Debt Crisis Is a Symptom of Wider Failings

The Wall Street Journal

By SIMON NIXON

There can be no solution to the euro-zone crisis that doesn't first address this governance crisis…

The euro zone in its current form was destroyed at Deauville in October 2010 with the insistence that bondholders would be required to take losses… it was buried at Cannes…The first introduced previously unexpected credit risk into the sovereign-bond market, the second introduced foreign-exchange risk…

…the run on the banking system is equally damaging…

At best, the ECB can only buy time—but time for what?

…full-blown fiscal and political union needed to credibly underpin euro bonds…

After almost two years in which the focal point of the euro-zone debt crisis has shifted from one European capital to another, it has finally arrived where it belongs: in the bloc's headquarters in Brussels.

The crisis has only ever been partly about the sustainability of the sovereign debts of Greece, Ireland, Portugal, Italy and Spain. More crucially, it has always been a political crisis, an institutional crisis, a crisis of governance. It has been about the failure of the euro zone to develop the necessary mechanisms to ensure financial discipline among its member states and to come to the aid of countries when they ran into financial trouble, thereby ensuring that a debt problem in one of its smallest members should become an existential threat to the currency itself. There can be no solution to the euro-zone crisis that doesn't first address this governance crisis.

This point has been powerfully brought home in the past few weeks. Two myths have until now sustained the hopes of those betting the euro zone could exit the crisis. The first was the belief that rising government bond yields simply reflected the loss of credibility by some governments—for which the solution was an even-greater commitment to austerity and structural reform and, if necessary, its replacement by technocrats. The second myth was the view that if the survival of the euro zone were threatened, the European Central Bank would ride to the rescue of cash-strapped governments, deploying its all-powerful "bazooka" to prevent a collapse into chaos.

The first of those myths has now surely been comprehensively demolished. Despite the landslide election of a fiscal hawk promising to do whatever it takes to restore Spain's credibility, Spanish 10-year bond yields ended |Monday 25 basis points higher, at 6.52%. Despite the appointment of a technocrat government in Italy under Mario Monti, a former European Commissioner, Italian 10-year bond yields remain at 6.63%. Even French government bonds now yield 1.55 percentage points more than Germany. It is clear the euro zone is in the grip of a powerful contagion. Meanwhile, the ECB continues to do everything it can to debunk the second myth, making clear at every opportunity that it can't and won't act as lender of last resort to governments.

What is surprising is that this contagion came as a surprise to anyone. Those who argued Greece's debt problems could be treated as a "unique" case that could be ring-fenced from the rest of the euro zone clearly didn't understand how contagion works. The euro zone in its current form was destroyed at Deauville in October 2010 with the insistence that bondholders would be required to take losses as the price of future bailouts, and it was buried at Cannes this month with the surprise announcement that Greece was free to choose to leave the euro. The first introduced previously unexpected credit risk into the sovereign-bond market, the second introduced foreign-exchange risk. The result is that now the entire market with the exception of German government bonds contains extreme liquidity risk, as investors, banks and corporations try to cut their exposure.

Even now, many cling to the belief the ECB could make these problems disappear. Yet even if the bank were to change its mind on the legality of a commitment to underwrite government debts, it isn't clear this would solve the problem. The ECB can only buy bonds in the secondary markets; its intervention wouldn't necessarily guarantee Spain and Italy could maintain access to the bond markets. After all, banks have been dumping Spanish and Italian bonds to escape the higher capital charges required under the new European stress tests. It isn't clear why ECB intervention would encourage them to start buying again, since this would make little difference to overall debt burdens and doubts about debt sustainability would persist.

What's more, investors know from the Greek private-sector involvement deal that any bonds acquired by the ECB will effectively rank senior to their own, leading to bigger haircuts in the event that the debt ultimately proves unsustainable.

Besides, the run on the sovereign-debt markets is only the most visible aspect of the crisis: the run on the banking system is equally damaging. Short-term dollar funding markets and senior unsecured bond markets have been closed since the summer; the interbank market is also closing down. HSBC reported this month that it had cut its exposure to Italian banks to just $2 billion, from about $30 billion a few years ago. Depositors are also withdrawing funds: UniCredit last week reported a substantial quarterly drop in corporate deposits at its Italian and German units. Despite the ECB's active role as lender of last resort to banks, there is little it can do to prevent a powerful deleveraging that is making their debt challenge much harder and further eroding their competitiveness.

At best, the ECB can only buy time—but time for what? It has always been clear that any true solution to the euro zone's debt crisis must start with repairing its broken sovereign-bond market—something that can only now be achieved by the creation of euro-zone bonds. The European Commission is due to announce proposals for creating common euro-zone bonds Tuesday but an agreement on a way forward could take months, while delivering the necessary treaty changes to achieve the two most effective options could take years. Meanwhile, the real question remains what political price Germany will demand to put its balance sheet on the line.

Germany's greatest fear is moral hazard. How can it be sure countries will stick with reforms once market pressure is relaxed? Simply replacing elected politicians with technocrats can only be a short-term remedy since fiscal sovereignty will remain with national electorates. Both EC President José Manuel Barroso and European Council President Herman van Rompuy are preparing proposals to improve euro-zone economic governance. But most of the ideas under discussion amount to tinkering with existing rules to improve scrutiny of national budgets, not the full-blown fiscal and political union needed to credibly underpin euro bonds.

Perhaps the intensity of the crisis will force dramatic political change in Brussels as it has in member states. Perhaps governments will embrace radical transfers of sovereignty to avoid the cataclysm of a euro collapse. But the risk is that, as so often in the crisis, when the politicians do finally act, it may be too little, too late.

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