FORTUNE — The downgrade machine has finally worked its way up to the top. Moody’s earlier this week placed the crème-de-la-crème of the troubled eurozone – Germany, the Netherlands and Luxembourg – on negative credit watch, noting that the three nations, especially Germany, were not immune to the economic troubles on the continent. German bond yields nudged slightly higher in trading on the news Tuesday, and went even higher on Wednesday as a German 10-year bond auction drew uncharacteristically weak demand from investors.
Germany isn’t in grave economic trouble at the moment, but it isn’t the picture of economic health, either. It actually suffers from some of the same underlying economic problems that have caused its neighbors to keel over in recent months. Unlike its neighbors, Germany has been able to stay afloat, even somewhat prosper, during the crisis, thanks to its strong export machine and its reputation as a prudent steward of capital. But with its export machine slowing and its reputation now bruised, Germany isn’t looking so hot. Add in all the money it has committed to the eurozone bailout and Germany starts to look somewhat weak.
Before any permanent damage is done to its reputation, Germany should use its clout to push for a much closer eurozone now while it still can. This will shield it from experiencing the kind of economic dislocation that has crushed its neighbors. It will also ensure its rightful place at the top of the eurozone pyramid.
Germany has benefitted greatly from the euro, so it makes sense that it would spend money to keep it alive. The currency eliminated exchange rate risk, making it much easier for Germany to export to its eurozone partners. At the same time, Germany, in particular, has also been able to increase exports to non-eurozone countries. The exchange rate of the euro is weaker than it would be, all things being equal, if Germany had kept its old currency, the Deutsche Mark.
Germany has been criticized throughout the eurozone crisis for not showing enough leadership, by allowing the crisis to drag on and on without a lasting solution. But up until very recently it appeared that the prolonged crisis has in some ways helped Germany grow its economy. Its exports outside the eurozone for instance have received a healthy boost thanks to the hammering the euro has taken in the markets. This helped Germany record strong GDP growth in 2011 (up 3.5%) while its eurozone brethren were suffering in deep recession.
But all good things eventually come to an end. Germany’s estimated GDP growth rate for 2012 has been revised down several times throughout the year and is now expected to come in well below 1%. Part of that has to do with its export machine. It turns out that Germany needs its eurozone partners more than originally believed. For example, while the cheap euro helped Germany grow its trade with nations outside of the eurozone by 3.4% this past May, on an annual basis, the chronic recession in Europe pushed trade with the other 16-members of the eurozone down 2.3% during the same time period. Since inter-eurozone trade makes up two-thirds of German exports, the incremental benefits of exporting outside the eurozone are no longer covering the loss in trade from Europe.
Meanwhile, new data out this week seems to confirm that Germany’s export engine has stalled. The demand for new German manufactured goods fell in July to the lowest level since May 2009. That pushed the German composite purchasing manager’s index down to 47.3 in July, the lowest level since June of 2009. A score below 50 in the PMI largely indicates that an economy is in contraction, so Germany could very well be experiencing no economic growth at all.
This is concerning, given Germany’s increasingly precarious fiscal situation. It turns out that while Germany does have a big economy, it doesn’t generate enough tax revenue to cover its bills. Eurostat reported on Monday that Germany had a debt-to-GDP ratio of 81.6% in the first quarter of the year, which is up 0.4% from the previous quarter. While that is lower than that of its profligate neighbors, like Greece at 123% and France at 89%, it is still far higher than the 60% cap to which eurozone members are supposed to adhere. Furthermore, while Germany has been successfully cutting spending it still ran a budget deficit of 25.8 billion euros in 2011. As the economy contracts, that budget gap is projected to grow.
But Germany’s already high debt-to-GDP ratio may not be telling the whole story. In putting Germany on a negative credit watch, Moody’s noted that it was concerned about the liabilities the country has taken on as a result of the crisis. Those liabilities are the billions of euros that have been supplied to the various EU bailout funds. It turns out that Germany is on the hook for an estimated 211 billion euros in cash and guarantees connected with the bailouts. If that number is added to Germany’s current debt load of 2 trillion euros, the nation’s debt-to-GDP ratio jumps to nearly 90%. In addition, the current debt number doesn’t account for unfunded liabilities in social security, healthcare and pensions that the state is responsible in paying out. Adding that all up would tack on an additional 5 trillion euros to Germany’s national debt, according to Bernd Raffelhueschen, an economics professor at Freiburg University. That would push Germany’s debt-to-GDP ratio to a mind-blowing 284%.
To be sure, no one is saying that Germany is going to go bankrupt anytime soon. Even if it loses its triple-A credit rating, it will still be seen as more than creditworthy, notwithstanding all of the current economic headwinds. That is, of course, if the euro stays together. If it breaks, UBS estimated last year that it would cost Germany around 20% to 25% of its GDP or around 514 billion to 642 billion euros in the first year off the euro. It would then cost the country around 300 to 350 billion euros every per year going forward as its economy shrinks to match its strong currency.
The warning from Moody’s (MCO) is just that – a warning. It is now up to Germany to make sure that this warning doesn’t result in a downgrade, or a more dangerous multi-notch downgrade. Keeping the euro together should be Germany’s number one priority but it needs to spread out the financial risk of any future bailout. United, Europe can set about to address its fiscal troubles while negotiating fair settlements with debt holders. But Germany needs to really put pressure on its neighbors to fall in line. If it successfully uses all its political and economic capital to get this done, then this warning would have done its job.