It’s quite simple, as long as the political will is lacking the crisis will inexorably move closer..
The markets started speculating against Italian and Spanish bonds a couple of months ago, triggering a new and potentially decisive leg in the long standing euro crisis saga.
When rates on Italian and Spanish debt move up sufficiently they simply trigger a self-reinforcing mechanism in which these countries public finances become ever more problematic as interest cost rise. Italy, with public debt at 120% of GDP is especially sensitive to higher interest payments.
It would force these countries into ever more drastic austerity, curtailing growth which in itself has a negative effect on the state of their public finances, so what was ultimately in prospect here was the kind of death spiral that has plagued Greece (and to a lesser extent Ireland and Portugal).
Lines in the sand
While most European politicians where on holiday, this left the ECB holding the bag. Buying up Spanish and Italian debt was a good way to restore a modicum of confidence and prevent these death spirals from materializing.
But the ECB can only do so much, and what’s more, the Germans (and Dutch) were strongly against this move. It was only supposed to be a stopgap measure before the EFSF, the European rescue fund, is authorized by the parliaments of all member states to buy bonds in the secondary markets.
But even that secondary defensive line is limited. The EFSF has 440M euro (part of which is already spend in Greek, Irish and Portugese bail-outs) and, you guessed it the Germans (and the Dutch) are sharply against an increase in size to give it more firepower and credibility in the markets.
So the lines in the sand are weak, exactly the kind of situation in which speculators feel encouraged to bet against the system.
They opened up a second front, speculating against European banks. This is logical, as these are the biggest holders of European debt. This was met by a temporary ban on short-selling in some countries, a rather knee-jerk reaction.
What would solve the eurocrisis
Everybody knows this. It’s either a break-up of the euro or a flight forwards into eurobonds. But you’ve guessed it. The Germans (and the Dutch) are also against this.
They are very afraid that the EU will move towards a ‘transfer union’ in which the stronger states support the weaker ones. The US is a transfer union by the mere size of its Federal government, which produces automatic transfers from stronger to weaker states. Weaker states automatically transfer less tax and receive more Federal outlays, it’s the reverse for stronger states.
But the EU budget is simply way too small (2% of the EU economy) to achieve this anywhere near the necessary scale.
So we need deliberate transfer, in the form of eurobonds (weaker members profiting from much lower interest cost on their debt, stronger countries face higher interest cost) and/or an increased EFSF.
But, as noticed, the Germans are against both options. It’s not hard to understand why. Not only would they be faced with most of the bill, the incentives for the weak countries to get their house in order would be blunted.
European Minister of Finance?
One way to deal with the latter problem is to give the EU (or the other member states) much more say in the public finances of member states. The recent Merkel-Sarkozy summit put the eurobonds firmly on hold, but took some very small steps towards more intervention of fiscal indiscipline of member states.
But for the market this has not been enough, and they are right.
We have long favoured an intermediate solution in which countries are pooling their debt into eurobonds up until 60% of GDP, while maintaining national bonds above that level (this is the Delpla-von Weisacker plan discussed here before).
Profligate members would face low interest rates on bonds up until that 60%, and high rates on debt issued above it. This maintains the incentive on profligate members to get their house in orders, while still getting overall interest payments down.
However, as long as Germany doesn’t make up its mind about what do do with the eurocrisis, the crisis will intensify, especially in a climate where growth is slowing and fears of another recession (with devastating consequences for public finances) increase.
But Germany is only firm in what it doesn’t want:
- It doesn’t want the ECB buying up government debt
- It doesn’t want the EFSF to be enlarged into sufficient size as to scare the markets
- It doesn’t want eurobonds
What does Germany want? How does it think the crisis will be solved? The Germans place a lot of emphasis on austerity, but this is likely to worsen public finances in the short-run as economic growth will suffer further.
As long as Germany dithers to take the bid decisions necessary, the clock is ticking near inexorably towards another financial crisis.