The eurozone enters a critical phase

On November 21st Ireland accepted financial support totalling around €90 billion from the EU and the International Monetary Fund (IMF). There was an awful inevitability about this outcome. The leaders of Germany and France triggered the turmoil by raising the spectre of private holders of government bonds incurring losses once a 'permanent crisis resolution mechanism' replaces the existing European Financial Stability Fund (EFSF). Borrowing costs for the struggling members of the eurozone jumped, and for good reason. Until then eurozone governments and the European Central Bank had ruled out debt restructuring (a polite term for default). By raising the prospect of default, the French and the Germans opened the way for increased market speculation. Such speculation will be hard to contain, not least because it will be fully justified: in the absence of action to address imbalances between member-states and with a treaty ruling out bail-outs, a fiscal union becomes essential. However, the political obstacles to such a union appear insurmountable.

Taken out of context there is merit to the Franco-German proposal. Investors should have been encouraged to differentiate more fully between the various members of the eurozone from the start. They were not, partly because default was officially impossible. Had the Franco-German crisis resolution mechanism formed part of a broader reform of the eurozone - including meaningful action to address private sector imbalances within the currency bloc - it might not have been so damaging. But it came shortly after it became apparent that eurozone reform will comprise of little more than a beefed-up Stability and Growth Pact. As such, the acknowledgement that default was possible was almost guaranteed to prompt a speculative attack on one of the weaker member-states.

When such speculation duly took place, policy-makers made belated attempts to 'clarify' their position. But their clarification - that existing bonds would not be affected, just those issued after 2013 when the new crisis resolution mechanism would replace the EFSF - was illogical. If the mechanism was implemented, struggling eurozone countries would in 2013 have to pay ruinously high borrowing costs because investors would be fearful of default. The EU would then have to choose between launching an open-ended bail-out of the countries in question - which the fiscally sound member-states would be likely to baulk at - or pushing ahead with a restructuring of their debts. The latter would, of course, leave the current holders of these countries' debts nursing losses, which explains why investors have taken fright.

Once investors expect a default, there is a risk of such an event becoming a self-fulfilling prophecy. If the perceived risk of holding governments' bonds increases, yields on these bonds go up, exacerbating countries' financing difficulties and leading, in turn, to a further round of speculation. This has huge ramifications for the future of the euro. The EFSF has adequate funds to support a bail-out of Portugal. But what would happen if the bond market were to turn its attention to Spain? Spain's debt position (both public and private) is not as grave as that of Ireland or Portugal, but it is far from clear that Spain's economy will recover quickly enough to make its debt burden sustainable.

Since the EFSF is not big enough to finance a bail-out of Spain, eurozone governments would then have to turn to their electorates and win support for underwriting more debt. Leaving aside the tricky domestic politics of this, how many eurozone member-states would be strong enough to participate? For example, it is unlikely that Italy could participate in a major bail-out without investors looking askance at its own position. Italy is not confronted with the aftermath of a housing market crash, but the country has a very high level of public debt (around 115 per cent of GDP) and extremely poor growth prospects. Belgium is in a similar position. This means that the number of countries able to fund such a bail-out would be small, increasing the amount of debt that each would have to guarantee and hence their domestic difficulties in doing so. Investors are, of course, fully aware of this.

There is nothing inevitable about the eurozone stumbling from crisis to crisis, but the EU will have to change track soon. First, rather than being replaced by a debt resolution mechanism, the EFSF needs to evolve into some kind of fiscal union. Without a permanent system to support member-states, it is hard to see how order can be restored to the bond markets. The eurozone's sovereign debt crisis is a political, not an economic, problem; taken as a whole the currency union’s debt position is manageable.

 Second, eurozone policy-makers need to acknowledge that the current strategy of forcing austerity and debt-deflation on the struggling peripheral member-states is self-defeating. If these countries were able to devalue it might work by boosting their trade competitiveness. Similarly, if serious action was taken to address trade imbalances within the currency union, the hard-hit member-states might have a chance of generating export-led growth. As it stands, however, a number of member-states are effectively insolvent and caught in a vicious circle. The collapse of economic growth has devastated tax revenues, while deflation threatens to push up the real value of their debts (as is already happening in Ireland). Third, the ECB should be loosening monetary policy and stepping up its strategy of bond purchases in an effort to save the currency union. In light of the risk of contagion to other member-states, including Spain, the ECB's very cautious strategy is much riskier than the potentially inflationary impact of such bond purchases.

With a significant chunk of the eurozone economy stagnant and much of Germany's growth dependent on exports, the threat of a surge in inflation is imaginary. Sadly, none of these things is likely to happen. Domestic politics in a number of member-states, not least Germany, probably presents insurmountable obstacles to even a minimal fiscal union. Fiscal austerity is being stepped up in the hard-hit member-states, not scaled back. The next move in eurozone interest rates will be up, and the ECB is committed to winding-down its bond purchases. The eurozone cannot survive under these circumstances.