Flawed systems can last a long time before a “trigger event” exposes their vulnerability. Flawed U.S. mortgage-lending policies existed for decades, but the first sustained decline in house prices since the Great Depression triggered a financial crisis that soon engulfed the globe. Similarly, the euro zone carried on fairly smoothly until the sovereign debt crisis exposed its flawed structure.
A 17-country monetary union without common fiscal governance is akin to 17 members of a family having equal access to a single bank account. While some members work hard and save their money, others slack off knowing they can dip into the common account. Worse, the spendthrifts also borrow money to finance their irresponsible lifestyles. When the givers get tired of seeing the family account being drained by the takers, they decide to end the arrangement. But having agreed to the joint account in the first place, the givers find that the debts of the ne’er-do-wells have become their debts, too.
As European Union leaders scramble to contain the debt crisis now strangling more than 40 per cent of the euro zone economy, it looks like the takers have pretty much exhausted the capacity of the givers. Handing over bailout cash has become extremely unpopular with German taxpayers and the cost of the bailouts has raised worries of a potential downgrade of France’s debt rating.
Meanwhile, it has become clear to bondholders that the €440-billion ($619-billion) European Financial Stability Facility (EFSF) is far too small to stave off potential default of the €2.7-trillion combined debt of Ireland, Greece, Portugal, Spain and Italy. European Central Bank president Jean-Claude Trichet’s proposal to issue “euro-bonds” – securities that would become the liability of all 17 members – is a tough sell.
The credit problem would be bad enough if debts could be contained at current levels. But almost every euro zone member is running serious deficits, requiring continuously expanding access to debt markets.
With Greek, Portuguese, Spanish and Italian bond markets requiring a risk-based interest rate of more than 6 per cent, more bonds must be issued to cover the mushrooming interest costs. The combined effect is a debt spiral that will be impossible to arrest without sovereign credit defaults. Because euro zone banks hold massive amounts of that debt, defaults might trigger a banking crisis as serious as the 2008 meltdown. But the safety net that cushioned the banking system’s previous fall has developed gaping holes.
In 2008, European governments propped up banks by buying their shares and backstopping them with sovereign credit. But the deficit-financed stimulus spending that followed, together with the current costly attempts to stabilize the euro zone, have transformed a private-sector financial crisis into a public-sector debt crisis. How do you use sovereign credit to stabilize a banking system when public debt is the cause of the crisis?
Northern euro zone leaders can either keep pouring cash into the 17-member joint bank account, or let the southern members accept responsibility for their own bills, setting off sovereign credit defaults that threaten the entire EU banking system. We can only hope politicians finally confront the euro zone’s fundamental flaw: A common currency union cannot function without a centrally controlled fiscal authority. But it’s inconceivable that the 17 countries would allow Brussels to have such control of their affairs.
The only choice is to terminate the ill-conceived and inadequate EFSF. The process would be messy. Some of the defaulting countries would forsake the euro, returning to traditional currencies such as the Greek drachma and Spanish peseta. Countries that retain solid debt ratings would need to step in, once again, to stabilize their banks with sovereign credit. Weaker countries would experience banking failures. Parts of the region would re-enter recession.
And yet, this decision would have positive impacts. The EFSF has become a destabilizing factor as the sovereign debt contagion spread from Greece to larger economies, diminishing the financial credibility of all euro zone members and leaving bondholders uncertain whether to base lending decisions on the fundamentals of the borrowing country, or on some hybrid between the borrower and the entire euro zone. Making it clear that each country is responsible for its own debts would be a cathartic step toward market stability. And countries that drop the euro would become much more economically competitive.
From the very beginning, the notion of expecting all euro zone members to pay for the dysfunctional behaviour of a few was doomed to failure. Every euro poured into trying to preserve this fatally flawed model will only hasten the day when the solvent join the insolvent.