EUROPE´S THREAT TO GLOBAL RECOVERY / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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DECEMBER 2, 2009, 10:12 A.M. ET

Europe's Threat to Global Recovery

By SIMON NIXON

The Dubai shock may be receding, but have the lessons been absorbed? The world is still awash with debt assumed to carry a guarantee from a rich neighbor. Take the euro zone: like the United Arab Emirates, it is a loose federation with a single central bank but only limited central political power to enforce fiscal discipline on profligate members. Excessive euro-zone deficits now present one of the biggest risks to the global recovery.

Several European countries – Greece, Italy and Belgium – already have debts of more than 100% of gross domestic product. Others will join them in 2010. Across the euro zone, the deficit in 2010 is likely to be more than 7% of GDP. The European Commission is demanding member states bring deficits back below the European Union's limit of 3% by 2013. Ireland and Spain already have introduced tax hikes and spending cuts, but Greece's new government has proposed only to cut its deficit next year from 12.7% to 9.3%, primarily through one-off tax-raising measures, and has earned itself a rebuke from the Commission.

The snag is that no one knows how far or how fast countries must cut their deficits to retain the support of markets. Government bonds are being artificially supported by central-bank policies. Banks in Greece and Ireland have been among the biggest users of facilities set up by the European Central Bank, and are using the funds to support their governments' borrowing.

Now that the ECB is discussing winding up those facilities, bond yields could rise – perhaps sharply. The ECB has warned banks to reduce their reliance on ECB liquidity, which triggered the recent sell-off in Greek bonds. It's likely to confirm Thursday that December's offer of 12-month liquidity will be the last. If it had to raise interest rates next year in response to a strong recovery in France and Germany, it could add to strains on the periphery.

Greece and Ireland's bonds already yield close to 5%, around 1.7 percentage points more than Germany's. Greece, which needs to sell €55 billion ($83.0 billion) of bonds next year, typically relies on foreign investors for half of its demand. Yet global supply of government bonds will break records in 2010. Morgan Stanley estimates net issuance will equal 16% of the overall government bond market in the U.S., 11% in the euro zone and 26% in the U.K.

If yields rise too high, deficits will become unsustainable. Medium-term, most countries need strong growth to reduce debt before they are hit by the huge demands on social spending as the baby-boomer generation retires. In theory, rising yields should impose market discipline on wayward governments. But without the traditional safety valve of devaluation, the sacrifices needed to restore competitiveness via wage deflation and falling living standards may be too much to expect from elected politicians.

Too often, politicians only make hard choices in response to a crisis. The Commission's powers to impose discipline are weak. The market assumes that if one member state faced a buyers' strike, the others would ride to the rescue, despite the euro zone's no-bailout policy. But that might depend on how hard countries are perceived to have tried to tackle their problems. Of course, countries can still turn to the International Monetary Fund for a loan, making an outright default highly unlikely. But either way, the euro zone is likely to find that the recovery poses far bigger challenges than the recession.

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