These are dramatic times for Europe. Many warn that it has only days left to save the euro currency or face a potentially disastrous break-up over debt problems. All eyes are now on a summit set for Dec. 8 and 9.
To avert disaster, Europe’s leaders must reach a “grand bargain” that includes short- and long-term solutions that will convincingly address both immediate and systemic problems. To solve either, help is now needed from the European Central Bank and Germany – the new “indispensable nation” of Europe and its largest and most successful economy.
The short-term challenge is to halt the rising cost of borrowing money for some eurozone countries, namely Italy and Spain. The interest rates they must pay to entice investors to buy their government bonds have reached unsustainable heights and have led to a self-fulfilling crisis: As financial markets become more concerned about the ability of these countries to repay their debts, they demand ever-higher interest rates, making it harder to repay debt.
For the foreseeable future, the European Central Bank seems to be the only actor able to arrest this vicious cycle by serving – in one form or another – as a backstop for Italian and Spanish debt.
So far, though, this idea is being rejected by the central bank and by Germany, out of worry that lax monetary policy could lead to higher inflation and take reform pressure off of debtor countries.
Should Europe, despite this bleak outlook, succeed in stabilizing the situation for the time being, it still faces a formidable long-term challenge. It must fix the flawed design of the euro, which lacks the backing of a common fiscal policy among the 17 countries that use it.
Several proposals seek to remedy this. One idea favors introducing jointly issued “eurobonds” that would be backed by the full faith and credit of all eurozone governments. Presumably, this less risky investment will satisfy investors and take the pressure off of interest rates.
Another idea is being put forth by Germany and France. On Monday, French President Nicolas Sarkozy and German Chancellor Angela Merkel proposed closer fiscal cooperation among the 27 members of the European Union. The two leaders favor tighter budget rules and automatic penalties for those who break them. They also both reject a eurobond (for now).
Their plan, though, would require amending treaties – not easy to do, given that treaty changes require unanimous agreement.
At their summit, if European leaders are not able to fix the immediate crisis, there may not be a euro left to save in the long run. And without addressing the long-term problems and assuring Germany (and others) that fiscal reforms are on the way, Germany is unlikely to tone down its opposition to necessary monetary actions in the short-term.
Yes, a grand bargain is needed. However, only a smaller agreement along the lines of the German-French proposal seems possible for now.
While this promise of longer-term action might momentarily halt the downward spiral of the crisis, it is far from certain that these limited treaty changes will be sufficient to stabilize the currency over time.
Tougher budget rules have been installed and subsequently broken before. Moreover, while such rules may have prevented a Greek-style crisis, they would have been futile in the cases of Ireland and Spain, because both countries were actually running budget surpluses before the current crisis.
In order to tackle the underlying causes of the euro crisis in full, at least two more steps will be necessary.
First, it seems likely that some form of jointly issued eurobonds will be required to assure markets of the safety of European sovereign debt. But strict conditions will have to be attached to the bonds in order to convince Germany and the central bank.
Second, trade imbalances within the eurozone, a root cause of the crisis, will have to be addressed. This is another sensitive issue for Germany, because its economy is so export-driven.
Thus even greater coordination of economic policy among the eurozone countries will be crucial, if a repeat of the current crisis is to be avoided.
Commentators have long lambasted Europe’s “muddling through” approach to the euro crisis. But the Europeans have come a long way over the past two years. Incremental steps taken at every turn of the crisis, more often than not deemed insufficient at the time by financial markets, trace a remarkable shift in policy when looked at as a whole.
The problem now, however, is that the magnitude of the crisis is such that muddling through is no longer feasible. In the current volatile environment, any minor misstep risks sending Europe’s economy over the cliff, possibly dragging the United States down with it. Under these unprecedented circumstances, it is time for Europe to make a big deal, not another half-way one.
Peter Sparding is a program officer in the Economic Policy Program of the German Marshall Fund of the United States in Washington. The views expressed are his own.