The showdown with Athens has become more than just dealing with a bankrupt country writes Daniela Schwarzer. As Greece defaults and its exit from the euro is looking like a real possibility, the real challenge now is the credibility of the eurozone’s governance framework. No matter how it goes with Greece in the next week, Germany faces significant political challenges as it struggles to do what’s best for Europe and its own public. Merkel cannot risk political fragmentation at home by being seen as giving too much to Athens, but the demands of shepherding Europe through a Grexit would also be steep. The survival of the eurozone is still at stake.

Chancellor Merkel bears a huge responsibility to handle the burning conflict between Athens and its European creditors, which is central to the future of the eurozone and the credibility of the EU as a whole. Germany’s relative economic strength and its position as the largest guarantor in the euro rescue mechanisms place Merkel in the lead on this, just as it has been in handling the crisis since 2010. Her relative strength, backed by a grand coalition at home, is emphasized by the weakness of other leaders – most notably President François Hollande of France.

Despite her power, the chancellor’s options are limited. From Berlin’s perspective, Greece can only be kept in the euro on the terms that Berlin deems key to ensure low inflation, sound budgets, and as little cross-border risk sharing as possible. German intractability on this is driven by economic ideology as well as the constraints of the German constitution.

Recently, a domestic political dimension has crept into the picture. If Merkel is perceived as giving too much leeway to Greece or risking billion-euro-losses for the German taxpayer due to a Greek default or debt relief, it could strengthen her opponents, including the right-wing populist party Alternative für Deutschland (AfD). A strong AfD would have lasting effects for Germany’s party system, increasing political fragmentation and volatility as we have seen in other EU states. At a time when more German engagement is needed in Europe and internationally, it would be disastrous if domestic divisions made Germany more inward looking, impacting its stance on Europe and foreign policy and hampering Berlin’s capacity to implement overdue domestic reforms.

As the Greek government has challenged the rules-based order of the eurozone, more people across Germany’s political landscape have started to think that Greece may need to be dropped to retain credibility. This view is shared by governments of crisis countries that fear their consolidation and reform efforts will be undermined if Athens gets its way. Greece has not divided the North, led by Germany, from the South in the EU. Instead, it has alienated Athens from all 18 other national capitals in the eurozone.

But this does not make the task of guiding the EU through a possible Grexit any easier. Contingency measures would have to go beyond simply protecting Italy, Spain, or Portugal from fallout. EU leaders would need to reaffirm that the eurozone is more than a fixed exchange rate system that countries can leave or join as they please. This requires a political deepening of the monetary union. If they don’t take these steps, markets would perceive the euro as revocable, country risk would be back, and financial and real economic investment strategies would be designed much more along national borders‎ than they have since the euro was introduced.

This would profoundly undermine the benefits of a single currency and of a European economy and financial market.
If Merkel decides to push for deeper eurozone integration, Germany will have to move beyond its currently held positions, for instance on European deposit insurance in banking union or eurozone fiscal capacity. The recently leaked German-French position paper on the future of the eurozone showcased how low the lowest common denominator between Berlin and Paris currently stands. After a Grexit, it will take a more ambitious deal to restore credibility to the eurozone.

Germany will also have to rethink what it can do for European growth. If Greece exits, the country will face one or two dire years, during which the EU will most likely need to support it financially, both for humanitarian and geopolitical reasons. But then growth is likely to return to Greece since it will be able to use its regained exchange rate for competitive devaluation and can trade short-term growth gains for sound public finances and low inflation.

If Greece recovered well outside the eurozone, even if it is unsustainable, it would fuel debates in other countries about the benefits of exiting the single currency. Italy, Portugal, or Spain could suffer an outflow of capital from the banking sector, government bond holdings, and foreign direct investment. Italy may be the first candidate in line, but Italy’s exit from the euro can hardly be ring-fenced and would unravel the euro area.

The German government should take this scenario seriously when the short and medium-term options of handling a possible Grexit are assessed. In this moment of crisis, Berlin’s responsibility is to bring all partners together and press ahead with consolidating the monetary union.

Daniela Schwarzer is GMF’s senior director for research and director of the Europe Program and the Berlin office. This article was first published by the GMF.