Early this week, sovereign bonds spreads for France and other Euro-core countries peaked.
Around noon on Tuesday the spreads on French and Austrian 10-year government bonds exceeded the German bund rate by some 1.9 percentage points.
This was higher than the spread for Italian bonds in July 2011. It goes almost without saying that the spreads for the southern countries, in particular Spain (4.57%) and Italy (5.32%), soared despite the fact that (according to market participants) the ECB intervened and bought Spanish and Italian government bonds.
Will the ECB start to buy Belgium, Austrian, and French bonds any time soon?
Politicians and analysts who still think that the crisis is just caused by some spendthrift countries at the European periphery and that it can be solved by imposing austerity programs on the sinners should take note: the crisis has arrived in the heart of Europe. And eventually the rescuers will themselves have to be rescued.
But the markets are not simply betting against countries, they are betting on a break-up of the Eurozone. We are facing a deep crisis of Eurozone governance. Without serious steps to revamp this governance structure they will win that bet and the euro endgame will be on – unless Eurozone governments, and especially Germany, get ready to take the necessary, though extremely unpopular, decisions.
The most important and most controversial step would be to allow the ECB to perform as a normal central bank by assuming the role of a lender of last resort. Only the ECB has enough firepower to backstop sovereign debts.
Backing the debts could be sufficient to restore confidence and would thus allow spreads to fall. Rather than monetising the debt by printing money, interventions in bond markets could eventually even be terminated – unlike today.
German politicians, when voting in favor of leveraging the European Financial Stability Fund (EFSF) in late October, did so with the deliberate intention to keep the ECB out. However, the alternative, the leveraging of the EFSF, is at best a surrogate of a solution and at worst it makes things worse.
In fact, things are already getting very nasty. The EFSF intends to guarantee the first 20% of the debt in case of a sovereign debt default. There are three problems with this construction:
Why should an investor buy government bonds from distressed Eurozone countries? If they would really go into default, the losses would be much higher than 20% – just look at the proposed “voluntary” debt reduction of 50% for Greece. Consequently, rather than joining in and thus leveraging the EFSF, banks and other institutional investors have started selling their sovereign debt holdings and are clearly unwilling to buy. The developments of interest rate spreads after the October summit clearly signal increasing (perceived) default risks.
Given the problems that Belgium, France and Austria already have with their banks, which are heavily exposed to sovereign bonds risk, this could easily intensify their own sovereign debt problems. Again look at the recent developments of their sovereign bond spreads.
If defaults really happen for countries bigger than Greece, what are now only a guarantees can easily become high realised losses for the countries that back the EFSF. Hence their state finances are in jeopardy, too, regardless whether domestic banks are exposed to problem debtors or not.
More than one and a half years of a muddling-through approach have helped to bring down four governments, increased the debt burden of all countries involved, increased the interest bill for almost all countries, except Germany, and sent many countries into severe recession.
Sooner rather than later, the taxpayers and their representatives in the corem and especially in Germany, will realise what they have decided on and what it really means for their control over their state finances.
The opposition in the core to further surrogate rescue operation will surely increase. Despite its potentially devastating consequences, the break-up of the Eurozone is rapidly becoming a realistic political and economic outcome of the present approach.
Only a radical shift in Eurozone governance can get the monetary union out of this dilemma. This is possible and it could even be a great step forward towards a more democratically governed Europe.
However, some officials will have to change their views of the world (and the role of the ECB). But at least Angela Merkel has in the past proven that she can be very flexible, if need be.
The major points are known and many economists have made them before, including myself on The Conversation. The difficulty the Eurozone is facing now is that all credible solutions will require the Eurozone (and Europe) to rethink its governance structure and their democratic foundation.
According to the so-called political trilemma, a country can choose only two out of three elements: national policy determination, integrated markets and democracy. If the Eurozone want to stick to one-money and integrated markets, it has to decide what policy areas should remain under national policy determination without ignoring the will of the electorates and what should be handled at the Euro-zone level – and how that level should be legitimated.
Policy makers have to make their decision on whether and how they will address the political trilemma in each of the four major steps to overcome the crisis:
The ECB must assume the role of a lender of last resort.
The Eurozone needs a real central bank, not just an inflation watchdog. If there is one lesson from the global financial crisis to central banking then it is that the central bank must have financial stability on its compass, too. With a clear and extended mandate the ECB will gain, not lose credibility as she will not have to buy sovereign bonds more or less reluctantly.
Fiscal coordination and strict and enforceable rules for medium-run budget discipline. This is necessary to make sure that the new role of the ECB will not result in excessive and potentially inflationary debts. The problem is serious, but it can be solved. In fact, several countries have already adopted constitutional debt breaks. Ultimately it has to be decided how much sovereignty should remain in the hands of national policy makers. A least intrusive solution would focus on overall deficit criteria and leave as much details as possible to national decision makers.
A Eurozone banking market regulation, supervision, and resolution regime. A single currency and a single monetary policy cannot provide both efficiency and stability at the same time if regulation and supervision remains nationally fragmented. “One money” needs “one banking market”, “one deposit insurance”, and a “one euro bank rescue fund”.
A Eurozone growth strategy to align national competitiveness.
Divergence of national competitiveness, not sovereign debts have been and are still the core of the problem. The current strategy based on austerity relies too much on deflation in problem countries instead of growth. Reducing debt-to-GDP ratio by means of recessions will hardly work. Structural reforms, pan-European investments via Eurobonds are some means discussed. Coordination of economic policies to avoid inflation differences like those seen in the past years is absolutely necessary.
All these steps require giving up at least some national self-determination (and in some cases deeply ingrained national convictions) in exchange for an effective Eurozone governance. It may, however, not need full harmonisation of (economic) policies as some politicians and observers suggest.
Europe and the Eurozone are not ready for that and will probably never be. But to make the Eurozone work some tough decisions will have to be made soon if it wants to rescue its single currency. To paraphrase a well-known Chinese curse: In the coming weeks and months the Eurozone will indeed live in very interesting times.