How to avoid a eurozone debt crisis

How to avoid a eurozone debt crisis

Opinion piece (The Wall Street Journal)
24 February 2009

Twelve months ago it seemed inconceivable that any European Union member could face a sovereign debt crisis. It would have been the stuff of fantasy to argue that Ireland or Austria could be among those at risk. Yet such an outcome is now within the realm of possibility. And if one country suffered a crisis, it would almost certainly trigger a wave of crises, plunging the EU, and especially the eurozone, into turmoil.

There is nothing inevitable about this. But a way out requires Germany to show more vision.

Some euro-zone members - Italy and Spain - are vulnerable because they have lost competitiveness over the years and investors are skeptical that they will be able to regain it. Others - Austria and Belgium - have disproportionately large banking sectors and/or banks with huge exposures to crisis-hit regions such as Eastern Europe. Ireland and Greece have lost competitiveness and have very exposed banking sectors.

One way forward might be for governments to collectively issue eurozone bonds, rather than their own national bonds. This would help address the problem of poor liquidity that has bedevilled many of the smaller eurozone financial markets. And it would reduce borrowing costs for most euro-zone countries.

There are, however, obstacles. German borrowing costs would rise, as it shared its fiscal credibility with the rest of the eurozone. It might be hard for Berlin to convince taxpayers that they should help pay for other countries' mistakes.

Also, such a move would arguably let profligate countries off the hook. It might then be difficult to ensure budgetary discipline in the fiscally weaker countries. The issuance of euro-zone bonds would require a far greater degree of political integration in the eurozone in order to curb the budgetary autonomy of member states.

These concerns highlight what many economists have always believed to be the inherent contradiction in economic and monetary union: the absence of a political union. However, the German government's objection to the pooling of bond issuance - that it would cost Germany too much money - is parochial. The alternative, failing to help its neighbors, would be much more costly for Germany and Europe.

Berlin is slowly realizing this. German Finance Minister Peer Steinbrück last week indicated that there may be a case to support hard-hit members of the eurozone. But he is mistaken if he thinks a fiscal crisis in one member state would be a cleansing experience, with the chastened country receiving a highly conditional, IMF-type bailout, and the others learning the lesson of their errant ways. Moreover, pre-emption is a better strategy than dealing with a crisis once it occurs.

First, one sovereign crisis would almost certainly lead to others as investors rapidly turned their attention to the next weakest link. There will be no shortage of euro-zone economies experiencing severe fiscal pressures. The direct costs of a bailout could be surmountable in the case of Ireland or Greece,but would pose a much bigger challenge in the case of larger member states, such as Spain or Italy.

Second, there would be indirect costs from a fiscal crisis in neighboring countries to the German economy, which depends on exports to the rest of the eurozone. The last thing Berlin needs is a further collapse in external demand.

Third, there is a worst-case scenario. If Italy or Spain were to default on its sovereign debt - perhaps as a result of the rest of the eurozone's failing to agree on a bailout or attaching excessively onerous terms to one - the repercussions for the eurozone could be dramatic and could well lead to its breakup.

For large, inflexible economies, it is far from clear that default within the currency union is more plausible than a default and a move to leave it. A member state could decide that having defaulted - and thus having cut itself off, at least temporarily, from most sources of capital -- it may as well exit the eurozone and devalue. This would at least help to restore competitiveness and get the economy growing again, while in the longer term importing inflation of course. If one country were to leave, pressure on others to follow suit would be intense.

Germany can't afford to be sanguine about such an outcome. German companies have spent years holding down costs. The result has been improved competitiveness versus the rest of the eurozone, but at the expense of weak domestic demand. If the eurozone were to unravel, Germany would experience a huge real appreciation, reversing almost overnight the competitiveness gains it has painfully ground out.

A move to issue eurozone bonds may help prevent such a worst-case scenario. And it would not mean Germany sacrificing its own interests for the good of Europe. A country as export-dependent and politically reliant on the EU as Germany is cannot afford to be blasé about economic crises in neighboring countries.

Germany is going to have to show solidarity one way or another, so it should do so in a way that imposes the fewest costs on itself and maximizes its political capital.