By STEPHEN FIDLER
Europe has dramatically scaled up its efforts to stanch its sovereign-debt crisis since the start of last year, but to no apparent avail as the turmoil threatened this week to overwhelm Spain and Italy.
Yet, governments still have some unused weapons in their armory—though the political cost of firing them will be high.
As the common currency of 17 nation states, the euro isn't like national currencies. Governments borrowing in their own currencies don't usually need bailouts, because, as a last resort, national central banks stand behind their banks and their governments.
The euro zone is different. The European Central Bank is prevented by treaty restrictions from lending to governments and has been a reluctant buyer of government bonds in the secondary market. Willem Buiter, chief economist at Citigroup, argues that this creates a "black hole" at the center of the euro zone that constitutes "a fundamental design flaw" of the currency union.
Euro-zone governments have tried to patch over this flaw by setting up bailout funds. Over the past 18 months, they have rescued Greece, Ireland and Portugal after they were shut out of financial markets.
But these steps haven't been enough to stop the much bigger economies of Spain and Italy from drifting into the debt vortex. One reason for this, according to analysts, is that the bailout funds haven't been big enough or flexible enough to handle large liquidity crises.
Euro-zone leaders made big strides boosting the tools available to the main rescue vehicle, known as the European Financial Stability Facility, at a summit July 21, which also set new aid for Greece.
The leaders agreed to almost double the fund's lending capacity to €440 billion ($620 billion). They boosted its flexibility, agreeing the fund should be able to buy government debt on the secondary market. Such purchases could support bond prices and prevent yields, which move inversely to prices, from rising to unaffordable levels for governments.
They also agreed to allow the fund to provide money to governments that need to bail out their banks—and also to provide precautionary finance to countries to stop them from sliding into trouble.
They expected these gestures, which Germany and others had resisted in the past, to give them some respite. But investors focused instead on the fact that the changes couldn't take effect because they needed ratification by the currency union's 17 national parliaments, some of which, like Slovakia's, seemed likely to oppose them.
The changes have also been criticized for requiring procedures that would make the fund too slow to react to fast-moving market crises. For example, the fund doesn't have a cash reserve to intervene quickly in the markets.
Valentijn van Nieuwenhuijzen, head of strategy at ING Investment Management, also points out that secondary-market bond purchases will need the unanimous approval of all the countries involved in the EFSF. "This is akin to calling a meeting to decide whether or not to send out the fire brigade in case of a fire," he argues.
Also, he says, the fund's precautionary credit lines will come with economic conditions attached. Agreeing on such conditions with a borrowing government takes time that is precious in a financial crisis.
Analysts also point out that the rescue funds—even when expanded as agreed last month—can sustain Spain only for a short time and are too small to handle Italy, whose gross funding needs run at €400 billion a year.
Mr. Buiter argues that the EFSF could be expanded to about €1 trillion while remaining a top triple-A-rated credit. It should be, he says, closer to €2.5 trillion to be a credible lender of last resort for "solvent but illiquid sovereigns" like Spain and Italy.
Expanding the fund to that size would have big consequences for the governments, such as Germany, guaranteeing the EFSF, potentially adding 40 percentage points to their current ratios of debt to gross domestic product. Partly as a result, getting their political agreement to do this is seen by many analysts as a very long shot.
Failing an expansion of the funds, the ball would return to the ECB's court, raising the question of whether it would be willing to step in to act as the buyer of last resort of Italy's and Spain's bonds. Mr. Buiter's view is that the ECB will, reluctantly, step in: "The ECB will have to come in or accept a couple of fundamentally unwarranted large sovereign defaults," he wrote in a note this week.
That step will be tough for the central bank, which has insisted that it is the governments that must step up to their responsibilities. As a sign of how tough, at least three of the ECB's 23-person board opposed Thursday resuming purchases in the much smaller secondary markets for Irish and Portuguese government bonds.
Write to Stephen Fidler at stephen.fidler@wsj.com
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