Pressure builds as core of euro zone shakes

All potential outcomes or solutions raise financial, legal and political concerns

Neither outcome is certain, of course - Europe’s leadership may well keep on its current path of offering piecemeal solutions that have quickly been rejected by an investor community that has lost all patience with the euro zone’s inability to act decisively.

And each of these potential outcomes, from Greece exiting the euro zone to, conversely, a deeper union in which a federal Europe takes control of national budgets, would bring with it serious political, legal and financial consequences. But with financial panic now threatening to move from Italy and Spain to Belgium, France and even Germany, the euro zone’s paymaster, the pressure upon Europe to arrive at a solution has reached its most intense point yet. Even the British satirical weekly Private Eye has weighed in, proposing last week that the answer was for Europe itself to leave the European Union.

Underlying these possibilities, however, from the absurd to the less so, has been Europe’s persistent inability to rectify the central conundrum of its common currency project: how to get money from the few countries that have it, mainly Germany, to the many that need it --Greece, Italy, Spain, Portugal, Ireland and perhaps even France. The potential consequences of continued inaction are dire. Uncertainty and austerity have killed the euro zone’s growth prospects, and analysts now expect the euro area’s economy to shrink 0.2 per cent next year.

US banks are among the worried onlookers. According to the Institute of International Finance, American financial institutions have $767 billion of exposure via bonds, credit derivatives and other guarantees to private and public sector borrowers in the euro zone’s weakest economies.

And as the European Central Bank (ECB) continues to hold back from printing money, as its peers in the United States and Britain have done, investors now see a much higher likelihood of a broad market crash and a worldwide recession.

Such anxieties were on display last week when Vitor Constancio, the vice president of the ECB, gave a speech to investors in London. It was billed as an address on the international monetary system, but given the circumstances, there was little interest from investors in Constancy’s views regarding fixed versus floating exchange rates and quite a lot in terms of what steps the ECB might take to address the crisis.

One somewhat frantic investor said that it was not only the Italians and the Spanish who were having problems selling their bonds; even the Germans were having problems. What was the ECB going to do about it? he asked. Constancio mentioned making loans available to banks and the bank’s bond-buying programme, but he was blunt in saying that unless countries like Greece and Italy followed treaty rules to reduce their budget deficits, there was not much he could do.

But it is this policy approach that many analysts are now saying is making the situation worse as countries throughout the euro area -- including even Germany -- cut spending and raise taxes to meet budget deficit targets.

In a recent paper, Simon Tilford, an economist at the Centre for European Reform in London, points out that imposing more rules in place of a federal framework whereby the euro zone could commonly transfer or borrow money would end in disaster.

“The solution to the problem has become the problem itself,” he said. “And investors see this. You cannot just keep cutting spending in the teeth of a recession.”

Bernard Connolly, a longtime critic of Europe, estimates that it would cost Germany, as the main surplus country in the euro area, about 7 per cent of its gross domestic product per year to transfer sufficient funds to bail out the deficit countries, including France. That amount, he has argued, would far surpass the $400 billion World War I reparation bill forced upon Germany -- the last payment of which Germany made just last year.

Obviously, any such move to a full-fledged transfer union would be resisted by Germany. And it is this unbending attitude by Europe’s richest country that it not become responsible for the debts of the weaker economies that has so far resulted in little progress on the widely supported proposal that the euro area be able to issue its own collective bonds.

All of this has pushed investors to consider more extreme possibilities -- for example, the exit from the euro zone of a country like Greece. Such a result, however, would have dire consequences for the departing country, from default to a collapse of the banking system, analysts say.

Austerity-induced pain
A recent report by UBS estimates that in the first year, the citizens of the departing nation would suffer a cost of as much as €11,000, or almost $15,000, per person on top of the austerity-induced pain already incurred. It might also be legally impossible.

There is no provision in any European treaty for a country to leave or be expelled from the euro zone -- a conscious choice by the framers to force the inevitability of the project. It is also true that if a country made such a decision, under the governing treaties, it would have to leave the 27-member European Union as well, thus entering a more profound state of exile.

In fact, a view is now taking hold that the ever-worsening crisis might lead to steps giving Brussels direct control over the budgets of countries that continue to run excessive deficits. “The will to make this thing work is stronger than you might think,” said Larry Hatheway, an economist at UBS and one of the authors of the report on the cost of a euro breakup.

In this vein, several economists at Bruegel, a Brussels-based research institute, have come out with a plan for a euro area finance minister, elected by the European Parliament, who would have limited revenue-raising powers on a federal level. These are radical measures, to be sure. Not only would they challenge the sovereignty of nations, they would require time and treaty changes.

Which is why, with time in very short supply, the pressure is building on the ECB to defy German objections and buy more distressed government bonds, although there is little sign that the bank has changed its view in that regard.

Constancio of the ECB actually took pride last week in explaining to investors that the bank’s bond-buying effort so far was equivalent to just 2 per cent of the euro area’s GDP -- compared with an intervention by the Federal Reserve in the United States equivalent to 11 per cent of GDP and one equivalent to 13 per cent by the Bank of England. “We are not financing the deficits of countries,” he said.