Angela’s vision: the promised land that lies ahead
keeps receding into the distance

In the third year of the euro crisis things are getting worse

By Charlemagne
The Economist, Jun 23rd 2012

In these times of tribulation for the euro, Germany offers a prophecy. One day, when the euro zone has got beyond the wilderness of austerity and structural reform, it will be rewarded with prosperity. Europe will have worked off its debt and become more competitive. Markets will see that the real problems of the world economy lie in debt-laden America and Japan.

The more the outside world criticises Germany, the more fervently senior German officials cling to this vision. Others have reason for doubt. In the third year of the euro crisis things are getting worse. Even good news brings no relief. Greece avoided the meltdown that an election victory by the anti-austerity Syriza party might have brought. But the new government of Antonis Samaras, leader of the centre-right New Democracy party, may not be able to halt Greece’s death spiral. An agreement to give Spain up to €100 billion ($127 billion) of euro-zone loans to recapitalise its banks did not stop the slide for long. Markets jumped at hints from the G20 summit that European rescue funds might start buying Spanish and Italian bonds, but for how long?

All along the fundamental doubt remains. What stands behind the euro: Germany, the European Central Bank (ECB), or nothing at all? Investors in euro-zone bonds want to be sure they will be repaid, and in euros, not devalued drachmas, liras or pesetas. National currencies are backed by national treasuries with the power to tax and central banks with the power to print money. But the euro is a single currency without a single government, and the ECB cannot lend to sovereigns.

For Angela Merkel, the German chancellor, the answer is to show that the single currency is backed by the commitment of all members to budget discipline and structural reform. Cutting debt and boosting competitiveness will, in time, win back market confidence, she says. Quick-fix solutions are ephemeral and often counterproductive. The ECB’s €1 trillion of cheap loans for banks was soon exhausted. Fiscal stimulus only adds debt. Enlarging the euro zone’s rescue funds raises questions about the creditworthiness of even its most solid backers.

Almost everybody disdains quick fixes. But they favour other routes to the promised land. France and others want some mutualisation of liabilities: a “fiscal union” through joint Eurobonds to cut troubled countries’ borrowing costs, a “banking union” to be a joint backstop for the banks. Either of these (preferably backed by the ECB as lender of last resort) could create a European lifesaver to prevent weak sovereigns and weak banks from drowning each other.

The germ of a banking union is the most likely outcome of the European summit on June 28th and 29th. This is partly because Spanish banks are the biggest threat to the euro right now. The European Commission is already working on essential elements, such as a system to wind up failed banks. Banking integration presents fewer political and legal problems if banks (not taxpayers) pay into a European fund to provide deposit guarantees.

But that may not be enough to stop a Europe-wide run on banks by depositors who fear a currency break-up. Only the full power of sovereigns and central banks can do that. Germany is right to say that, in the end, banking union is the start of fiscal union. Germany may be strong, says Mrs Merkel, but not strong enough to stand behind trillions of euros’ worth of European debt. For her, market pressure is the best incentive for belated reforms. After all, it was the decade of cheap credit when financial markets barely distinguished between Greek and German bonds—behaving as if Eurobonds already existed—that created the imbalances that lie behind the crisis.

Germany’s price for any mutualisation of liabilities is greater economic and political integration. Do Europeans want a banking union? Better to start with a strong European supervisor to stop the farce of national regulators applying stress tests that hide more than they reveal. Do Europeans want fiscal union? Well, first they should reduce debt levels, and get fit enough to keep up with Germany. In short, European countries must surrender much economic sovereignty before Germans will trust them to share their bank account. The Germans are already debating the future of the European project, including how to make it more democratically accountable. Others would be wise to think beyond just begging them for more unconditional support.

Time is running short

For the moment, Germany will provide no more than limited remedies that, at best, buy more time. There is much to be said for its belief in fiscal stability and reform, but playing for time may do more harm than good. The countries of the euro zone are not going through a normal adjustment. Their crisis is existential. Delay also raises the cost of salvaging the single currency (if Greece is to stay in the euro it will surely need yet another bail-out or debt-restructuring). Procrastination saps confidence in the euro. Loss of confidence, in turn, weakens growth in the core and deepens recession in the periphery.

All this makes it harder for countries to balance their books, antagonises those who must endure austerity and exasperates those who must provide more credit. A chronic crisis, moreover, erodes citizens’ belief in the European project, and thus their readiness to accept the integration that is needed to save it.

Austerity and structural reforms will be of little help unless confidence returns. That requires an unequivocal, if limited, sharing of liabilities. The proposal by Germany’s council of economic advisers to pool part of the euro zone’s stock of debt is a good start. Mrs Merkel is understandably worried about the risks her country would be taking on. But if she does not show faith in the euro’s future, neither will the markets.

The euro: tumbling towards the summit

Europe is trying to deal with the euro crisis one problem at a time

That approach is doomed to fail

The Economist, Jun 23rd 2012

A system is only as strong as its weakest point. Reinforcing one link in the chain exposes the vulnerability of the next. The euro zone is now so fragile in so many places that if the single currency is not to break apart, Europe must set about redesigning the system as a whole. The European summit on June 28th and 29th is a test of whether the euro zone’s leaders will be capable of that (see Charlemagne). Even though some of the wiser ones are now hatching plans for a banking union and for intervening directly in government-debt markets, the evidence so far is that the task is still, alas, beyond them.

The futility of treating the euro crisis as a series of separate national emergencies was plain for the world to see this week—first in Greece, then in Spain, and finally at the G20. On June 17th Greek voters chose parties that say they will broadly stick by the bail-out agreement (see article). The new government, a coalition of the three parties, headed by Antonis Samaras of New Democracy, vowed that Greece’s place in Europe would “not be put in doubt”.

It was a rare victory for the euro, but investors’ relief lasted only a few hours. That was partly because Greece has so many more weaknesses to overcome. To accomplish anything at all, Mr Samaras will have to put aside a lifetime of rivalry and rise above the politics of patronage. He must persuade ordinary Greeks, battered by austerity, to accept cuts to the minimum wage, pensions and spending, as well as a programme of structural reform that has no parallel in modern Greek history. If he fails, Greece will not qualify for further tranches of rescue money. Even if Greece’s official creditors give some leeway, by slightly lowering interest rates or rescheduling debt payments, the threat will remain that Greece will have to leave the euro.

Greece, thus, is trapped. As long as the country is in danger of leaving the euro, growth will continue to shrink, bail-out targets will be missed and politics will drift to extremes. But as long as Greece lacks growth, misses targets and fails in its politics, it will be in danger of leaving the euro.

Spain is now in a similar bind. Earlier this month it secured a pledge of up to €100 billion ($127 billion) from the euro zone to shore up its banks. But this did nothing to restore confidence. Bad loans in Spain are at an 18-year high: as The Economist went to press, rumours swirled that the latest assessment of the banks’ dodgy assets would be well above €100 billion. And the bill for shoring up the banks is supposed to be paid by the Spanish government, which may not be able to afford it. On June 19th Spain sold 12-month bills with a coupon of over 5%, more than two percentage points higher than a month ago (and, again, not sustainable).

To solve this problem, another fix is proposed. At the G20 summit in Mexico some countries suggested that the euro zone’s rescue funds should be used to buy the bonds of governments which, like Spain’s, are under attack. The European Stability Mechanism and its forerunner, the European Financial Stability Facility, can exploit a special contingency to spend hundreds of billions of euros trying to put a ceiling on borrowing costs.

Yet again, a new wheeze sparked a market rally. But for how long? Germany, the euro-zone economy that counts, has not signed up to the plan. Even if it does, the funds would be barely enough to save Spain, to say nothing of Italy, which has €2 trillion of sovereign debt. The inadequacy of the funds available risks being seen as a signal that there are limits to the euro zone’s commitments—in other words, an invitation for investors to flee.

Only if the rescue funds were free to borrow unlimited money from the European Central Bank could they credibly stand behind national debts—and there is not yet any sign of that (see article). And even if they had such firepower, the rescue funds’ intervention might prove counterproductive if bondholders fear that big purchases by the funds are merely pushing other investors back in the queue of creditors. For the euro zone to find its way through this crisis, intervention in bond markets needs to be combined with a bolder overhaul of the system itself. As we have argued, that means a detailed plan to build a banking union and to mutualise some debt.

That sinking feeling

The reassurances from Berlin are that, at the last hour, Germany will do what it takes. But by sticking to half-measures and emphasising the limits to Germany’s ability to help, Chancellor Angela Merkel is sowing doubt and deepening the economic pain. Each quick fix that is hailed as a victory before being swept aside saps the credibility which will be necessary to push through real reforms. This lets politics drift. France’s new president, François Hollande, is calling for cross-border help, even as he pursues policies (see article) guaranteed to scare Mrs Merkel’s electorate into thinking that Germany is being tricked into paying for other countries’ laxity. In Italy Mario Monti is meeting ever more public resistance to his reforms.

In theory all this is manageable. In practice it is hard to see how the euro zone’s leaders can reconcile the months of political wrangling ahead with investors’ tendency to flight.