Debt crisis is changing Europe's currency union
Europe and the euro will never be the same. The debt crisis is forcing governments to rewrite some of the eurozone's most fundamental rules.business Updated: Dec 04, 2010 10:42 IST
Europe and the euro will never be the same. The debt crisis is forcing governments to rewrite some of the eurozone's most fundamental rules. While some see the current turmoil as the slow-motion wreckage of the common currency bloc, others maintain Europe will have the political resolve to keep it together and even bring it closer together.
Either way, one thing is clear: Thanks to new debt and bailout rules being agreed among the 16 eurozone nations, Europe's monetary union will be forever altered, even if it survives the crisis. On Monday and Tuesday, European finance ministers will work on fleshing out a so-called European Stability Mechanism. The new rules will effectively rearrange the eurozone's power structure to protect stronger economies like Germany from paying for the profligacy of 'peripheral' countries like Greece or Portugal, threatening to create a two-tier Europe.
But the prospect of such a growing divide, unexpectedly, raises the question of closer fiscal union - money flowing from rich countries to weaker ones - even though there is huge political resistance to such a scenario.
"The debt crisis is uncovering deeper problems within Europe, calling into question the EU's future development," Monument Securities analyst Stephen Lewis wrote in a note this week. "Without political union of eurozone member states, the hopelessness of the euro's situation is likely to appear overwhelming. The search is on for the magic bullet that will cure the euro's malaise," Lewis said.
At the heart of the stability mechanism - chiefly sought by Germany, Europe's paymaster - is forcing investors to take part of the losses in debt crises. Bondholders - including banks and hedge funds - were protected in both the bailouts of Greece and Ireland. Now, politicians say that from 2013 they will have to become liable for the risks they agree to take as part of their profession. The most direct consequence, however, has been that investors are asking for higher premiums on fiscally weak governments' debt. That in turn risks pulling Europe in two different directions - that of economically strong countries who will keep paying low borrowing rates and those who will pay more because of the perceived risk surrounding their debt.
Greece, Ireland, Portugal and even Spain and Italy have to spend more money to refinance their debt, burning up cash that could otherwise have built schools, roads and hospitals and boosted growth and jobs. No longer will they be able to borrow at interest rates close to those paid by fiscally solid Germany - as they did for years after the euro's launch in 1999.
Germany argues that the higher interest rates will push these countries to be more disciplined in their spending to regain investor confidence.
For the moment, however, they seem to be doing the opposite. Ratings agency Standard & Poor's warned on Thursday it may downgrade Greece's long-term debt - adding pressure on already weakened public finances - if the new bailout rules prove too harsh on private bond holders.
Whatever finance ministers eventually make of the new stability mechanism, the debt crisis has already called into doubt the assumptions underpinning Europe's monetary union. Until last year, the eurozone stuck to two seemingly contradictory mantras: No government could ever default, and no country could ever be bailed out.
The no-bailout idea fell in May, when Greece received euro110 billion in rescue loans. The no-default premise was stamped with a 2013 expiration date last Sunday, when European Union finance ministers agreed to force losses on private creditors if a country's debt pile is deemed too big to bear.
But a growing number of experts believe the region's problems require much bolder action, in spite of firm opposition from some nations and the European Central Bank.
When they sketched an initial agreement on the new European Stability Mechanism on Sunday - just as they cleared a euro65 billion bailout for Ireland - EU finance ministers hoped to keep the debt crisis from taking down Portugal, Spain, or even Italy. Agreement on the bailout and a crisis mechanism failed to stop the sell-off in vulnerable government bonds. Markets only stabilized after ECB chief Jean-Claude Trichet indicated the central bank would extend its emergency lending to banks and would continue its purchases of government bonds. But interest rates on sovereign debt remain too high for heavily indebted governments to sustain over the longer term.
Many economists argue that the debt loads of Greece, Ireland and Portugal are already unsustainable, since the harsh austerity measures they have been forced to take are killing off desperately needed economic growth.
One solution might be to restructure those countries' debts now and allow them to get their economies in order under humane circumstances, said Simon Tilford, chief economist at the Centre for European Reform, a London-based thing tank.
Such a simultaneous shock-and-awe move, Tilford said, might stop contagion and take pressure of Italy and Spain.
"By going halfway, you're making everything worse," said Tilford.
To avoid defaults altogether, another option would be to flood a new emergency loan fund with cash to stabilize the eurozone with brute financial muscle.
Mere government guarantees like the ones that hold up the current bailout fund wouldn't be enough, said Gilles Moec, an analyst at Deutsche Bank in London. "It will be about creating a regular flow of permanent funding to this facility."
Money could come from a pan-European tax or special bonds issued for the entire eurozone, experts say. But such a step toward fiscal union is set to face firm opposition from the bloc's richer members, particularly Germany, which frown at regularly transferring funds to weaker nations.
Others see an even stronger role for the new facility. "It should be able to do just about anything, including buying up government bonds," said Stefano Micossi, director general of Italian business association and think tank Assonime. The new mechanism should get unlimited access to central bank credit to stabilize bond prices, said Micossi. "One trillion, 2 trillion, you name it."
At some point, a support system for the eurozone's weaker members might even be necessary, since the low borrowing costs they enjoyed in the healthy days of the currency union are likely gone forever. But such measures - the direct flow of cash throughout the eurozone - would imply a level of political union that countries have so far been very reluctant to accept for fear of losing sovereignty.
Olli Rehn, the EU's top economic official, on Friday said he expected the eurozone to go through years of transformation. "If the 1990s was the decade of constructing the Economic and Monetary Union and the 2000s the decade of turning it into reality," he said in a speech, "we are now at the beginning of the decade of its fundamental reform."