Is the Euro Zone Back From the Brink?

Can European leaders rebuild the euro’s shattered rules to hold monetary union together?


Most people know of someone who has stared death in the face and survived against difficult odds. A lifelong smoker and heavy drinker, say, who suffers a heart attack in middle age, undergoes a multiple bypass and emerges leaner and fitter, with a dedication to healthy habits. An image of a trim Bill Clinton walking his daughter, Chelsea, down the aisle recently comes to mind. Such transformations inspire others to believe that, with enough will, they too can overcome adversity and see a brighter tomorrow.

Such hope is on the rise in Europe these days.

Four months after the sovereign-debt crisis threatened to tear apart the euro area and send the single currency crashing, officials in Brussels, Frankfurt and national capitals in Europe express growing confidence that the region has pulled itself back from the brink. The extraordinary measures taken in early May by the 16 euro area governments — providing €80 billion ($106 billion) in loans to Greece and committing €440 billion to a bailout fund to prevent contagion from hitting Ireland, Portugal and Spain — combined with unprecedented bond purchases by the European Central Bank have eased fears of a sovereign default and restored a semblance of calm to Europe’s government bond markets. Bank stocks have rallied and credit default swap rates have declined, following a July stress test on 91 banks across the European Union, which found that virtually all of Europe’s major banks had adequate capital.

[Video caption: Worries about the Euro zone resurfaced Tuesday, September 7, as finance ministers met in Brussels. Wolfgang Munchau, co-founder and director of Eurointelligence, joined CNBC. Airtime: Tues. Sept. 7 2010 | 11:05 AM ET]

The Greek government, meanwhile, has begun to deliver on an ambitious and painful austerity program that aims to slash its deficit — a massive 13.6 percent of gross domestic product in 2009 — by more than three quarters in four years’ time. Spain and Portugal have chipped in with additional budget cuts of their own, in a bid to instill confidence. And Europe’s economy, far from sinking into an austerity-fueled recession, has actually improved, in contrast to the sputtering U.S. recovery, led by rapid growth in Germany. Even the euro itself, which tumbled more than 18 percent earlier this year, to a low of just under $1.19, on the debt worries, had rallied to trade at about $1.27 late last month.


The outcome is better than almost anyone would have predicted back in the spring, when Europe was struggling to contain a crisis every bit as severe as the one that hit U.S. and global markets after the collapse of Lehman Brothers Holdings two years ago.

“It could have been the collapse of Europe,” Christine Lagarde, France’s Finance minister, tells Institutional Investor in an interview in Paris. “It certainly could have been the collapse of the euro. But, although it took a bit more time than we would have hoped, I think it was equally a transformational moment for Europe.”

Jürgen Stark, an executive board member of the European Central Bank’s governing council in Frankfurt, echoes the budding optimism. “Europeans have acted swiftly,” he says. “They have acted in a flexible and decisive way. We see after three months that it has worked.”

Yet crisis eased is far from crisis resolved. As impressive as Europe’s actions have been in recent months, euro area governments are only at the beginning of a long and arduous process of fiscal and institutional reform, and it remains uncertain whether they will stay the course. The reform process threatens to aggravate tensions between core euro

countries, led by Germany, which are financing today’s bailouts, and the periphery, which is being forced to accept tough austerity measures.

Consider Greece. The Socialist government of Prime Minister George Papandreou beat its target for deficit reduction in the first half of this year and has embarked on landmark pension and tax reforms under a workout program approved by the EU and the International Monetary Fund. This month euro area members are expected to approve a second tranche of loans under a €110 billion EU-IMF bailout. The harshest spending cuts are yet to come, though. If Athens sticks to its program, it will emerge at the end of the three-year bailout with a debt of 149 percent of GDP and an economy that has contracted by more than 10 percent since the crisis started, according to EU and IMF forecasts. And even then, Greece will face a decade or more of austerity to regain competitiveness with core euro countries like France and Germany. Not surprisingly, Greek government bond yield spreads, which narrowed when the bailout program was agreed upon in May, have widened in recent weeks, with ten-year bonds yielding 883 basis points more than German bonds. “The fact is, real money investors are nowhere to be seen,” says Mark Cliffe, global head of financial markets research at ING Group in London. Credit default swap rates on Greek bonds, which reflect the price of insurance against default, have surged to 911 basis points, a level exceeded only by Venezuelan bond CDSs.

“I can’t see how Greece can avoid defaulting,” says Gabriel Stein, an economist at Lombard Street Research in London. “The question is, will they default and remain in the euro area, or will they default and leave?”

Other euro area countries aren’t out of the woods yet either. The yield spread on Irish bonds jumped to 332 basis points last month, after Standard & Poor’s cut the country’s credit rating by one notch, to AA-, on concerns that the costs of bailing out Irish banks will soar. Credit ratings of Western European countries plunged over the past year, according to II’s annual Country Credit survey (“ September 2010 Country Credit: The New World Trumps the Old ”). Ireland, Portugal and Spain are also slashing spending, in a bid to contain deficits, which the EU expects to range from 7.3 percent to 11.5 percent of GDP this year. (By contrast, the projected U.S. deficit of $1.3 trillion this year amounts to 9.2 percent of GDP.) Such austerity measures, combined with fiscal retrenchment in most other euro countries, could sap Europe’s economic recovery.

Beyond the difficulties of economic management, Europe faces a big challenge to overhaul the euro area’s rules and institutional framework to prevent any repetition of the recent crisis. The euro was founded on three bedrock principles that were supposed to guarantee the currency’s future: a pact to limit budget deficits and debt, a no-bailout clause to prevent a profligate state from contaminating the entire bloc and an inflation-fighting European Central Bank that wouldn’t finance government deficits. All three have been shattered or severely shaken by the crisis; rebuilding them won’t be easy.

A group of finance ministers and other senior officials led by European Council president Herman Van Rompuy is considering ways to toughen the bloc’s deficit rules, known as the Stability and Growth Pact. The proposals would require closer budgetary cooperation among national parliaments and EU authorities, impose earlier sanctions on countries that violate the pact’s deficit and debt ceilings and extend economic surveillance to competitiveness measures like unit labor costs and current account deficits. The group is due to submit its ideas for approval by EU leaders at a summit meeting in Brussels next month. Proponents admit it’s an ambitious agenda. Skeptics say it’s bound to fail, considering that Europe effectively abandoned sanctions back in 2004 and 2005 — at the bidding of Berlin and Paris — when Germany and France violated the deficit rules.

“I think they are deluding themselves,” says Charles Wyplosz, a professor of international economics at the Graduate Institute in Geneva and an adviser to several EU governments. “You cannot sanction a friendly, democratic country.”

Euro area countries are also grappling with the need to create a permanent crisis mechanism, an issue that divides Germany from most of its partners. Last month the bloc established a European Financial Stability Facility, which can borrow up to €440 billion on behalf of any members that find themselves locked out of the bond markets (the IMF will chip in €250 billion more, if needed), but the facility will last only three years. Almost everyone agrees on the need for a successor — a European Monetary Fund of some type. The key question is, what kind of policy stick should accompany the carrot of a bailout fund? Germany, the traditional EU paymaster, approved the EFSF with great reluctance, and Chancellor Angela Merkel wants to minimize the risk of future bailouts by setting up a debt restructuring mechanism that would impose haircuts on existing bond investors. Most other euro area members reject the idea out of hand, regarding restructuring as an admission of default, and fear that merely debating the issue could spook investors and force up European bond yields. “We’re not Argentina,” says one senior EU official, who spoke on condition of anonymity. “Debt default and restructuring do not happen in the euro area.”

It all adds up to a daunting set of challenges. Officials insist that, having stared into the abyss in April and May, they will rise to the occasion. Governments may have flouted the rules in the past, but now that they are paying the costs of those mistakes, they are determined to put stronger safeguards in place.

“Member states have put money on the table — they had to help Greece,” says Marco Buti, director general for Economic and Financial Affairs at the European Commission in Brussels. “They have endured quite a lot of political costs domestically. So they have to show that a system of coordination and penalties will work in the future. I am sure that in a year’s time we will see a different economic and monetary union, with holes plugged and a system of surveillance and coordination that is going to be stronger.”

“We have to defend the currency,” says Lagarde. “And all of us, including France and Germany, we have to be very strict about our rules, about the rules of the club.”

Market participants want to see actions, not words. The crisis has been grist for the skeptics who say EMU was doomed from the start because of economic disparities among member states, the absence of a central government to shift tax revenues from strong regions to weak ones and insufficient labor mobility. Theodora Zemek, head of global fixed income at AXA Investment Managers in London, told investors at a recent conference that the EU rescue had only delayed a likely Greek default that would lead to “at best a split in the euro zone, at worst the destruction of the euro.”

Such a breakup scenario remains a fantasy for most economists and policymakers. The Maastricht Treaty makes no provision for leaving the euro, and any country considering an exit could see interest rates soar and banks collapse as investors and depositors flee — the economic equivalent of killing the patient to cure the disease. There’s a reason Greeks, Irish and Spaniards are pushing ahead with austerity — the alternative is even bleaker. ING’s Cliffe estimates that Greece would see its output plunge by 7.5 percent if it pulled out of the euro, and bond yields would soar to as high as 12 percent in countries like Spain and Portugal. “If people start to really think about the consequences of Greece exiting, it’s likely to concentrate minds and make breakup, or an exit, less probable,” he says.

Still, the euro’s endemic problems, if not tackled with radical reforms, could condemn its members to poor economic performance and recurrent crises. “EMU is kind of floating up in the air without a firm foundation,” says Thomas Mayer, chief economist of Deutsche Bank in Frankfurt. “If we don’t put the pillars back in a sober way, then I think EMU will become a weak currency union.”

Today’s troubled climate is a dramatic turnabout from the atmosphere that prevailed just two years ago, when European officials were praising the euro for invigorating the economy and helping to insulate Europe from the U.S. financial crisis. “Far from suppressing growth and entrenching divergences, the euro has spurred a spectacular drive of job creation virtually everywhere in the Union,” ECB President Jean-Claude Trichet said in a 2008 speech at a Frankfurt conference commemorating the tenth anniversary of the euro’s launch.

Growth in the euro area did accelerate this decade, powered by booming economies in Greece, Ireland and Spain; the area surpassed the U.S. for the first time in a decade with an average growth rate of about 3 percent in 2006 and 2007. Bond yields stayed low, and the euro soared to a record high of just over $1.60 in July 2008. The ECB’s aggressive provision of liquidity, meanwhile, helped the region’s banks weather the financial crisis. However, serious problems that academics had long warned about, but policymakers — and financial markets — had chosen to ignore, were still brewing.

Germany, which saw costs get out of hand during the postunification boom of the late 1980s and early ’90s, put on a hair shirt to regain competitiveness, with companies and the public sector clamping down on wages. The effort made Germany the so-called sick man of Europe — its growth averaged 1.5 percent annually for the decade ended in 2006 — but it proved successful in its aim. Unit labor costs were essentially flat during that period, setting the stage for Germany’s revival as an export powerhouse.

Countries on the area’s periphery, meanwhile, ran up massive current account deficits, believing the euro had made them irrelevant. The single currency’s one-size-fits-all interest rate, heavily influenced by slow-growing Germany, spurred faster growth and inflation in outlying countries and fueled housing booms in Ireland and Spain. Unit labor costs in Greece, Ireland and Spain rose by more than 3 percent a year from 2002 to 2008. The countries were living large on borrowed money — and time.

Papandreou led his Socialist party to victory in Greece’s October 2009 election, after promising to increase public spending to boost growth. Within weeks of taking office, however, Papandreou blamed his predecessor for masking the true state of Greece’s finances and said the 2009 deficit would be 12.7 percent of GDP (it would later be revised up again), more than double previous forecasts. Rounds of market turmoil, credit rating cuts, pledges of spending cuts and union strikes ensued, but Europe offered little more than vague pledges of support until this spring, when contagion threatened to engulf the 16-nation euro area.

German public opinion was hostile to a bailout, but in a pivotal series of meetings in Berlin at the end of April, Trichet and IMF boss Dominique Strauss-Kahn made clear to Merkel and members of the Bundestag that the future of the euro area — and the health of the German banking system, which had $45 billion of exposure to Greek borrowers — was at stake.

With Greece just days away from defaulting on €8.5 billion in maturing bonds, euro area finance ministers and the IMF agreed on May 2 to provide Athens with €110 billion in loans over three years, on condition that Greece slash government spending, reduce public sector wages, raise taxes, overhaul its pension system and make fundamental reforms to boost competitiveness. The package calmed fears about Greece, which won’t have to tap the bond markets until 2012, but failed to stop the contagion. Markets seized up after Trichet announced on May 6 that the ECB had not discussed purchasing government bonds at its meeting that day. The following day Spanish banks found themselves locked out of the repurchase agreement market, a critical source of liquidity.

In another series of crisis meetings, in Brussels that very next weekend, EU leaders and finance ministers endorsed a package designed to shock and awe financial markets. They agreed to set up the EFSF, guaranteed by euro area governments, which can borrow up to €440 billion over three years to support any countries locked out of the markets; countries seeking to draw on the facility would need to submit to a reform program with the IMF, which will provide as much as €250 billion of its own money. The European Commission chipped in an additional €60 billion. And last but not least, the ECB announced it would intervene in the bond markets.

After months of wavering, European leaders had acted boldly and succeeded in stemming the panic in markets. But in doing so they had effectively jettisoned several of the euro area’s core principles.

The fallout was immediately apparent at the ECB. Although the Federal Reserve Board and the Bank of England have purchased government bonds as part of their unconventional policies to lower long-term rates and foster recovery, ECB officials had resisted such a tactic, seeing it as a violation of the Maastricht Treaty prohibition against central bank financing of government deficits. Trichet justified the decision to reverse the bank’s stance by saying bond purchases were necessary to restore a two-way market. Surges in bond yields to more than 6 percent in Ireland and Portugal and more than 12 percent in Greece were threatening to render the ECB’s 1 percent monetary policy rate ineffective. But the decision provoked an unprecedented dissent from Axel Weber, the Bundesbank president who sits on the ECB’s governing council. He announced that he had opposed the move, saying bond purchases by the ECB posed “significant stability risks” and could undermine the bank’s credibility.

For a central bank that claims to eschew votes at its governing council meetings and take decisions by consensus, Weber’s dissent was a shock — the first public disagreement on a policy issue among ECB leaders in the bank’s 11-year history. “It’s no coincidence that a German said this,” says Deutsche Bank’s Mayer. “The Bundesbank never, ever would have thought of buying debt of states in trouble.”

Weber’s outspoken critique angered many European officials. Opposing a policy decision is fine, they say, but airing that dissent in the midst of a market panic is dangerous. “He should put his head down and shut up,” says one EU official.

Other ECB executives, including Stark, the other German on the governing council, have rallied around the decision. Stark points out that, unlike the Fed, the ECB is sterilizing its bond purchases by draining liquidity from the banking system. “Our purchases have a clear aim, to guarantee the functioning of the transition mechanism of monetary policy,” he says. “It’s not quantitative easing.”

Weber’s dissent could damage his chances of gaining the ECB presidency when Trichet steps down late next year. Backroom jockeying is already under way, with Weber and Italy’s Mario Draghi the presumed front-runners. Still, a compromise candidate from a small country could emerge. Some observers believe Germany’s support for euro area bailouts gives Chancellor Merkel a strong hand. “The Germans have accumulated IOUs with the EFSF,” says the Graduate Institute’s Wyplosz. “They are likely to get the reward with Axel Weber.”

The stability facility was formally established last month under the direction of Klaus Regling, a former top German and EU financial official. The Luxembourg-based entity is a curious construct: Officials say that, as a mechanism designed to instill market confidence, it will succeed best if it is never used and countries like Spain continue to access the bond markets directly.

Some key details about the facility remain to be decided, including the terms of any EFSF loans. Berlin wants to charge a penal interest rate, both to discourage use and to appease taxpayers worried about Germany’s €123 billion commitment to the facility. Most other states disagree, saying the EFSF should merely charge its own funding costs. There is also some doubt over whether the 15 euro countries backing the fund (Greece, for obvious reasons, is excluded) would actually deliver on their commitments, if called to do so. Last month, Slovakia’s parliament reneged on footing its share of the bill for the €80 billion loan to Greece after the newly elected prime minister, Iveta Radicova, said poorer states shouldn’t bail out richer ones. Other countries criticized the move as a dangerous rift in unity. “Solidarity is not a one-way street,” says Jörg Asmussen, state secretary for financial and European policy at the German Finance Ministry. “One can’t just take the benefits of monetary union.”

The best way to prevent such disputes is to avoid crisis in the first place. To that end, euro area governments are now focusing on ways to rebuild a set of fiscal and economic rules to replace the shattered Maastricht framework. The foundation, it’s hoped, will be a new and improved Stability and Growth Pact that monitors countries’ competitiveness, as well as their fiscal health, and provides a real threat of sanctions to ensure compliance.

Drawing on a proposal from the European Commission, the Van Rompuy ministerial group is considering a new stability pact, which would set broad guidelines for economic policy each February that would influence national legislation and budgets. EU surveillance would expand to cover a range of economic indicators — including current account deficits, unit labor costs and housing prices — to guard against unsustainable booms. Governments with larger outstanding debts would be obliged to make faster and deeper cuts in their budget deficits, to bring them well under the Maastricht ceiling of 3 percent of GDP. The rules would be enforced with a range of sanctions, from requiring governments to post interest-bearing deposits with the EU, for mild infractions, to withholding EU funds or suspending voting rights, for serious violators. Crucially, the ministers want sanctions to be imposed automatically unless a qualified majority of euro area member states vetoes them; in the past a majority had to vote in favor of sanctions, something that never happened.

Will the new rules work? Most euro watchers have their doubts. “The simple, obvious problem with both the old and the proposed, new and improved, Stability and Growth Pact is that neither has any mechanism to override national sovereignty,” says Marco Annunziata, London-based chief economist at UniCredit Group.

Annunziata believes the only solution is to hardwire fiscal discipline into each country’s constitution, in the same way that U.S. states have laws requiring balanced budgets. The model here is an amendment adopted by Germany last year that requires the government to reduce its structural deficit — the part that doesn’t reflect swings in the business cycle — to no more than 0.35 percent of GDP by 2016, from a projected 3.6 percent this year, and to require German states to balance their budgets. Belgium and Sweden are considering similar moves.

Support for such measures is tepid in many countries, though. President Nicolas Sarkozy called for France to adopt a deficit amendment and appointed a commission of experts and parliamentarians, headed by former IMF chief Michel Camdessus, to make recommendations, but the panel couldn’t agree on a clear deficit ceiling. “The politicians are dead-set against that because they see it as an infringement on their power,” says Wyplosz, who served on the commission.

Coming up with a permanent crisis mechanism to replace the EFSF promises to be even more contentious. The big sticking point is Germany’s insistence on a restructuring procedure. Finance minister Wolfgang Schäuble argues that the euro area needs the equivalent of an orderly bankruptcy process for profligate members. The plan calls for establishing an independent body of experts, a so-called Berlin Club, to intervene if a country were to become overextended; figure out a workout program of economic and fiscal reforms; and restructure the country’s outstanding debt with an exchange of bonds, like the Brady bonds used to resolve the Latin debt crisis.

“We need an efficient, robust and credible crisis-resolution framework for the euro area,” says Asmussen, a Schäuble deputy. “If you don’t have this, you’re setting the wrong incentives. If a country repeatedly misbehaves, there’s always a kind of assurance that they will get assistance from the other members.”

With the exception of Finland, which has embraced the idea, most euro area members adamantly oppose it. They note that the German plan is modeled on a sovereign-debt restructuring mechanism, which the IMF proposed back in 2001 but quickly abandoned as impractical. “If you admit that one country in the euro area has its debt restructured, then a taboo is broken and the suspicion of the market goes to all the others,” says Christian Noyer, the governor of the Banque de France. “It’s a Pandora’s box that should not be opened.” For her part, France’s Lagarde prefers to skirt the issue; she and Schäuble issued a joint Franco-German proposal to the Van Rompuy group that avoids any mention of the German plan. “There is no restructuring debate at the moment,” she says.

The clash over the issue underscores the continuing tensions and divergence of views at the heart of Europe’s monetary union. Lagarde touched on another one of those tension points earlier this year when she suggested that Berlin consider fresh stimulus measures to boost its economy and give a lift to struggling members of the euro area. That view is shared in Washington by the Obama administration and officials at the IMF, but it met with a swift rejection from Germany, which insists that deficit reduction holds the key to restoring confidence. The country’s remarkable second-quarter growth spurt — at 2.2 percent, it’s fastest in two decades — gives Merkel and Schäuble all the ammunition they need to fend off the critics, for now.

Tensions over economic policy seem bound to persist. Greece, Ireland, Portugal and Spain continue to slash their budgets in the midst of full-blown recessions; they will need years of austerity to restore competitiveness. The resulting weakness in the euro is a boon for Germany’s export-led economy. The euro, far from fostering unity, is aggravating differences among its members.

Europe will no doubt muddle through. As the ECB’s Stark says, “European integration has always experienced setbacks, and always Europe has survived and come out stronger than before.” But the debt crisis has yet to spark the life-altering transformation that the euro area needs.