Europe’s Monetary Fault Line

Photography by European Parliament

Even while Chancellor Angela Merkel and President Nicholas Sarkozy are enjoying their summer holidays, the government debt crisis within the Eurozone is now threatening to envelop Spain and Italy, with potentially calamitous consequences not just for the Euro but for the global economy as a whole. Yet this crisis is really a natural consequence of the flawed vision of European political figures of the 1980s and 1990s, particularly Helmut Kohl and François Mitterand, who never wanted to accept the economic logic that monetary union without a concomitant political union was a financial disaster waiting to happen.

The current Eurozone debt crisis has been a long time in the making but what is startling is the speed with which it has spread in the last few weeks. Now it is not just geographically and economically peripheral countries such as Greece, Portugal and Ireland which are being affected but rather the Eurozone’s third and fourth largest economies, Italy and Spain, which are now coming under threat. Such is the size of Italy’s debt though, that according to Domenico Lombardi of the Brookings Institute, if the contagion spreads to Italy, “it would generate a financial earthquake.” The ramifications are so potentially large, “it would be close to impossible to manage that crisis,” he said.

Yet based on the yields on Italian and Spanish debt this scenario is becoming ever more likely. Investors who buy government debt - mainly hedge funds, sovereign wealth funds and large investment banks - are demanding higher interest rates to carry on lending money to the Italian and Spanish governments. Last week these yields hit the highest rate since the Euro was born in 1999, with Italy’s 10-year bond reaching 6.22 percent, while Spain’s bond hit the 6.43 percent mark at one point. This is around 3-4 percentage points higher than Germany is currently paying to borrow money and is getting closer to the critical 7 percent level at which the European financial bailouts for Greece, Ireland and Portugal were triggered.

Leaving aside for one moment the contagious impact on market sentiment which will occur as Spanish and Italian bond yields get closer to 7 percent, why is it that individual member states within the Eurozone are paying different amounts to borrow money? The answer is that European monetary union was always a potentially flawed project without a unified political authority possessing the tax and spend power to transfer money speedily to ‘weakest link’ countries such as Greece, Portugal and Ireland before a problem became a crisis. Although the European Central Bank (ECB) can tinker around at the edges by buying up government bonds, it can’t intervene massively without the consent of the Eurozone’s political masters. Consequently, the bailouts of Greece, Ireland and Portugal have been entirely reactive in nature and have required full-blown European summits to hammer out the details.

Spare a thought for ECB head Jean-Claude Trichet who must surely envy the monetary tools available to his Federal Reserve counterpart Ben Bernanke when tackling a crisis. Any move by the ECB in terms of buying Spanish or Italian bonds would have to be on the sort of massive scale used by the US central bank but it is clear that there is neither the financial muscle nor the political will for such an intervention. Indeed, the decision by the ECB to buy Irish and Portuguese debt, came in spite of opposition from Bundesbank head Jens Weidmann who maintains that the ECB lacks treaty authority to amass government bonds in the same way that China owns foreign debt, and that such intervention amounts to a “collectivisation of risks” posing a threat to monetary stability. If Germany and its central bank are opposed to the ECB’s largely symbolic decision to purchase bonds on the small scale seen in the case of Ireland and Portugal then any decision to intervene in Italy would require the sort of concerted political backing which thus far has been lacking from the Eurozone’s most powerful members. According to Willem Buiter at Citigroup, the ECB will have to intervene in support of Italy by buying its bonds, “or accept the biggest banking crisis since 1931.”

It is no wonder that US Treasury Secretary Tim Geithner is reportedly concerned at the inability of Europe’s political leaders to get ahead of the curve in terms of tackling the crisis. The current European bailout fund (to save countries as well as banks) stands at a measly 500 billion Euros, yet for it to be credible in the long-term, Citigroup’s Chief Economist Willem Buiter argues that it needs to be increased five-fold to €2.5 trillion. Such a figure though, much of which would have to be guaranteed by Germany, would be anathema to Angela Merkel who has already taken a political hit domestically over Berlin’s previous financial commitments for the Greek bailouts.

All of this merely underlines the farcical nature of a European monetary union where individual countries are charged different interest rates to borrow money and which, because of its dodgy political design, has no lender of last resort. In other words, the Euro lacks a central bank like the US Federal Reserve or the Bank of England with the power to intervene quickly to calm the markets and which is accountable to only one set of political masters.

President Mitterand and Chancellor Kohl felt that European economic union would in time lead to closer political union – the goal they both shared as a means of preventing the mistakes of the 20th century from being repeated. The choice facing Europe now is between a move towards greater political union to allow the ECB to act with the same speed and determination to tackle crises as the Federal Reserve Bank, or, as seems more likely at present, the demise of the Euro within the next few years as it is enveloped by one banking crisis after another. It would be a particular irony if monetary union - the vehicle which Kohl and Mitterand saw as the means of forging a closer political union - ultimately reveals the inadequacy of European political and economic institutions while affirming the continued relevance of the nation state.

Posted on August 7, 2011

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