Merkel and Sarkozy Have Lost Credibility

The Wall Street Journal

Six weeks to save the euro," European leaders promised the world in September. That deadline passed at last week's Cannes G-20 summit with the goal looking further away then ever. Nothing of substance was agreed on the French Riviera to aid the cause of euro survival, but one giant decision was taken that could hasten its demise. Angela Merkel and Nicolas Sarkozy's announcement that Greece is free to leave the euro has transformed the nature of the euro.

The United States fought a bloody civil war in the nineteenth century to stop states seceding from the union. Yet the German and French leaders have decided the euro zone will be a voluntary union, not because of an attachment to the principle of national self-determination but to protect the principle that euro-zone countries should not become liable for each other's debts.

The significance of Ms. Merkel and Mr. Sarkozy's Cannes declaration is immense. At a stroke, they have introduced foreign-exchange risk into a sovereign-debt market still grappling with the realization that euro-zone government bonds contain unexpected credit risk. Worse, throughout the crisis, the two leaders said they will do whatever it takes to save the euro. Yet the assurances they've given haven't been worth the paper they were written on: First, there were to be no sovereign defaults; then the first Greek haircut was a "unique situation;" the second Greek haircut followed 12 weeks later; now euro-zone exits are possible. No wonder the markets won't lend and China won't invest in Europe's bailout funds. Nothing these leaders say any longer carries any credibility.

All that can end Europe's debt crisis now is evidence that debt burdens are actually falling. Instead, the evidence suggests the euro-zone economy is disappearing down a sink-hole. Without any mechanism for fiscal transfers, the weakest economies are being forced to tackle their debt problems through ever greater austerity, leading to a downward spiral.

Meanwhile the disarray in government bond markets has triggered a full-scale institutional run on euro-zone banks, which have been shut out of key funding markers. So not only are the weakest countries trapped in an uncompetitive exchange rate but they also face higher borrowing costs too as banks cut back lending, adding to their competitiveness challenge.

In desperation, the euro zone appears determined to force out the Prime Ministers of Greece and Italy, hoping they might be replaced by new governments willing to speed up the pace of reform and boost competitiveness. George Papandreou and Silvio Berlusconi both chose to pander to their political bases rather than undertake serious structural reform, destroying any hope either country might reduce their burden of debt. Both governments have persistently dragged their feet on reform commitments given to the euro zone in return for financial support, in Italy's case via European Central Bank purchases of its bonds. But it is hard to be confident that removing two leaders in command of parliamentary majorities will deliver more effective government.

In Greece, the best hope is that a coalition will emerge able to survive long enough to ratify the Oct. 26 debt deal, thereby securing the next tranche of its bailout money and avoiding a disorderly default next month. But even if the euro zone survives this hurdle, a general election is likely to quickly follow. Perhaps the threat of national bankruptcy will force all major parties to pledge to support the debt deal, even though opinion polls show 60% of voters oppose it. But it's hard to imagine how a deal that requires Greece to hand over economic sovereignty while leaving it with a debt pile many suspect remains unsustainable cannot become an election issue. In recent European elections extremist parties have made substantial gains. And whatever new government emerges in Athens, it must still deliver on the bailout conditions, so the threat of disorderly default will remain.

In Italy, the hope is that Mr. Berlusconi can be forced out and replaced by a technocratic government appointed by the President which would take the radical measures needed to restore confidence. After all, Italy is a rich country—its northern provinces have the highest income per capita in Europe. There's talk of a wealth tax to rapidly cut the country's debt to GDP ratio. But even if this result can be engineered—installing a technocratic government still requires the parliament's consent—Italy is unlikely to rapidly regain bond-market access. A string of European banks last week saw their stock prices bounce after they revealed they dumped holdings of Italian bonds in the previous quarter. The prospect of the euro zone's bailout fund offering insurance that will cap their losses at 80% of the nominal value is unlikely to entice too many buyers in the market.

The best that Italy can expect is that a change of government provides cover for further ECB bond-buying. But this may not be panacea many imagine. New president Mario Draghi last week reiterated the ECB line that its bond buying program is temporary and limited. Despite ECB bond buying, Italian 10-year bond yields rose above 6.3% last week. The ECB is also helping fund Italian banks. There's a limit to how much Italian exposure the ECB will be comfortable taking before it insists Rome seeks external liquidity support, as it did with Greece, Portugal and Ireland. And as in Greece, Italy cannot postpone its date with the voters for ever—political uncertainty will continue to sap investor confidence.

What started as a financial crisis is now a full-blown political crisis in two euro-zone states. If the euro zone is to survive, it is now clear it will only do so by increasing its democratic deficit. The economic policies of Southern Europe will in future be dictated by a Brussels-based technocratic elite, which voters will be asked to rubber-stamp on pain of economic ruin. What is also clear is that the one thing that has always seemed vital to any lasting solution to the crisis—large-scale fiscal transfers from Germany to the periphery and a willingness to underwrite future debt—looks less likely than ever. The euro will outlive its six-week deadline, but its long-term survival remains in serious doubt.

Write to Simon Nixon at simon.nixon@wsj.com and follow him on Twitter @simon_nixon