Analysis: Thinking the unthinkable on Europe's debt crisis

Published May 12, 2011

| Reuters

By Luke Baker

BRUSSELS (Reuters) - There is a solution to Europe's debt crisis. It's called proper fiscal and political union. The only problem is Germany, France, Austria, Finland, the Netherlands and quite a few others would never accept it.

For well over a year, Europe's leaders have been coming up with bold, multi-billion-euro measures to try to put a stop to the debt rot eating away at Greece, Ireland and Portugal, and which could soon affect other member states such as Spain.

The net result, especially when looked at through the eyes of the financial markets, is no improvement. Greece and the others are no closer to resolving their problems, and the likelihood of a debt default or restructuring has only risen.

For their next move, euro zone leaders are expected to decide to extend the maturities on 110 billion euros of loans already granted to Greece, could lower the interest rate, and may come up with a further package of support.

The terms of Ireland's bailout could also soon be altered, and if Portugal finds itself unable to make progress on fiscal reforms, its package could be tinkered with in time too.

From the markets' point of view, the situation is unsustainable. The debts of Greece, Ireland and Portugal just keep rising as a proportion of GDP, and there is little prospect of them financing themselves in the markets for years to come.

As a result, the euro zone will have to keep providing them with emergency loans to tide them over -- effectively lending them more money to try to overcome their bad debts -- or the debts will have to be restructured, with potentially deep repercussions for Europe's banking system and wider economy.

"There's no one silver bullet. There's no one optimal solution," said Janis Emmanouilidis, a senior policy analyst at the European Policy Center who studies the crisis.

"Policymakers are having to decide between multiple, unpleasant, sub-optimal solutions."

The likelihood, given the immense political constraints on taking more radical, far-reaching solutions, is that the euro zone will stick to its current course of action and do whatever it can to avoid the prospect of a debt restructuring or default.

But one potential solution -- and something economic historians say the euro zone will have to move toward in the decades to come if it is to be a strong and enduring single currency union -- is fuller political and fiscal integration.

The alternative could be countries dropping out of the euro zone, as reports last week suggested Greece was considering.

HISTORY TO CONSIDER

When the euro was introduced for 11 EU countries in 2002, it was a logical next step in a now more than 50-year process of economic integration. With 17 of the EU's 27 states now in the euro, the single currency is one of the region's greatest achievements.

But despite its successes, the euro has not brought with it the depth of macroeconomic and fiscal coordination that some of its early architects envisaged.

Greece's economy is hardly comparable to Germany's; Portugal's bears little resemblance to Finland's. In those differences, and the debt and deficit imbalances they have wrought, lies the seat of the sovereign debt crisis.

If there were tighter political and fiscal integration, with the euro zone one unified economy, the argument goes, it would be in a much better position to weather its current distress.

Average euro zone debt as a proportion of GDP is just over 80 percent, a much more manageable level than Greece's, at near 150 percent or Ireland's, which is above 120 percent.

If the euro zone issued bonds collectively -- an idea that has been proposed, dismissed out of hand by Germany and others, but which has not entirely gone away -- then markets would still be buying the debt, not driving yields higher, traders say.

In an analysis last month, comparing the euro zone crisis to similar problems in the U.S. banking system in the 19th century, Adalbert Winkler, a professor of finance at Franfurt's School of Finance and Management, concluded:

"A substantially more comprehensive economic union might be needed to stabilize the euro area... Already in 1990 the Bundesbank argued that a political union might be a prerequisite for the smooth functioning of European monetary union."

The problem -- as economists, EU policymakers and market participants know -- is that it is politically near-impossible.

Not only would it mean surrendering sovereignty -- few issues are more sovereign than collecting taxes and running and financing a budget -- but it would be the bailout to end all bailouts: wealthy central and northern European countries such as Germany and the Netherlands quite literally assume the collective debts and risks of the likes of Portugal and Greece.

"It would mean denouncing your own country and there is way too much nationalism at this point for that idea to get anywhere close to reality," said Mark Grant, managing director of structured debt at Southwest Securities in Florida.

"To provide aid on a case-by-case basis is one thing. To turn your sovereignty over to Brussels is quite another."

It would also mean that those countries "rescued" in the euro zone safety net would face no incentive to overhaul their economies to make themselves more competitive and grow. They would be more likely to go on as they have done, knowing they are protected under the euro zone banner.

That is the very reason Germany, Finland and others are adamant that strong "conditionality" is attached to the bailout loans to Greece, Ireland and Portugal.

Yet even if the whole idea of deeper fiscal and political union is unthinkable for a decade or more, the long-term trend for the euro zone points in that direction. As Portuguese Prime Minister Jose Socrates said this week:

"The European project faces a challenge, and this challenge has to be answered by deepening the European project...The common currency is defended by deepening economic integration. It's best if we all work together."

(Editing by Ralph Buolton)

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