EUROPE IS EDGING TOWARDS THE UNTHINKABLE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Europe is edging towards the unthinkable

By Wolfgang Münchau

Published: November 28 2010 20:49

A correspondent whom I respect challenged me last week. It is easy to criticise eurozone governments, he wrote. But how about some constructive advice?


OK. The following actions would solve the problem. But the chances are you are going to hate them.


First, I would favour some immediate debt restructuring for Greece, Ireland and Portugal – the three countries with the most unsustainable debt trajectories. This could involve haircuts, debt-for-equity swaps or other schemes. What matters is that the liabilities of the public sector are reduced to a sustainable level.


On its own, this would not be a solution at all. On the contrary, the bond markets would seize up completely. Investors would quickly conclude that all European debt – except German – was insecure.


For the plan to work, it would take two further steps. First, we have to find a way to separate national debt from financial debt. I would change the remit of the European financial stability facility, the sovereign bail-out fund, and charge it with the restructuring and downsizing of the European banking sector. Banking must be taken away from the member states.


That would alleviate the pressure on sovereign debt but would not solve the problem. For that, I would turn all outstanding sovereign bonds, existing and new, into a common European treasury bond.


Since a single bond constitutes the core of a fiscal union, you also need a functioning institutional set-up. You need, of course, a eurozone treasury, lots of rules and democratic control. What I am proposing is a regime change. It would require a new European treaty, no doubt. But it would end the crisis. And it would end all speculation about the longevity of the euro.


Meanwhile, back on earth, let me assure you that my proposal stands no chance of success. For a start, Angela Merkel, the German chancellor, would not allow it. The German constitutional court would not allow it either. The proposed treaty change would almost certainly be defeated in some referendum if it were agreed. And member states would never countenance ceding control of their banking sectors.


So how about some realistic suggestions? I think we have moved beyond a situation in which the “realistic” technical fix can do the job. If we had the luxury of not starting from here, as the Irish joke goes, a much less invasive solution could have been found several years ago. One could have constructed a system based on policy co-ordination. One could have established credible bail-out, default and exit rules. But the European Union chose not to act during the euro’s fair-weather decade. The longer you wait, the more radical the solution has to become. Today, the eurozone must deal with a simultaneous – and inter-acting – financial and governance crisis. The radical nature of my proposed solutions is merely a reflection of the mess we are in.


So what is going to happen? The eurozone has only one strategy for now, the bail-out, shortly to be followed by the bail-in. Axel Weber, president of the Bundesbank, last week made a revealing comment when he offered his macro-arithmetic of the crisis. He said the various bail-out funds added up to €925bn. The maximal possible financial risk in the eurozone is €1,070bn, leaving a small gap of €145bn. The implication is that the eurozone would somehow find the petty cash to make up the difference in a worst-case scenario.


This is very typical of the complacency with which European policymakers approach this crisis. How can we be so certain about the maximum damage? Every day last week, the markets seized on another country. On Friday it was the turn of Spain. Who knows, this week they might go after Italy and Belgium.


There are other accidents waiting to happen. Ms Merkel and Nicolas Sarkozy, the French president, were last week putting the final touches to their new bail-in rules, to introduce collective action clauses in sovereign bond contracts. I would not be surprised if at least one member state rejected the Franco-German diktat. For example, I cannot see how Spain or Italy can conceivably support them. To use a seasonal analogy, it would be like turkeys voting for Christmas.


Another accident waiting to happen could be a decision to appoint an unknown technocrat to lead the European Central Bank when Jean-Claude Trichet retires next autumn. As Mr Weber is skilfully manoeuvring himself out of contention, there is a danger that the EU may once again settle for a less well-known candidate, similar to Herman Van Rompuy, who in his first year as president of the European Council has failed to provide leadership during the crisis.


A more immediate accident could be an unco-ordinated decision to wipe out Irish bank bondholders. If that happened, eurozone sovereign risk premiums would go through the roof. This is why I am proposing to separate banking risk from sovereign risk – and to pool the latter. I think bondholder bail-ins are a good idea. But they cannot work on their own.


The eurozone is manoeuvring itself into a position where it confronts the choice between two alternatives considered “unimaginable”: fiscal union or break-up. If you are saying my proposals are unrealistic, you are making a very strong statement indeed – one with implications that I somehow find unimaginable.


Copyright The Financial Times Limited 2010.