The U.S. Congress may have narrowly avoided a government-debt disaster, but financial troubles are resurging across the Atlantic. If European leaders can’t find the political will to implement the drastic measures needed to stem their crisis, markets could soon put them in an untenable position.
The market for Italian and Spanish government bonds offers an indication of how little confidence Europe’s most recent package of rescue measures has inspired. As of Wednesday, the yield on the 10-year Italian bond stood at 6.08 percent, near its highest point since the introduction of the euro. The yield was about 3.7 percentage points higher than the yield on 10-year German bonds -- a spread that suggests rising concern that Italy might default. The comparable spread on Spain’s 10-year bond was 3.9 percentage points, up from 3.2 a month earlier. Belgium’s spread hit a euro-era high of 2.1 percentage points.
Investors’ jitters are dangerous, because they can become a self-fulfilling prophecy. As worries about default push up governments’ cost of borrowing, debts that were once manageable can become unsustainable. No wonder European Commission President Jose Barroso, while calling the rising yields in Italy and Spain unwarranted, voiced “deep concern” Wednesday about the market developments.
Consider Italy, which carries the euro area’s second-largest debt burden after Greece. At a 5 percent cost of borrowing, the government must run a budget surplus of about 29 billion euros a year -- not including interest payments -- to stabilize its gross government debt at its current level of about 120 percent of annual economic output. At a 10 percent cost of borrowing, the required surplus rises to about 125 billion euros, or one-sixth of all government revenue. That’s roughly what the government spends every year on Italy’s largely state-run health system. At some point, default becomes a necessity.
To restore confidence, Europe’s leaders -- specifically German Chancellor Angela Merkel and French President Nicolas Sarkozy -- must demonstrate they are willing and able to fix the flaws in the currency union that the crisis has laid bare.
As Bloomberg View has advocated, any comprehensive solution will probably entail creating a finance ministry with the sole power to issue euro bonds backed jointly and severally by all the nations of the union. It will also involve fiscal transfers that, like earned-income tax credits and unemployment insurance in the U.S., ease the pain of wage and competitiveness adjustments that states in a currency union inevitably must undertake.
Raft of Measures
The latest raft of measures takes some steps in the right direction. For one, European leaders have essentially said they’re ready to backstop governments and recapitalize banks throughout the euro area. By lowering the interest rates on loans from the European Financial Stability Facility, and by aiming to channel more infrastructure investment toward Greece, they’ve also moved toward fiscal transfers.
Still, the package isn’t nearly comprehensive enough. Even the relatively ambitious debt relief provided to Greece is a half-measure. It’s enough to make credit-rating services call Greece in default, but probably not enough to put Greece’s finances on a sustainable path.
If political will is lacking, Europe does have some options. Instead of replacing the debt of strapped governments with euro bonds, leaders could push the European Central Bank to step in and buy large quantities of troubled governments’ outstanding debt. But that would risk undermining the ECB’s independence and inflation-fighting mandate, and in any case would be only a temporary solution.
Ultimately, like the debt crisis in the U.S., Europe’s challenge in resolving its problems boils down to a fundamental social question: Can Germans and Greeks, rich and poor, find common ground? If they can’t, the advanced world is headed down the path to polarization. History suggests it wouldn’t end well.
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