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Money Flows, but What Euro Zone Lacks Is Glue

As European Union leaders prepare for yet another crisis summit meeting next week to discuss fundamental changes in economic governing, there are growing concerns that the latest potential approach — a more aggressive intervention by the European Central Bank — will not be enough to stabilize the markets and preserve the euro.

The assumption has been that if political leaders can convince voters in their countries that they are capable of enforcing greater discipline and centralized intervention in national budgets, as Germany demands, then the European Central Bank will have the political breathing space to move more aggressively to support the bond sales of Spain and especially Italy. The thought is that the bank can flood the market, driving down interest rates to tolerable levels, buying time for Europe to fix its debt problems and overhaul laggard economies.

But with Europe veering toward recession and with increased skepticism that discipline will solve the deep structural imbalances in the euro zone, the markets’ concerns have passed from doubts about the solvency of individual countries to fears for the euro zone as a whole. Those doubts now include Germany, which cannot by itself, even if it wishes to, guarantee the credibility of Italian and Spanish debt, which totals more than $3.3 trillion.

For Kenneth S. Rogoff, an economics professor at Harvard, the biggest problem for the euro is not money so much as structure, or the lack of it. “This is a deep constitutional and institutional problem in Europe,” Mr. Rogoff said. “It’s not a funding problem.”

Yet, with even German interest rates rising, the markets are now worried about the sustainability of the euro zone as a whole, said Simon Johnson, a former chief economist for the International Monetary Fund and a professor at the M.I.T. Sloan School of Management. “The market has signaled that the risk is relative currency risk, not sovereign risk,” Mr. Johnson said. “So a ‘big bazooka’ won’t work for Europe now, because of worries about the euro itself breaking up and German interest rates going up.”

The last plan that was supposed to stop the rot, agreed upon last July but not put fully into place until mid-October, was the European Financial Stability Facility , with a lending capacity of 440 billion euros, or about $587 billion. While large enough to cover, as intended, a second Greek bailout, Ireland and Portugal, it is far too small for Italy and Spain, which are now in play.

And efforts to “leverage” the fund upward, a crucial element of the “big bazooka” Mr. Johnson referred to, are falling considerably short of the $1.35 trillion target, European officials acknowledged Wednesday. That failure is in large part because, as Mr. Johnson noted, the bond spreads for even the AAA-rated euro zone countries are going up, leaving less leeway for leveraging.

Mr. Johnson is a euro hawk, predicting a breakup of the euro zone. Others say Europe has more time, especially if the European Central Bank can intervene to support Italy more forcefully, which by its charter it is not supposed to do, at least not directly.

If so, Mr. Rogoff said, “the Europeans can stretch it out a long time, they have the money.” Nevertheless, he said, they “need to take a big step toward economic and political union, whoever wants to be a part of it.” Germany “is right to hold out for systemic changes,” he said. “The Europeans hoped to have 30 to 40 years to integrate more fully. Right now they don’t have 30 to 40 weeks.”

Some say they have far less than that.

“We are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union,” said the bloc’s economics commissioner, Olli Rehn, on Wednesday.

France and Germany are concentrating their efforts on a fundamental shift in powers among the 17 European Union states that use the euro, seeking to amend the bloc’s treaties to allow more centralized oversight of national fiscal and budget policies, and more centralized interference in them, too. Penalties would be assessed on those countries that violate the rules of economic discipline, which will be tightened and clarified.

End of the European project?

Those proposals, if accepted in principle at the summit meeting on Dec. 8 and 9, will bring about a major restructuring of the European Union and the institutionalization of a two-speed Europe, French officials said, with more economic and governmental integration among euro zone countries.

President Nicolas Sarkozy of France intends to speak to his country on Thursday to explain the ideas for a treaty change, and Chancellor Angela Merkel is expected to do the same in Germany on Friday.

Such changes, because they involve some further ceding of national sovereignty and powers, will require ratification by the nations involved, and very possibly by all 27 members of the European Union, which would mean referendums in a few countries. So France in particular is willing to move to a treaty just of the euro zone itself.

"We are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union,” said the bloc’s , , on Wednesday." -EU Economics Commissioner, Olli Rehn

While treaty change can be a lengthy process, the hope is that the effort will create enough momentum for economic convergence and discipline that will provide the political cover for Germany’s leaders to allow the European Central Bank to step in much more forcibly to defend Italy and Spain and try to stabilize the market.

But experts say it may already be too late for that plan to work.

New rules for discipline may help prevent future maladies, but they are a distant cure for the current disease. New disciplinary rules do little to address the structural flaws in the euro zone, where countries of very different economic levels, models and export potentials share the same currency, creating persistent trade and credit imbalances. Structural reforms inside countries, no matter how valuable in the long run, take a long time to work. And austerity alone cannot produce economic growth, which is the main cure for too much debt.

The endgame is constitutional change. But in this middle game, “there must be enough momentum for constitutional change to provide political cover” for the central bank “to step in,” Mr. Rogoff said. “But that’s only buying more time. They can’t finance everything, and Germany can’t declare that it’s paying for an open bar for Europe.”

Nouriel Roubini, the economist who has been accurately pessimistic for the most part, argues that Italy must restructure its debt now, from about 120 percent of its gross domestic product to 90 percent or below. If not, he said, it risks a disorderly default and the collapse of the euro.

With interest rates on the 10-year bond between 7 and 8 percent and zero growth, Italy would need a primary surplus — excluding interest payments — of at least 5 percent of its G.D.P. to stabilize its debt, Mr. Roubini wrote in an op-ed article in The Financial Times. But interest rates are rising and growth is slowing, and the austerity demanded by Germany and the European Central Bank, he argues, will push Italy deep into recession and risk a Greek-style “debt trap,” in which the debt grows faster than the country’s ability to pay it.

Mr. Rogoff said that “they need to pray that Italy is solvent.” He is not sure, “but they need to give it a chance, because if Italy blows, the whole thing would become unraveled, with big risks in all directions.”

Mr. Johnson contends that there is nothing much wrong with Italy that a vacation from the euro and a 20 percent devaluation of the currency would not solve — the traditional, pre-euro way Italy promoted growth and kept solvent.

He said that “there is always a feeling of foreboding and failure at the end of all exchange-rate arrangements,” but that European economies are largely strong. If the common currency does end, he said, “I don’t think it’s the end of the European project.”

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