These two deficiencies—no concessional rates for Italy or Spain and no preparation for a possible default and defection from the eurozone by Greece—have cast a heavy shadow of doubt both on the government bonds of other deficit countries and on the banking system of the eurozone, which is loaded with those bonds. As a stopgap measure the European Central Bank (ECB) stepped into the breach by buying Spanish and Italian bonds in the market. But that is not a viable solution. The ECB had done the same thing for Greece, but that did not stop the Greek debt from becoming unsustainable. If Italy, with itsdebtat108percentofGDPandgrowthoflessthan1percent,hadtopayriskpremiumsof3percentormoretoborrowmoney,itsdebtwouldalsobecomeunsustainable.
The ECB’s earlier decision to buy Greek bonds had been highly controversial; Axel Weber, the ECB’s German board member, resigned from the board in protest. The intervention did blur the line between monetary and fiscal policy, but a central bank is supposed to do whatever is necessary to preserve the financial system. That is particularly true in the absence of a fiscal authority. Subsequently, the controversy led the ECB to adamantly oppose a re-structuring of Greek debt—by which, among other measures, the time for repayment would be extended—turning the ECB from a savior of thesystemintoanobstructionistforce.TheECBhasprevailed:theEFSFtookovertheriskofpossibleinsolvencyoftheGreekbondsfromtheECB.
The resolution of this dispute has in turn made it easier for the ECB to embark on its current program to purchase Italian and Spanish bonds, which, unlike those of Greece, are not about to default. Still, the decision has encountered the same internal opposition from Germany as the earlier intervention in Greek bonds. Jürgen Stark, the chief economist of the ECB, resigned on September 9. In any case the current intervention has to be limited in scope because the capacity oftheEFSFtoextendhelpisvirtuallyexhaustedbytherescueoperationsalreadyinprogressinGreece,Portugal,andIreland.
In the meantime the Greek government is having increasing difficulties in meeting the conditions imposed by the assistance program. The troika supervising the program—the EU, the IMF, and the ECB—is not satisfied; Greek banks did not fully subscribe to the latest treasury billauction;andtheGreekgovernmentisrunningoutoffunds.
In these circumstances an orderly default and temporary withdrawal from the eurozone may be preferable to a drawn-out agony. But no preparations have been made. A disorderly default could precipitate a meltdown similar to the one that followed the bankruptcy of Lehman Brothers, but this timeoneoftheauthoritiesthatwouldbeneededtocontainitismissing.
No wonder that the financial markets have taken fright. Risk premiums that must be paid to buy government bonds have increased, stocks have plummeted, led by bank stocks, and recently even the euro has broken out of its trading range on the downside.Thevolatilityofmarketsisreminiscentofthecrashof2008.
Unfortunately the capacity of the financial authorities to take the measures necessary to contain the crisis has been severely restricted by the recent ruling of the German Constitutional Court. It appears that the authorities have reached the end of the road with their policy of “kicking the can down the road.” Even if a catastrophe can be avoided, one thing is certain:the pressure to reduce deficits will push the eurozone into prolonged recession. This will have incalculablepoliticalconsequences.TheeurocrisiscouldendangerthepoliticalcohesionoftheEuropeanUnion.