Euro debt crisis 101: What can Merkel, Sarkozy plan accomplish?

German Chancellor Angela Merkel and French President Nicolas Sarkozy are pushing for a more economically disciplined and unified eurozone as a way to stem Europe's spiraling debt crises. But it remains to be seen just how much the two leaders can do to reverse the economic damage spreading quickly. Below, the Monitor answers key questions about the debt crisis and the trouble it spells for the eurozone.

Berlin

1.What is Europe's debt crisis and why is the eurozone economy in such trouble?

A brokers reacts in a trading room of a Portuguese bank in Lisbon Wednesday, Aug. 17. Portugal has raised euro 1.16 billion ($1.67 billion) in a short-term debt auction amid continuing market jitters over the eurozone's sovereign debt crisis. Portugal needed a euro78 billion bailout earlier this year to help pay its heavy debts as it struggles to break out of an economic recession. (Francisco Seco/AP)

The eurozone is a monetary union, launched in 1999, and consisting of 17 EU members, which have adopted the euro as their common currency. These countries include nations differing widely in economic weight. The German gross domestic product (GDP) for instance was more than $3 trillion last year, while that of Greece was $310 billion.

As members of one currency, these nations waived two important fiscal instruments – individual interest and exchange rates. This was bound to create problems, says Michael Wohlgemuth, Managing Research Associate at the Walter Eucken Institute in Freiburg, Germany. "A country like Germany, which had rather bad growth figures in the early years of the eurozone, would have needed lower interest rates, while, let’s say, Ireland would have needed higher rates.”

Equally important: eurozone members signed up to the Stability and Growth Pact, obliging them to keep the annual budget deficit lower than 3 percent of GDP and the national debt under 60 percent of GDP. But hardly any member state has stuck to these limits.

“The lack of fiscal discipline and the temptations of low interest rates led to a typical over-consumption crisis, particularly at the periphery of the eurozone,” says Mr. Wohlgemuth. “Basically, countries like Greece, Portugal, and Spain threw a party with borrowed money.”

Sovereign debts spiraled out of control – Greece’s is now at about 140 percent. The rating agencies downgraded several EU economies in recent months, making it virtually impossible for them to raise money to pay off their debts. Consequently, Greece, Ireland, and Portugal all received financial aid from the other eurozone members and the International Monetary Fund (IMF) in return for promises of structural reforms, privatization of public assets, and spending cuts. Spain and Italy initiated austerity programs to avoid being drawn into the crisis, but markets remain nervous.

Is the eurozone at risk of breaking apart? And what about the euro as a currency?

The eurozone has always been a political project as much as a monetary one. Germany and France have been the driving forces. Apart from the legal and economic implications, giving up on the eurozone would mean a huge loss of political capital that Chancellor Merkel and President Sarkozy are determined to avoid, according to Ferdinand Fichtner from the Berlin-based German Institute for Economic Research (DIW). “Germans and Frenchmen appreciate the integrating power of the common currency. They won’t throw that away easily.”

If the crisis is not solved though, the euro risks losing credibility as a reserve currency. It has lost some of its shine already, says Mr. Fichtner, but profits from the weakness of the dollar.

“It would have been better to start the eurozone with fewer members,” says Wohlgemuth. “Now it is virtually impossible to exclude anyone – there is no legal basis for it. And the economic consequences for any country leaving the euro would be devastating. Any speculation about such a move would cause people and investors to withdraw their money, the banking system in such a country would collapse.”

Leaving the eurozone would not solve debt problems either – in fact, it would enhance them. If Greece for instance was to return to its old currency, the drachma, it would still have to serve creditors in euros. A sovereign default would be inevitable.

What's being done to stop the crisis and prevent future problems?

The current debate about how to stop the crisis centers on two terms – bailouts and eurobonds. Bailouts are financial aid packages, which are currently provided by the IMF and the European Financial Stability Facility (EFSF), a vehicle created specifically to help eurozone members overcome the crisis. Critics argue that bailouts are stopgap solutions and have so far failed to calm financial markets. Indeed, Greece had to be bailed out twice already within the last two years, and there could be need for further aid.

“Still, the EFSF is a much better tool than eurobonds,” Mr. Fichtner insists. “A bailout is a loan which comes with conditions, like austerity measures and fiscal discipline for the future. Eurobonds on the other hand create no incentive to cut spending and decrease debt.

Eurobonds would be issued by the European Central Bank (ECB) and replace government bonds, lowering the interest rates countries like Greece and Portugal have to pay now when buying their bonds back, but raising the rates for strong economies like Germany. In effect, the whole eurozone would guarantee the debts of individual member states – which current EU regulations rule out.

The creation of eurobonds would require a much more integrated fiscal policy in the eurozone, something Merkel and Sarkozy hinted at after their Paris meeting on Tuesday, when they spoke of “true economic governance” needed in Europe. But resistance against such a centralizing move is high, not just in smaller economies fearing to be sidelined, but in Germany, too, notably in Merkel’s own party.

Why does Germany always get stuck with the bill and will it stop bailing other countries out?

France's President Nicolas Sarkozy (r.) speaks to German Chancellor Angela Merkel as he welcomes the German leader at the Elysee Palace, in Paris, Tuesday, Aug. 16. (Philippe Wojazer/AP)

Germany is not only Europe’s strongest economy, it also an export-oriented one, No. 2 in the world after China, and as such very interested in solvent trading partners. “Germans are quite aware of the economic advantages they take out of the eurozone,” says DIW expert Fichtner. “But they also recognize the political and historic responsibility they bear for a peaceful and united Europe, and they see the euro as a stabilizing force.”

But his colleague, Wohlgemuth, disagrees. “I see a growing unease within the German population over the prospect of more bailouts coming our way. There is no political party yet trying to capitalize on that sentiment, but many here see the euro as a failed experiment, and the aversion against EU authorities in Brussels will increase. I think it is taken as a fact: We’ve got more problems with the euro than we would have without it."