Bailout blues

This Irish rescue package agreed this week – along with the Greek bailout earlier in the year - has found the eurozone countries hopelessly divided over the question of how to save the common currency in the long term.

They have good reason to be concerned: The bond markets aren't showing a healthy interest in Portugal, another likely bailout candidate. Nor are they particularly impressed with Spain, an even bigger economy with a similarly troubling debt load, a high unemployment rate and a stagnating economy. Should these countries also seek relief, the future of the euro could be on the line.

Worried in Berlin

The alarm bells are ringing in Berlin. The German government could end up paying 17 billion euros or more of the expected 90-billion-euro Irish rescue package.

On Tuesday, German Finance Minister Wolfgang Schaeuble warned lawmakers that the Irish debt crisis posed a huge risk. He said the race to shore up Ireland's banking sector and public finances "puts our common currency at stake."

The excessive debt levels in Greece and now Ireland, the minister added, only reinforce Germany's strategy of trimming its budget during a nascent recovery.

But Berlin's austerity strategy has drawn criticism from major partners, including the United States. So has Chancellor Angela Merkel's suggestion that, in future euro crises, private bondholders should bear more of the losses.

Merkel's proposal is motivated, in part, by pressure from Germany's constitutional court, which could still declare the government's participation in European bailouts illegal.

In addition to being promised that the euro would be as stable as the deutschmark, Germans were told prior to the deutschmark-euro conversion that there would be a "no bailout clause" that would prevent Europe's richer countries from having to rescue the indigent.

Irreconcilable camps

With every new day of uncertainty, fears are mounting that the ongoing crisis in Europe could lead to the default of individual countries and ultimately the collapse of the eurozone. A deep divide now runs through the two almost irreconcilable camps: the one led by Germany and supported by mainly northern European countries defending a culture of economic and monetary stability; and the other consisting mostly of southern European countries referred to as PIIGS– Portugal, Italy, Ireland, Greece and Spain. European policymakers are now trying to achieve a consensus between the two camps.

"The Europeans have a difficult task," said Friedrich Heinemann, a director at the Centre for European Economic Research in Mannheim, Germany. "On the one side, they must avoid panics and irrational attacks on solvent governments. On the other side, they must refrain from establishing a guarantee mechanism, which would smash consolidation incentives."

Germany is "aware of both dangers," Heinemann told Deutsche Welle, and has taken what he calls "a highly responsible position." The government, he said, consented to the 750-billion-euro European Financial Stability Facility but insisted on a crisis resolution mechanism that would include creditors in a solution for insolvent countries.

"The latter position may not be popular among highly indebted countries but it is important for the fiscal and political future of Europe," Heinemann said. "Euro member countries must remain responsible for their own public finances."

Other analysts agree. "I think Germany is right in wanting to avoid a transfer union," said Marco Annunziata, chief economist at Unicredit Group.

There are two possible ways of avoiding this, according to Annunziata. The first, he said, would be to have a true centralization of European fiscal policy – something that would require a greater degree of political union than seems feasible at this stage.

The second is to have a framework for sovereign debt restructuring - a credible signal to investors that the next time a eurozone country has difficulties servicing its debt, it will be helped only if at the same time private investors suffer haircuts. This would make private investors more careful when assessing sovereign risk, and would therefore impose stricter discipline on countries by driving debt spreads wider at the first signs of fiscal indiscipline.

"These issues need to be resolved soon, however," Annunziata told Deutsche Welle. "Otherwise, the risk is that popular support for the eurozone might disintegrate very quickly."

"A more German eurozone"

Some experts question, though, how big a role Germany, Europe's largest economy, should play in stabilizing the eurozone. Turning the eurozone into a larger Germany, says Philip Whyte with the Centre for European Reform in London, could have adverse consequences - not only for the country itself but also for Europe and even the rest of the world. He maintains that "a more German eurozone" would be afflicted by chronically weak demand, debilitating cycles of competitive wage cuts and prolonged economic slumps in the deficit countries.

Like many others, Whyte agrees the time has come to make some tough decisions. "The genius of the European Union has been to muddle its way through," he said. "I don't think that muddling is an option this time."

So should investors unload their euros while they are still worth something? Expert Heinemann is confident the common currency will survive. "I don't see the euro breaking apart," he said. "Or does anybody see the US currency union breaking apart because of the imminent Californian bankruptcy?

Author: John Blau
Editor: Sam Edmonds