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Widening Split in Europe on the Virtue of Austerity

Liz Alderman and Graham Bowley|The New York Times
Thursday, 17 Nov 2011 | 12:06 PM ET

Throughout Europe’s long debt crisis, Germany has prescribed the same strong remedy to its troubled neighbors: a stiff dose of fiscal discipline.

European Central Bank
Travelpix Ltd | Photographer's Choice | Getty Images
European Central Bank

As long as the patients were southern European countries like Greece and Italy, seen as victims of an unhealthy lifestyle, northern-tier nations like France, Austria and the Netherlands have been willing to go along with Germany’s prescriptions for reducing debt in the name of economic health. And they were willing to support Germany’s insistence that the European Central Bank not be a lender of last resort to indebted governments by actively buying their bonds.

But suddenly, as investors’ fears mount that many euro area nations are about to tip into recession , even countries like creditworthy France are finding it much more expensive to borrow money in the open market. And with that development comes a dawning realization: that austerity, rather than making it easier for them to pay down their higher debts, could make it harder — and more expensive.

The exposure of the United States, and in particular its banks, to Europe’s debt problems caused a sharp sell-off in stocks Wednesday in the final two hours of trading. The Standard & Poor’s 500-stock index, flat on the day by about 2 p.m., lost 20.9 points, or 1.66 percent, to close at 1,236.91, after the rating agency Fitchwarned that United States banks were vulnerable if Europe did not solve its crisis quickly.

As investors worried about the European sovereign debt held by banks and their vulnerability to stress in the European financial system, bank shares led the declines. Goldman Sachs lost 4 percent to $95.50. Morgan Stanley closed down 8 percent at $14.66. Citigroup lost about 4 percent to $26.90.

“All this underscores the ongoing nervousness about Europe generally and the banking sector specifically,” said Barry Knapp, head of American equity strategy at Barclays Capital.

In Europe, as France’s borrowing costs become increasingly divergent from Germany’s, so might its attitude toward having the European Central Bank step in. Already, French officials are openly disagreeing with Germany on the policy.

On Wednesday, Chancellor Angela Merkel of Germany continued to speak out against the idea of the central bank buying bonds, while the French finance minister, François Baroin, was arguing just the opposite.

Mr. Baroin called for the support of all European institutions, including the central bank, to respond to the crisis. “But Germany, for historic reasons, has closed the door to the direct involvement of the E.C.B.,” Mr. Baroin said in an interview with the French business newspaper Les Échos.

Mr. Baroin’s remark was a reference to Germany’s deep-seated fears over the inflation that could result if the central bank pumped more money into the region’s economies.

The so-called yield gap — the premium that investors demand for holding French 10-year government bonds, rather than German ones — rose Wednesday to a new high since the euro began of nearly two percentage points. It later eased back somewhat, to 1.9 percentage points.

That is still not close to the yield gap of nearly 5.2 percentage points that beleaguered Italy has with Germany, but it is a disturbing new trend for France. Austria and Netherlands are also experiencing widening yield gaps with Germany, and Spain has become a new source for concern.

The central bank was more aggressively in the market buying the bonds of Italy and Spain on Wednesday to stabilize the situation, traders said. It bought about 146 million euros, more than the 28 million euros it had bought over the previous two days, according to TD Securities. That helped lower yields earlier, but the effect didn’t last and interest rates rose again later.

In Spain, which holds elections this weekend, the 10-year yield rose to 6.4 percent — up from 5 percent just five weeks ago, and back to the levels that first prompted the central bank to begin its current relatively low-level bond buying program in the summer.

In its warning, Fitch said United States banks “could be greatly affected if contagion continues to spread beyond the stressed European markets.” The banks’ exposure to European countries’ debt and to European banks was “sizable” then “unless the euro zone debt crisis is resolved in a timely and orderly manner, the broad outlook for U.S. banks will darken.”

Another agency, Moody’s , downgraded several German lenders, adding to investors’ jitters.

Italy continues to be a major source of bond market worries, despite the announcement Wednesday by its new prime minister, Mario Monti, of a new cabinet stocked with academics and people from the banking industry and the upper reaches of the civil service.

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Italian 10-year yields were back to nearly 7 percent, the level at which analysts say financing the country’s 1.8 trillion euro ($2.4 trillion) debt mountain becomes unsustainable.

But the market anxiety has moved well beyond Italy, as the specter of a regionwide recession is making investors realize that if every country is tightening its belt at the same time, few will be able to grow their way out of the problems any time soon.

So far, France, the Netherlands and Austria have been among Germany’s allies in the crisis. France, eager to show that the French-German axis is thriving, has even backed Germany’s stance on central bank lending. The question now, though, is whether other countries will start to resist Germany’s policy prescriptions.

“The Germans have been able to rely on the French, the Dutch and the Austrians,” said Simon Tilford, the chief economist at the Center for European Reform in London. “But if they get dragged into this and their borrowing costs continue to rise, that could influence whether they continue to back Germany and the line taken on the euro zone crisis.”

On Wednesday, the French government showed a clear sign of divergence. It called on the central bank to help calm the crisis by buying the bonds of Italy, Greece and other governments whose borrowing costs are surging.

“The E.C.B.’s role is to ensure the stability of the euro, but also the financial stability of Europe,” said Valérie Pécresse, the French budget minister.

Mr. Baroin, the French finance minister, went further, alluding to the German fear of inflation, which many historians say helped Hitler’s rise to power. Indeed, much of Germany’s response to the current economic crisis is rooted in a desire not to let history repeat itself.

Mr. Baroin said that the United States Federal Reserve and the Bank of Japan had intervened in their bond markets with little fear that they were being influenced politically. “But Germany has a history, a memory about inflation and overindebtedness,” he said.

The central bank is also being sought out by banks that are desperate for cheap financing to offset losses. The chief executive of UniCredit, one of Italy’s largest lenders, urged the European Central Bank to increase access to central bank borrowing for Italian banks, the Italian press reported.

Berlin fears that allowing countries to rely on the central bank as a white knight would make them lazy about fixing their own finances. On Monday, Jens Weidmann, president of the German Bundesbank and an influential member of the European Central Bank’s governing council, said it would be illegal to use the bank to solve government budget problems.

“The increasing demand being placed on monetary policy is dangerous,” Mr. Weidmann said. “Monetary policy cannot and may not solve the solvency problems of governments and banks.”

Analysts, though, say the time for insisting on ideology is quickly running out. Because European policy makers still have not started up the main bailout fund for Europe — the European Financial Stability Facility — there are virtually no other tools besides austerity to whittle down debts and deficits.

But, said Mr. Tilford, the euro zone “is going to crack unless E.C.B. enters the picture soon.” If the central bank really starts carrying out the lender of last resort function, then the crisis can still be reined in, he and others said.

The question is whether the central bank is engaging in a strategy of brinkmanship to extract as many reforms from governments before it intervenes, or whether it genuinely intends to resist pressure to be a lender of last resort.

“If it’s a game of chicken, then it’s a very risky one,” said Mr. Tilford. “If they are resisting becoming a lender of last resort, then the future of the euro zone is very much in doubt.”

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