The euro crisis, part 394

Rearranging the deckchairs

The markets once again are calling euro-zone leaders’ bluff. Time to get ahead of things

The Economist

Aug 6th 2011 | from the print edition

WHATEVER plans European leaders had made for their holidays are being disrupted by an adversary that never takes a break: the bond markets. A fortnight after yet another summit in Brussels to resolve the euro zone’s debt saga, the pressure on Greece, Ireland and Portugal—the three minnows to have been bailed out by Europe and the IMF so far—has eased. But the strains on far-bigger Spain and Italy are rapidly worsening. The extra interest that both countries pay to borrow for ten years compared with Germany rose to euro-era records this week. Shares in Italian banks, stuffed with domestic government bonds, are being pounded on a daily basis.

Markets are nervous in part because of national politics. José Luis Rodríguez Zapatero, Spain’s prime minister, has announced early elections for November, which could mean months of distraction from the job of deficit-cutting. Italy’s politicians pulled together well last month in passing an austerity budget, but many of the measures are backloaded and the country’s leaders—not just Silvio Berlusconi but now also his finance minister, Giulio Tremonti—are mired in scanda.

Both countries can plausibly argue that their debt loads are sustainable. Spain’s public-debt level is lower than the euro-zone average; Italy’s is very high, at 120% of GDP, but it runs a primary surplus (ie, excluding interest payments). Yet the low growth and uncertain politics in both countries create enough doubt to spook investors, and there is far too little reassurance from the rest of the euro zone to settle them down.

At every stage of this crisis Europe’s leaders have reacted late and inadequately. The summit of July 21st continued the pattern. In particular, it failed to increase further the lending capacity of the European Financial Stability Facility (EFSF), the single currency’s rescue fund. The EFSF’s firepower is due to rise from its current €250 billion ($357 billion) to €440 billion in the autumn. If you assume that the IMF kept stumping up its share of rescue funds, the pot would be just enough to see Spain through the next three years without having to go to the markets: but it is nowhere near enough to cover Italy too. The safety-net beneath the euro zone’s third- and fourth-biggest economies is flimsy, and investors know it.

Heads from the sand

What to do now? The first thing is to get off the beach. Mr Zapatero has postponed his holidays; too many other leaders are off sunning themselves. The second task is to give some immediate shade to the exposed Italian and Spanish bonds. The July summit did agree to expand the EFSF’s remit so that it can buy government debt in secondary markets. But Europe’s institutional machinery grinds along at a pace that would shame snails. The summit’s conclusions have to be signed and ratified by all 17 euro-zone governments before the EFSF can get busy. That could take weeks. In the meantime the European Central Bank should dust off its bond-buying programme.

The third thing for Europe’s leaders to do is properly ringfence Italy and Spain. Dramatically expanding the size of the EFSF, to at least €1 trillion, is one (politically fraught) option. But the EFSF is backed by guarantees from euro-zone members, so the burden on France and Germany, the two big funders, would rise sharply. French bond spreads are already creeping up: there is a risk that France could get sucked into the morass, too. The alternative to a bigger EFSF would be the issuance of Eurobonds that are jointly and severally underwritten by euro-zone members. That is a huge step towards fiscal union, one that Europe is ill-prepared to take. But increasingly, this looks like the least bad option.