Bloomberg News

Tale of Two Visions for Euro Boils Beneath Greek Crisis Fight

June 29, 2011

(See {EXT4 <GO>} for more on Europe’s debt crisis)

June 30 (Bloomberg) -- The longer Greece avoids default, the closer European leaders come to breaking one of their oldest taboos by taking responsibility for the finances of a neighbor.

Even as they resist European Central Bank President Jean- Claude Trichet’s call for a “major strengthening” of fiscal ties, European authorities are becoming the biggest holders of Greek debt. That would leave the country a virtual ward of the state, the objection of the bloc’s politicians to sharing sovereignty undercut by their own efforts to save the euro.

“The more debt restructuring is avoided the more Greece’s liabilities are socialized and the more a de facto fiscal union occurs,” said David Mackie, chief European economist at JPMorgan Chase & Co. in London. “If the ECB is successful in its attempt to prevent any kind of restructuring in the near- term, the region will move down the path towards the destination Trichet wants.”

Greek lawmakers yesterday approved an austerity package, clearing the way for the second international rescue in two years, which would expand taxpayers’ stake in Europe’s most- indebted country. For investors, greater subsidies from the strong to the weak risk hurting the German bonds that serve as the region’s benchmark.

The outcome of the scrap may determine whether the euro evolves or runs aground on the concern that its 17 members are too diverse to be united in one currency if some aren’t willing to abide by the rules and others won’t aid those in trouble.

Europe’s ‘Crossroads’

“We are at the crossroads for Europe,” said Guy Verhofstadt, Belgium’s prime minister for most of the euro’s first decade, said in an interview. “It is impossible to have monetary union in the coming years if we don’t build economic and fiscal union. We see Trichet realizing that, but some political leaders have other views.”

The cost of greater union would fall mainly on the core economies. Nomura International Plc economists calculate that reaching a U.S.-level of integration would require Germany to transfer 3.5 percent of gross domestic product, compared with the 0.7 percent it contributes to the EU budget that amounts to about 1 percent of GDP.

Strategists at Brockhouse & Cooper Inc., a Montreal-based brokerage, say funding Greece, Ireland and Portugal will amount to about 2 percent of the gross domestic product in France and Germany in 2011, roughly the same as their growth rates.

Household Share

Open Europe, a London-based research group, estimates each euro-zone household already underwrites 535 euros ($773) of Greek debt and a second bailout would almost triple that by 2014.

Trichet made his most public case yet on June 2 when he accepted the Charlemagne prize, awarded annually by the German city of Aachen to supporters of European integration. Seeking to turn the crisis into an opportunity to deliver a “union of tomorrow,” the 68-year old central banker urged politicians to fix a flaw in the euro architecture he helped build.

While the ECB has delivered the price stability required of monetary union, beating current “difficulties requires a major strengthening of the rules and organizations that govern fiscal and economic policies,” said Trichet. He proposed European institutions wield veto power over the budgets of countries in crisis and the creation of a regional finance ministry that, while lacking spending powers, would monitor policy making.

The likes of German Chancellor Angela Merkel, 56, fret that deeper ties mean national capitals will lose influence over their budgets as they transfer more cash across borders to keep the euro area together.

‘Meet in the Middle’

Still, the need to prevent a Greek default has already led toward greater fiscal solidarity, says Gary Jenkins, head of fixed income at Evolution Securities Ltd. in London.

Even more would force yields on the bonds of the so-called periphery to “meet more in the middle” with Germany’s, he said. “Greek debt would look better and German debt worse.”

Investors demand a premium of about 13 percentage points to hold 10-year Greek debt over 10-year German notes. The spread has narrowed from a record 15 percentage points as Europe moved closer to a second bailout. German borrowing costs are now about the same as in the U.S., where 10-year yields were higher by an average of 18 basis points in the first five months of the year.

Jim O’Neill, chairman of Goldman Sachs Asset Management, says countries may need to start issuing common bonds to attract investors to Europe and terminate the crisis.

Survival Mode

“If you wanted economic and monetary union, you have got to start delivering it,” said O’Neill. “This crisis is all about whether Europe’s policy makers want this thing to survive.”

Germany now rejects such an idea for fear it would impose higher borrowing costs on its economy. A solution suggested by the Brussels-based research group Bruegel would have countries fold their debts up to 60 percent of GDP into a joint “blue” bond that would likely enjoy relative lower interest rates than governments currently pay. Any excess debt would then be sold on a national basis as a “red” bond, which by facing a higher yield would carry an incentive to cutback.

“The benefit for Germany is if it strengthens the system and makes fiscal policy more disciplined, while smaller countries get access to a larger market,” said Jean Pisani- Ferry, Bruegel’s director and a former EU adviser. Those with large debts “suffer a margin cost.”

The euro area’s lack of a U.S.-style mechanism to spray money around the region to smooth gyrations has been singled out from the start by critics as its Achilles heel. Billionaire investor George Soros said June 26 that the euro has “fundamental flaws that need to be corrected.”

Bundesank’s Wish

Signatories of 1991’s Maastricht Treaty, which created the currency bloc, dodged the issue to maintain control over their individual purse-strings and policies. In doing so, they ignored the Bundesbank’s call for a “comprehensive political union’” and instead imposed limits on budgets and debts that have never been enforced.

What they sought to dodge may nevertheless be happening. While the rulebook bans bailouts and monetary financing of member states, the fiscal strains of Greece, Portugal and Ireland have been soothed with 256 billion euros in aid and 77 billion euros of bond buying by the ECB.

“One of the endgames of this crisis is more fiscal integration and we may be getting more of it because of this crisis than we did in the last 20, 30 years,” said Laurent Bilke, head of European interest rate strategy at Nomura in London and a former ECB economist.

‘Quantum Leap’

Trichet, a co-writer of the Maastricht treaty who is set to step down in four months, has chastised governments’ recent efforts to harden surveillance of economies for lacking the “quantum leap” that would involve “quasi-automatic” fines and fewer voting rights for transgressors. Governments respond that they are still tightening their grip by enforcing their budget rules faster, setting annual targets for debt reduction and advancing the vetting of national fiscal plans.

Trichet’s 11th-hour campaign underscores how much the ECB has at stake. The Frankfurt-based central bank has about 120 billion euros of exposure to Greece, having bought its bonds and accepted them as collateral for emergency bank loans, London- based Fathom Financial Consulting estimates. A 70 percent writedown would cost the ECB about 25 billion euros and its collateral would take a hit of 20 billion euros, erasing its entire capital base, it said.

‘Political Will’

Trichet’s cause may be carried on when Bank of Italy Governor Mario Draghi replaces him at the helm of the ECB in November. Draghi told the European Parliament this month that the debt crisis poses “a real test for the political will in Europe to do whatever is needed to ensure the achievements of economic and monetary integration.”

Merkel, the biggest contributor to the EU’s bailouts and an advocate of having investors share the cost, says her aim is to preserve a system in which the taxpayers of prudent nations aren’t on the hook for the mistakes of the wasteful. For her, fiscal union spells a weaker not stronger euro.

“The question for me as chancellor isn’t just showing solidarity,” Merkel said on March 23. “There’s also a question of where does that solidarity end” and the risk is that Europe’s strength drifts into “mediocrity.”

A push toward fiscal union and the euro itself could still founder if the public runs out of patience. The role of governments is being questioned throughout the continent with Greeks taking to the streets to oppose the austerity measures demanded of them and opinion polls showing Germans irritated by footing the bailout bill.

Popular Opposition

“The people of Europe do not want any form of fiscal union, so any debate is just theoretical,” said Eric Chaney, chief economist for the Axa SA and a former French finance ministry official. “If it means fiscal transfers the population is very clear in opposing that.”

Trichet has failed to win some past battles. As well as governments rebuffing his tougher budget monitoring, they ignored his idea to replace the ECB as a buyer of bonds and his reluctance to involve the IMF in supporting Greece.

Notwithstanding these defeats and what he calls Germany’s aversion to “unlimited liability union,” Gilles Moec, co-head of European economic research at Deutsche Bank AG, sees signs of greater fiscal links already forming as policy makers head off what would be the first default by a euro member.

At their latest round of crisis talks, authorities this month vowed to do whatever it takes to prevent a Greek bankruptcy. To do so, they boosted the size of their rescue fund, agreed the investment of creditors would be voluntary and said their future crisis-resolution mechanism would no longer have priority over investors in any post-default repayment.

“The losses arising from a sovereign default on Greece, Portugal and Ireland would be shared across all euro-zone’s taxpayers,” said Moec, a former economist at the Bank of France. “This is a clear step towards fiscal union.”

--With assistance from James Neuger in Brussels. Editors: James Hertling, Andrew Atkinson

To contact the reporter on this story: Simon Kennedy in London at

To contact the editor responsible for this story: James Hertling at

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