Europe’s leaders urgently need to convince the market that they can prevent financial distress in Greece and elsewhere from bringing down the banking system and infecting bigger countries such as Italy and France.
Instead, as they meet today for their second summit in four days, they’re engaged in a high-stakes game of chicken.
On one side, French President Nicolas Sarkozy has proposed raising the money needed -- at least 3 trillion euros ($4.2 trillion), by Bloomberg View’s calculations -- from the European Central Bank, the only institution that can credibly pledge such a large sum.
On the other side, central bank officials, with the backing of German Chancellor Angela Merkel, are holding out. They don’t want to pony up for a full rescue without first fixing key flaws in the euro area, such as the lack of a unified fiscal authority with the power to impose budget discipline on member countries. Such reforms require treaty revisions that could take years to push through, suggesting the ECB won’t be providing the firepower Europe needs to end its crisis anytime soon.
As a result, barring some miracle, Europe’s leaders will test markets’ patience with yet another inadequate bailout -- if they reach a deal at all. Early reports suggest private creditors might be pushed to write down Greece’s debt by about 50 percent, not quite the full reckoning required to draw a line under sovereign defaults. Plans to enhance the European Financial Stability Facility might boost its lending or guarantee capacity to 1 trillion euros or so, far short of what is needed to recapitalize banks and protect solvent governments from market attacks.
Keeping Armageddon Alive
Central bank officials may be hoping that by keeping the threat of financial Armageddon alive, they can coerce the region’s people and governments into moving toward the deeper union that the euro’s creators envisioned. If so, they’re making an extremely risky bet. Market turmoil is pushing up borrowing costs for banks and companies at a time when economic indicators are pointing toward a recession, making the financial positions of otherwise solvent governments increasingly precarious.
Consider Italy. If its nominal economic growth averages 2.6 percent, as the International Monetary Fund forecasts, it must run a primary budget surplus (excluding debt-service payments) of 1.9 percent of gross domestic product to keep its debt burden from growing -- a target it is on track to meet next year. If the average growth rate falls to 1 percent, however, the required surplus rises to 3.6 percent of GDP -- roughly an added 26 billion euros a year.
At some point, the ECB will inevitably have to step in, as it already has done by buying some 169.5 billion euros in government bonds. The longer the crisis lasts, the greater the cost will be, and the greater the chance it will overwhelm even the central bank, triggering a global meltdown far worse than what the world suffered in 2008 and 2009.
To be sure, ECB officials do have a point. To reassure markets, the central bank would have to put up enough money to guarantee all new bonds issued by Greece, Portugal, Ireland, Spain, Italy, France and Belgium. In doing so, it could encourage governments to act even more irresponsibly. As Bloomberg View has pointed out, only by giving up some fiscal sovereignty can the highly divergent economies of the euro area make their currency union work in the long run. Aside from enforceable budget controls, a closer union should include the kind of federal transfers, such as unemployment insurance and infrastructure spending, that can help struggling countries as they try to get back in sync.
Ideally, Europe’s leaders would find a way to fast-track the deeper reforms. There won’t be much left to fix, though, if they don’t succeed in forestalling financial disaster in the meantime. It would be a cruel irony if, in their efforts to build a better union, Europe’s central bankers ended up destroying it.
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