29 Nov 2011

The Endgame is Fast Approaching for Europe

Gobble, gobble: The economic shark is already devouring Greece and Italy, Portugal, Spain and others may well be next. Gobble, gobble: The economic shark is already devouring Greece and Italy, Portugal, Spain and others may well be next. Photo: Getty Images

EIGHTEEN months into a sovereign debt crisis - and after many futile efforts to resolve it - the endgame appears to be fast approaching for Europe.
While its leaders may well hold to the path of offering piecemeal solutions, nervous investors are fleeing Europe and its banks.
Two main options exist: Either the euro zone splits apart or it binds closer together. Each of these paths - Greece, and possibly others, dropping the euro or the emergence of a deeper political union in which a federal Europe takes control of national budgets - would lead to serious political, legal and financial consequences.
But with financial panic now threatening to move from Italy and Spain to Belgium, France and even Germany, the euro zone's paymaster, the pressure on Europe for a solution is at its most intense.
Even Britain's satirical weekly Private Eye has weighed in, proposing last week that the answer was for Europe itself to leave the European Union.
But underlying these scenarios, from the absurd to the less so, has been Europe's persistent inability to rectify the central conundrum of its common currency project: how to get money from the few countries that have it, mainly Germany and the Netherlands, to the many that need it - Greece, Italy, Spain, Portugal, Ireland and perhaps even France.
The consequences for continued inaction are dire. Uncertainty and austerity have killed the euro zone's growth prospects and analysts now expect the euro area's economy to shrink by 0.2 per cent next year - a blow for the many US companies that export there.
US financial institutions are also at risk. According to the Institute of International Finance, US financial institutions have $US767 billion ($A789 billion) of exposure via bonds, credit derivatives and other guarantees to private and public sector borrowers in the euro zone's weakest economies.
And as the European Central Bank continues to hold back from printing money as its counterparts in the US and Britain have done, investors now see a much higher likelihood of a broad market crash and a worldwide recession.
Such anxieties were on display last week when Vitor Constancio, vice-president of the ECB, addressed investors in London.
It was billed as an address on the international monetary system but, given the circumstances, there was little interest from investors in Constancio's views about fixed versus floating exchange rates and quite a lot in terms of what steps the ECB might take to tackle the crisis.
One somewhat frantic investment banker noted that beyond the Italians and the Spanish, even the Germans were having problems selling their bonds. What, he asked, was the ECB going to do about it?
Constancio mentioned the bank's bond-buying program and making loans available to banks, but he was blunt in saying that unless countries such as Greece and Italy reduced their budget deficits, there was not much he could do.
''The countries must deliver,'' Constancio said. ''In the end it is governments that are responsible for the euro area, not just the ECB.''
But it is this eat-your-spinach policy approach that many analysts are now saying is making the situation worse as countries throughout the euro area cut spending and raise taxes to meet budget deficit targets.
In a recent paper, Simon Tilford, an economist at the London Centre for European Reform, points out that imposing more rules in place of a federal framework, whereby the euro zone can commonly transfer or borrow money, will end in disaster.
Bernard Connolly, a long and persistent critic of Europe, estimates that it would cost Germany, as the main surplus country in the euro area, about 7 per cent of its gross domestic product a year to transfer sufficient funds to bail out the deficit countries, including France.
Analysts say it is Germany's unbending attitude that has so far stymied progress on the widely supported idea of a euro area able to issue its own bonds.
Lack of movement on a federal Europe has pushed investors to consider what would happen if a country such as Greece left the euro zone. Analysts predict dire consequences for the departing country, ranging from default to a collapse of its banking system.
Such a move may be legally impossible: there is no provision in any European treaty for a country to leave or be expelled from the euro zone.
But if a country made such a decision, it would have to leave the 27-member European Union as well, thus entering a more profound state of exile.
A view is now taking hold among many European leaders that the ever-worsening crisis may result in Brussels being given direct control over the budgets of countries that continue to run excessive deficits - a proposal made recently by the euro's most passionate advocate, Jean-Claude Trichet, a former president of the ECB.
In this vein, several economists at Bruegel, a Brussels-based research institute, have come out with a plan for a euro-area-wide finance minister, elected by the European Parliament, who would have limited federal powers to raise revenue, a radical measure, to be sure. Not only would that challenge the sovereignty of nations, but it would also require time and treaty changes.
With time in short supply, pressure is building on the ECB to defy German objections and buy more distressed government bonds, although there is little indication the bank has decided to do so.
''We are not financing the deficits of countries,'' Constancio said

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