So I arrived in London this morning, to help out my colleagues with the escalating Europe debt crisis story, only to find out that in the mere 12 hours I was on a plane, not only has the entire face of the crisis changed, the entire continent has changed. After Europe’s leaders did everything they could to undermine investor confidence and spread contagion, they completely reversed course and announced an eye-popping plan to amass nearly one trillion dollars to rescue heavily indebted Eurozone members. This is the equivalent of a financial “shock and awe” campaign, and it seems to have worked. The spiraling debt crisis was stopped dead in its tracks. Stock markets across Europe surged and the euro recovered some lost ground against the dollar.
Is it crisis over? Hard to tell on just one day’s good news. But my guess is that the plan could provide some much-needed stability in the short term. This is the first time throughout the crisis that the Eurozone has shown a true commitment to the euro and the monetary union. It was collective action that was always missing; without it, the Greek crisis was destined to spread to the other indebted PIIGS (that’s Portugal, Ireland, Italy and Spain, along with Greece), and from there, it was anybody’s guess. Now Europe may be able to rebuild confidence in financial markets — as long as its leaders can convince investors that the plan is real and credible. There’s always a chance that we’ll see public outcry in a country like Germany, which would put pressure on political leaders to back out or change the arrangement. Any sign that the rescue scheme is unraveling might hit the debt-crisis reboot button.
But if it holds, the plan could do the trick – convincing investors that the sovereign bonds of weak Eurozone states that they had considered riskier and riskier no longer are. That would stabilize markets, allow countries such as Portugal and Spain to finance themselves more easily, and buy them time to get their own houses in order. In other words, the hope here is that the one trillion is never actually needed. Its mere theoretical existence would be enough to stop contagion and end the debt crisis. The Europeans finally realized that they needed to commit money now to save themselves a bundle in the future.
Yet at the same time, the bailout plan doesn’t actually solve the real underlying problems of the Eurozone. And that’s where things get interesting.
The PIIGS are still going to have to undertake painful fiscal adjustments to bring down their budget deficits and stabilize debt levels. That’s going to hurt, especially since the recovery from the Great Recession is only barely underway in much of Europe. A country like Spain, with 20% unemployment, can ill afford cutting back fiscal spending at this point. That means the political leaders of the PIIGS are going to come under tremendous pressure from disgruntled populaces at home (as in Greece). And in turn, investors could again get nervous if the PIIGS backslide and keep amassing more and more dangerous levels of debt.
That’s why the Eurozone has no choice but to enforce such reform programs. Voters in the richer Eurozone countries, such as Germany, which will have to carry the heaviest burden of the rescue plan, are already angry about their country’s wealth being used to bailout neighbors seen as profligate. So if France’s Nicolas Sarkozy and Germany’s Angela Merkel are going to sell the bailout plan to their own people, they’ll have to get clear reform pledges from the PIIGS in return, and probably strengthened tools to sanction these wayward states in the event they don’t follow the rules. Otherwise, this bailout plan would create the mother of all moral hazard problems, and would therefore never politically fly in the richer members of the Eurozone.
And it’s in that little conundrum that the real importance of the bailout can be found. The plan is completely overhauling the way in which the Eurozone works. Though Europe has wanted to benefit from economic integration (a common market, a common currency), its member states were at the same time protective of their sovereignty. Though they agreed to certain common standards, they didn’t necessarily want fellow Eurozone members interfering too much in their domestic affairs. That’s how the PIIGS built up so much debt without their neighbors stopping them in the first place. The European states were also pretty clear that they didn’t want to be responsible for another member’s financial problems – thus the “no bailout” clause in EU treaties. In other words, the Eurozone members wanted to use a common currency, but, despite that high degree of connection, leave each other alone as much as possible.
Now that’s out the window. The Eurozone governments have finally woken to the reality that their monetary union is only as strong as its weakest links, and that if the euro is to thrive (or even survive), it will take more collective action and commitment. The flip side of that is probably a shift towards greater interference in each other’s domestic affairs. You’re not going to see that greater commitment take place without greater control within the Eurozone over the decisions of individual governments.
That’s a dramatic change in a very short period of time. Remember, it was less than two weeks ago that we were all wondering if Europe could get together on just the Greek bailout alone. Now, over a weekend, the Eurozone has altered the very relationship between its members in a fundamental way. Some economists have argued that a currency union can’t survive without political integration as well. Now it appears Eurozone states will be sacrificing more of their political independence to the greater EU. Who knows where this process can go once it gets started.