The Euro project is in deep trouble as contagion spreads to Spain and Italy, the big southern countries. Alarm bells are also going off in France as, like early swallows in late winter, reports and opini0n pieces are appearing on the likelihood of France losing its AAA rating. The bond spread between French and German bonds had spiked to about 90 basis points and is now simmering at about about 48. Indeed, the commentariat is of the opinion that the EU’s ‘Lehman moment‘ is fast approaching.
In a valiant attempt to forestall Spanish and Italian fiscal crises, the ECB has shed its habitual reticence in all matters fiscal and has been intervening in the bond markets at an unprecedented rate. Last week, it bought €22 billion in bonds. By contrast, its intervention in bond markets since the start of the Greek crisis had been a mere €74 billion. This trend cannot last. The volume of bond purchases needed to keep the spread of Italian and Spanish bonds at affordable levels would result in the ECB significantly exceeding its limited fiscal mandate.
Edward Hugh at A Fistful of Euros puts it well.
… the issue involved is no longer one of the mechanics … The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency.
The reason the ECB is impelled to intervene is because of the run on Italy. More Hughes:
With something like 1.9 trillion Euros in outstanding debt, Italy is the planet’s third largest issuer of sovereign bonds … and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe’s financial system … means that a considerable portion is not …
He has more to say on why Italy has escaped attention so far.
The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background.
And these macroeconomic problems are harder to tackle in the Eurozone than in a country like a national currency because of difficulties in synchronizing monetary and fiscal policy. In the recent words of Gordon Brown, the Euro, when created had
no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong.
After arguing against moving towards three outcomes for the Eurozone, i.e.
- Fiscal union
- Muddling through through, for example, piecemeal expansion of the EFSF
- Complete break up of the Euro, with each member going back to its original currency
Hugh argues for a fourth option, the creation of a 2-Euro zone. The first zone would consist of the northern countries; Germany, Austria, Holland, Finland and perhaps a couple more. The second zone would consist of the big southern countries and France. He then goes on to describe the benefits of this separation, as well as tackle some of the details. These include the problems faced by northern banks holding southern assets, due to a sudden devaluation of said assets. While inevitable, Hugh argues that the devaluation could be made more palatable by likening it to the haircut being currently proposed for all Greek creditors.
An interesting read. Recommended.