GERMANY´S GIFT TO EURO INTEGRATION / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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JUNE 28, 2011.

Germany's Gift to Euro Integration .

By SIMON NIXON

Angela Merkel has been dealt a lesson in the markets.

Last week, the German chancellor conceded the euro zone doesn't have the tools to deal with the side effects of imposing losses on Greek government bondholders. It's a shame she didn't work this out 10 weeks ago before her government's efforts to restructure Greek debt succeeded in destabilizing the euro zone and global economy. A far more comprehensive plan is now needed to tackle the euro crisis, regardless of whether Greece defaults or not.


What Ms. Merkel and other policy makers and investors advocating an early Greek default failed to realize was that far more is at stake in this crisis than the bondholders of a small euro-zone economy: At its heart, this remains a banking crisis as much as a sovereign-debt crisis. A simple calculation of the losses from any given level of reduction applied to Greek debt, called a haircut, even if one includes possible losses under credit-default-swap contracts, could never give an accurate picture of the mayhem a default might unleash. That is because the principal contagion risk always was via the bank-funding market.


These risks now are materializing: Rising sovereign-bond spreads are feeding through to higher bank-funding costs, regardless of how well capitalized the banks are. Peripheral country banks find themselves either shut out of markets entirely and forced to borrow from the European Central Bank or forced to push up borrowing costs to the domestic economy, hurting growth and jeopardizing fiscal objectives. These risks now have spread well beyond Europe's periphery. Italian bank stocks had to be suspended last week following a threatened Moody's downgrade on funding concerns.


Perhaps, these risks would have emerged anyway. But what the euro zone has squandered is the advantage of time. If Greece votes against the austerity program agreed with its lenders, thereby triggering a default, the euro zone probably will be forced to provide emergency lending anyway to prevent the total collapse of Greece's banking system and protect what value remains of the ECB's existing collateral. It also would need to shore up other euro-zone countries vulnerable to contagion, with debt guarantees and further ECB support for their banking systems, deepening economic integration.


But even if Greece does adopt the austerity program, the euro zone won't be off the hook. Confidence in the euro zone's willingness to support bigger and more interconnected economies, such as Spain and Italy, has taken a hammering; only a comprehensive and credible package of financial and institutional overhauls may now restore investor faith in the currency bloc.

The bad news for Ms. Merkel is that she can't give bondholders a haircut, she can't walk away, and she has forfeited the option of a short-term fix. Unwittingly, she has bought closer the very thing she has been trying so hard to avoid.


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