Solution Is at Hand—With a Little Courage

By SIMON NIXON

The Wall Street Journal, July 13 2011.

The darkest hour is just before dawn—and these are undoubtedly dark days for the euro zone. Italian and Spanish bonds have hit record euro-era spreads over German bunds; shares in many banks from peripheral euro-zone countries are now at post-Lehman lows; the euro has fallen sharply against the dollar and Swiss franc. Few now doubt a Greek default risks triggering a "Lehman moment" for the euro zone and the global economy. Yet a comprehensive solution to the euro crisis could be activated in days. All it requires is political courage.

So far, political courage has been in short supply. Germany, which holds the key to the crisis, has for the past three months been bent on an entirely counter-productive campaign to impose losses on private-sector holders of Greek government debt. The looming prospect of a Greek default has predictably destabilized the entire euro-zone bond market. Moody's last week specifically attributed its decision to downgrade Portuguese government debt by four notches to a junk rating to the euro zone's apparent new policy of imposing losses on bondholders as a first rather than last resort. Similar concerns lie behind the precipitous loss of confidence in Italy this week.

Monday's statement by euro-zone finance ministers offered scant comfort. Most commentators concluded that it showed member states remain as confused and divided as ever. Although ministers talked for the first time about expanding the size and scope of the European Financial Stability Facility, they provided little detail and no action—and crucially didn't rule out a Greek default as they have on previous occasions. In short, ministers appeared to be doing the bare minimum and ducking the hard decisions.

It has been painfully clear for much of the past three months that there is no middle ground between closer political union and the disintegration of the euro zone—an event that could precipitate the collapse of the European Union itself, bringing a truly alarming geopolitical dimension to the bloc's woes. But the conventional wisdom has maintained that any further integration is politically impossible in the current climate and would require undeliverable treaty changes.

That need not be the case. The solution to the euro-zone crisis already exists. Graham Bishop, an independent analyst of European financial affairs, points out that for much of the past year, the European Council, which consists of European heads of government, has been blocking adoption of Europe's proposed economic governance reforms. Most of the details of the new arrangements, known as the "Six Pack" and designed to replace the discredited Stability and Growth Pact, have been agreed with the European Parliament. Just one issue remains outstanding: France and Germany won't accept a proposal stipulating that only a qualified-majority vote could overturn a European Commission ruling that a member state is in breach of the rules.

Perhaps that's not so surprising. France and Germany were instrumental in undermining the stability pact in 2005, when they unilaterally refused to accept the verdict of the European Commission that they had been running excessive deficits. Both countries view the prospect of submitting their budgets to the binding scrutiny of the EC as an unacceptable loss of sovereignty. Yet both countries are debating introducing binding domestic budget rules. And the reality is that agreeing this package of reforms—undoubtedly a major step toward political union—is vital to restoring market confidence in the long-term credibility of the euro zone. It is the best guarantee the current fiscal problems won't recur.

More importantly, once the Six Pack has been agreed and a truly credible, binding permanent budgetary surveillance regime was in place, objections to a much wider set of reforms including expanding the EFSF, reducing the interest rate on loans and even allowing member states such as Greece to use EFSF loans to buy back bonds and thereby reduce their debt burden should fall away. With no need for any new constitutional reforms, the EFSF would become a de facto euro-zone bond which could be made available on demand to countries that met their agreed budgets. Those that failed could still be denied funding—a powerful sanction.

And if EFSF lending were extended at close to its marginal interest rate of around 3% rather than the current rate of closer to 6%, Europe's sovereign-debt crisis would be radically transformed. Even Greece's debt burden might start to look sustainable. The specter of sovereign defaults that has been dogging the euro zone for the past three months would be lifted; member states would be certain they could replace maturing bonds and that banks would retain access to European Central Bank facilities. That would feed through to lower bank funding costs, and in turn to lower borrowing costs for businesses and households, helping fuel a recovery.

Indeed, once the crisis on the euro-zone periphery starts to ease, the market will be free to focus once again on the bloc's fundamental economic strength. After all, the euro zone as a whole is forecast to have a primary deficit of just 1% of gross domestic product in 2012, well below the 6-7% of GDP forecast for the U.S. and Japan. The euro zone also runs a current-account surplus, unlike the U.S., which continues to run a 4% deficit.

But will Angela Merkel and Nicolas Sarkozy back down over the Six Pack, thereby making this scenario possible? That will require both to rise above domestic politics. Statesmen are politicians who have accepted they won't win another election. The German leader has been in power for six years and the French leader for four. Neither can boast substantial achievements and both face difficult elections next year. A bold act of statesmanship now to save the euro would guarantee their place in history. So too would triggering a global slump—albeit a place of a different sort.

Write to Simon Nixon at simon.nixon@wsj.com