Eurobond Plan Would Need a Big Sweetener

The Wall Street Journal

The euro-zone crisis is solved. It took some doing, but the final pieces are in place.

First, Italian Prime Minister Silvio Berlusconi has promised to reform his nation's no-growth economy. Second, the European Central Bank has agreed to buy bonds of troubled countries, including Spain and Italy. Third, euro-zone leaders have agreed to authorize their bailout fund—a.k.a. the European Financial Stability Facility—to buy euro-zone government bonds in the secondary market. I would add a fourth but it takes irony too far: Euro-zone leaders have benefited from advisory phone calls from President Barack Obama, and Treasury SecretaryTimothy Geithner's warning that they are moving too slowly to confront their debt crisis.

Worries over and head for the beaches.

Not so fast. Even if you give full faith and credit to Mr. Berlusconi's promises, major uncertainties remain. Mr. Berlusconi, who only a few days ago blamed all of Italy's problems on "speculators," has yet to deliver his Parliament, or overcome the opposition of the professions and businesses he plans to liberalize.

Investors are not convinced that he can push through a real austerity/liberalization program that will awaken the Italian economy from its decadelong slumber: Yields on Italian bonds are now higher than those on Spanish bonds, and are at a euro-era record when compared with German bunds, the haven choice of investors.

The ECB's decision to enter the bond market is a case of much too-little, much too-reluctant. When the bank ended its four-month absence from the bond market by buying Irish and Portuguese bonds, investors not only in those bonds but also in Italian bonds yawned. And with reason: Bailing out tiny countries is one thing; bailing out Spain and Italy, the euro-zone's fourth- and third-largest economies, is quite another. Indeed, the ECB's reactivation of its Securities Markets Program proved counterproductive.

• It reminded investors that the bank doesn't have sufficient resources to shore up Italian bonds, which were paying 4.8% only a month ago but now yield in the range of 6%, a rate considered unsustainable for a stagnant economy;

• It reminded investors that it was adding to its balance sheet IOUs at risk of the haircuts that Germany insists be imposed in the event of default;

• It moved the bank from the realm of monetary policy into the highly political area of fiscal policy, damaging its credibility as an inflation fighter; and

• It revealed that the bank's board was divided: at least three of the 23 board members, including the head of the Bundesbank, voted against restarting the bond-purchase program.

With Mr. Berlusconi's promises still to be raked over by Parliament and run the gauntlet of entrenched interests, and the ECB unable to stem the tide of investor discontent with Italian IOUs, the last line of defense is the EFSF, authorized on July 21 to buy the bonds of euro-zone governments. Small problem: The deal has to be approved by the parliaments of each of the 17 member nations, no sure thing since Slovakia is opposed, and not possible until late September, since many parliaments are in recess. It takes more than a financial crisis to interfere with most politicians' planned summer vacations, even though crises don't take vacations.

The bigger, much bigger problem—Germany has refused to agree to an expansion of the EFSF's €440 billion ($628 billion) fund lest more generous support persuades needy nations to resume their profligate ways. Do the math, as television commentators are prone to say. The International Monetary Fund estimates that over the next five years Italy needs between €340 billion and €380 billion to cover its deficits and redeem debt coming due. Analysts are guessing that Italy can roll over its short-term debt, leaving some €200 billion of medium- and long-term debt to be financed in the markets. To keep rates at sustainable levels, the EFSF would have to buy a large tranche of Italian bonds. But a portion of its €440 billion is already committed in one way or another to Ireland, Greece and Portugal. In short, Italy is simply too big to bail.

At least, it is too big to bail under existing arrangements. That is why European Commission President José Manuel Barroso is calling for a "rapid reassessment of all elements" of the deal cut only a few weeks ago, and to equip the bailout fund "with the means for dealing with contagious risk" that extends beyond "the euro-area periphery."

German Chancellor Angela Merkel is having none of it, since all of these demands mean a still greater call on German taxpayers, already hostile to the transfer of their hard-earned euros to what they see as early retiring, lolling-in-the-sun, irresponsible Greek, Spanish and Italian citizens who live year-round lives that Germans can enjoy only when on vacation.

Least of all do Germans want anything to do with the idea of a Eurobond, which would wrap together all of the euro-zone countries in one low-risk offering. David Owen, chief European financial economist at Jefferies & Co. calculates that the deficit of the euro area as a whole—a financially consolidated entity—would have a budget deficit of only 4% of GDP in 2012, and general government debt of 89% of GDP, far below Italy's 10% and 120%, respectively.

No one doubts that numbers anything like that would be attractive to investors—Germany would pay a bit more, the Club Med set a lot less. Which is one reason why Italy is more eager than Germany for an emergency meeting of finance ministers to redo last month's deal. Some sort of free lunch just might be served.

Irwin Stelzer is the director of economic policy studies at the Hudson Institute, Washington.