The ECB must stand behind the euro

The eurozone is now subject to a full-blown run on its bond market. Spanish and Italian borrowing costs are now higher than those of Greece, Ireland and Portugal when they were forced to seek bail-outs from the EU and IMF. The crisis has spread to Belgium and France, and even to Austria, Finland and the Netherlands. The spread – or difference – between Belgian and German borrowing costs stood at 3 percentage points in mid- November, the same as the spread with Italian and Spanish bonds a couple of months earlier. French spreads have touched 2 percentage points. The fact that Austria, Finland and the Netherlands – indisputably ‘core’ countries with strong public finances – have been drawn into the crisis shows that investors are starting to price in a break-up of the eurozone. ECB action to stabilise the situation is indispensable, as is a timetable for the mutualisation of member-states’ debt. Germany is holding out against both steps, but it faces mounting isolation.

Why has the crisis worsened so dramatically since October’s EU summit and its supposedly ‘comprehensive’ solution? First, the summit agreement failed to secure any additional firepower for the European Financial Stability Fund (EFSF). Instead, it promised to use the existing funds to insure struggling members’ bonds against the risk of partial default (up to 20 per cent of the value of the debt). By doing this, the available funds could be “leveraged” and the fund’s firepower increased. Investors were understandably sceptical of such a wobbly construction, and the subsequent deepening of the crisis has rendered the EFSF largely irrelevant. France could not now risk underwriting additional funds without prompting a further rise in its borrowing costs, and Germany and smaller ‘core’ member-states could not guarantee the whole of an expanded EFSF by themselves.

The second reason for the worsening of the crisis is that the summit reaffirmed fiscal austerity as the core strategy for regaining investor confidence in the eurozone. All member-states are required to pursue fiscal austerity simultaneously. They will be subject to tough fiscal targets, and if they fail to meet them they will effectively have to cede sovereignty to a troika of the European Commission, ECB and IMF. Unprecedented fiscal austerity across the currency union has already led to a dramatic deterioration in both consumer and business confidence and pushed the currency bloc to the edge of a slump. Despite being well short of pre-crisis levels of activity, the eurozone economy is almost certainly slide back into recession in the fourth quarter of 2011.

The eurozone crisis cannot be solved by fiscal austerity alone. The austerity strategy has failed in Greece as well as in Ireland and Portugal, with all three experiencing dramatic increases in their levels of public indebtedness. Despite this, Italy and Spain are being asked by the Commission to follow the same route and tighten fiscal policy severely. This will further erode both countries’ already dire economic growth prospects and with it confidence in their ability to service their debts. It is a similar picture in France, which has responded to the weakening of economic growth by stepping up spending cuts.

Eurozone countries are now subject to self-fulfilling crises: fears of default are driving up the borrowing costs of solvent countries, leading to a worsening of their debt positions and heightening fears of default. An announcement that all eurozone economies would move gradually to mutualise their debt would stabilise the markets; there is no prospect of the eurozone as a whole defaulting. Debt mutualisation will have to form part of any lasting solution to the crisis, but it cannot happen quickly enough to re-establish investor confidence: the political basis for such a step is currently lacking. The only available circuit-breaker at this stage is ECB action: the central bank has to act as a lender of last resort to governments. It stepped up its purchases of struggling eurozone economies’ sovereign debt in November, but not by enough to dispel default fears. The ECB should announce that it will do all that is necessary to bring down Spanish and Italian borrowing costs and make some large initial bond purchases. This would probably suffice to reassure investors, and would be cheaper than the central bank’s current strategy of piecemeal intervention in the markets.

The ECB opposes this course of action. The new president, Mario Draghi, has taken a similar line to his predecessor, Jean-Claude Trichet: the crisis is a political one that can only be addressed by governments. However, there is an element of brinkmanship in the ECB’s stance: after all, by November 2011 it had bought around €200 billion of eurozone sovereign debt. The big obstacle to the central bank performing the necessary lender of last resort function is opposition from a number of member-states, in particular Germany. They fear that an open-ended ECB guarantee to intervene to hold down borrowing costs would reduce pressure on governments to push through reforms and ultimately prove inflationary.

If there is a glimmer of hope, it is that Germany is becoming increasingly isolated. The French government, shaken by the rise in its borrowing costs, is becoming more openly critical of Germany’s refusal to support more concerted ECB action. With Mario Monti, a former EU competition commissioner, now prime minister in Italy, it will be harder to brush aside Italian concerns. And crucially, with their borrowing costs rising relative to Germany, it is far from clear that the Dutch, Austrian and Finnish governments will continue to support the German line. A Germany in a minority of one and subject to increasingly vocal criticism may yet bend.

Germany faces a choice. It can stick to its guns and preside over the dissolution of the currency union, in the process sacrificing much of its post-war investment in an increasingly integrated Europe. Or it can put forward a workable quid pro quo for saving the euro. The outlines of this are clear: in return for tougher fiscal targets and sanctions for missing them, Germany should end its opposition to the ECB acting as lender of last resort and agree to a gradual move to debt mutualisation.