The Bonds That Tie—Or Untie

European Leaders Need To Think and Act More Boldly To Stem The Euro Crisis

Aug 20th 2011
Courtesy Of "The Economist"

THE pattern has grown tiresomely familiar. Bond markets shift sharply against weak euro-zone members. Leaders hold a crisis summit to save the euro with more forceful rescue measures. The initial euphoria lasts a few weeks, a few days or even just a few hours—and the cycle begins once again. Can Europe’s politicians ever break it?

To judge from this week’s summit between Germany’s Angela Merkel and France’s Nicolas Sarkozy, the answer is no. The two came together in the holiday season partly because the markets had moved on from an assault on Italy to attack France, a core AAA-rated euro member. Investors were hoping for a deal to expand the euro zone’s bail-out fund, the European Financial Stability Facility (EFSF), or to start issuing mutually guaranteed Eurobonds. Instead the two leaders did little beyond repeating previous accords, promising stronger euro-zone economic governance and putting up such distractions as a financial-transactions tax, harmonised corporate taxes and constitutional commitments to balance budgets—along with more euro-zone summits in future (see article).

The markets were unimpressed. A day later the European Central Bank was again buying Spanish and Italian government bonds, having spent €22 billion ($32 billion) the previous week. The latest shockingly low growth figures for the euro zone in the second quarter may partly reflect fiscal austerity, but they also suggest that it will be harder than ever for troubled economies to grow out of their debt burdens.

It is understandable that Mrs Merkel, in particular, should be loth to embrace bold new rescue plans. She is cautious by nature, more a follower than a leader. She recognises the deep hostility of her voters to big fiscal transfers to weaker, more profligate euro-zone countries. She is already finding it hard to persuade her coalition partners to support in parliament the deal she struck in July to expand the EFSF’s powers and let it buy up government debt. She is mindful that the Bundesbank is vociferously against a big ECB programme to buy government bonds (the ECB has already spent €100 billion). And she fears that her country’s constitutional court may rule all euro zone bail-outs to be illegal.

Yet Mrs Merkel needs to be mindful of something else as well: that the current rescue plan for the euro is just not working. The markets continue to price in default by Portugal as well as Greece (though the third bailed-out country, Ireland, is looking a bit healthier). The attempt to limit the trouble to these three and stop contagion spreading to Spain has manifestly failed: instead Italy and now France, both of which seem to be solvent, have been infected. A year ago it was said that the euro zone could take care of two or three small countries but that Spain was too big to fail. Today, with Italy and even France looming into the picture, the very survival of the euro is coming into question.

A break-up of the euro may not be unthinkable, but it would certainly be damaging, painful and very expensive. This is most obvious for debtor countries whose banks and governments would go bust; but Germany and other creditors would also pay an extremely high price. And the consequences would be scarily unpredictable: Europe’s single market, and even the European Union itself, might be at risk.

Explore our interactive guide to Europe's troubled economies

Mrs Merkel must know that it is worth paying a lot to avoid all this. That means, at minimum, a large expansion of the EFSF, to at least €1 trillion, though there is a limit to how much bigger it can get without denting some creditor countries’ ratings. It is likely to require further large-scale bond-buying by the ECB. It involves accepting bigger restructuring of Greek and maybe other debt. In the end, it may even necessitate mutually guaranteed Eurobonds (see article).

Honesty Is The Best Policy

Any or all of these measures have three things in common: they involve stronger countries giving more support to weaker countries; to offset this, they require intrusive outside control of national fiscal policies. They thus constitute a step towards political union. That is what airy labels like “economic government” or “deeper integration” actually mean.

The problem is that most governments have no mandate from voters to move in this direction. Politicians therefore need to start explaining to their electorates the choices they face, and the consequences of those choices. If Europe’s leaders sign up for a level of integration deeper than voters want, the backlash could split the EU apart—exactly the outcome they are trying to avoid.