. China gets a lot of flak for artificially manipulating its currency to maintain its exports. Germany doesn’t have to do that – all it needs to do is sit back and watch another weak eurozone nation go down in flames and its exports get more competitive on the world stage. Take the latest export data out of Germany. Even though the eurozone is in crisis and the region looks to be headed for another recession, German exports in September rose nearly 1% from the previous month to 91.3 billion euros, which is the highest level since records began. In August, when the crisis hit overdrive, exports were up 0.2% from the previous month. Meanwhile, imports into Germany fell 0.8% for September, increasing the nations burgeoning current account surplus. Normally that would cause Germany’s currency to strengthen, but since there was trouble down south, the euro weakened, making German exports even more competitive. The second way the euro helps Germany is that it has given them a much larger market to dump their goods. Around two-thirds of German exports go to members of the eurozone – that’s just the 17 members part of the common currency, not the 35 that are part of the European Union’s free trade area. The euro makes business much simpler as it eliminates foreign exchange risk. An artificially low euro in Germany means an artificially high euro in weaker countries like Spain and Greece. That means those countries can afford to buy German goods. It’s therefore no wonder why German cars, white goods, electronics and machinery dominate the eurozone. In Greece, a country that arguably shares much more in common with its Middle Eastern neighbors than its eurozone partners, being on the common currency has been a bit of a curse. With access to new credit lines, the Greek populace and its government went on a spending spree. Much has been discussed about how the Greek bureaucracy paid itself lavish wages. While true, that is just part of the massive sovereign debt bill the country rang up in the past decade. The country also paved lots of roads, constructed new airports, tunneled new subway systems and procured state-of-the-art weapons for its military. Behind most of these projects were German companies. What’s troubling is that the Greek bureaucracy was persuaded to use German companies, not only because of the quality and the common currency, but also because they were paid off. German companies like Siemens SI , Daimler, Deutsche Bahn, and Ferrostaal have been accused of funneling millions of euros to Greek politicians to secure military and civilian government contracts. In one incident, Siemens allegedly paid 100 million euros to Greek officials to secure a contract to upgrade Athens’s telecommunications infrastructure for the 2004 Olympic Games. Most of the big-ticket projects executed by German companies helped upgrade Greece’s antiquated infrastructure. But there was a reason it was antiquated – Greece is not a rich nation. But with an artificially strong currency and access to cheap debt, the Greeks took the money and ran. Would you blame them? The strong currency also meant that the Greek economy became totally uncompetitive. Greece’s main exports, like olives, were too expensive to sell abroad. Meanwhile, partying on Greek Island became several times more expensive than partying on a similar one in Turkey. That was fine when the economy was good, but when it seized up, Greece’s tourism industry took a dive. The weakness in the Greek economy and its big deficits should be expected when Germany’s export machine is firing on all cylinders. Since there is so much intra-eurozone trade, a current account surplus in one member naturally means there will be a deficit in another. A costly exit UBS tried to assess what it would cost Germany if it did break away. The analysts figured it would cost around 20% to 25% of the country’s GDP or 6,000 to 8,000 euros per German citizen upfront to walk away. It would then cost around 3,500 to 4,000 euros per German citizen every year going forward. In contrast, UBS figured that if the eurozone swallowed 50% of the debt of Greece, Ireland and Portugal it would cost a little over 1,000 euros per German in a single hit. That’s a much better outcome than going it alone. The study did not include extending a bailout to Italy, which has total debt outstanding that is around three times that of all those nations combined. But for the sake of argument, say one takes a 50% haircut on Italian debt – some 900 billion euros, that bailout would theoretically still cost less to the Germans than it would if they decided to leave the euro. The reason it costs so much is because a new German-only currency would be very strong – too strong to support its current export-driven economy. While it’s tough to know what the new German currency would be valued at, some of the best guesses have been around two dollars per euro, which is a 50% increase to its current exchange rate with the greenback. That means a mid-range $50,000 Mercedes would now need to be priced at $75,000. While it’s still a great quality automobile, there are many of other non-German options that American consumers would probably choose in that case. To get competitive, the German government would have to flood the market with their new currency, which would then decimate the savings of their penny-pinching populace. The instability within Germany that would result from such a move would probably make the riots in Greece look like a fun trip to the beer garden. The Germans need the euro, but they need it to be weak in order to survive. To do that, they are going to need Greece and the other peripheral countries to stay in. While talk of kicking Greece out of the eurozone and pursuing a two-speed Europe may score some political points, it doesn’t reflect the reality of today’s interconnected European economy.