A Liquid Europe

BRUSSELS – Is the eurozone stepping back from the brink? This might just be possible, because the emerging outlines of a new framework to resolve the ongoing sovereign-debt crisis contain a key component that was missing so far. Indeed, that component’s absence was behind this summer’s spreading financial crisis, which moved beyond small, peripheral countries like Greece, Ireland, and Portugal to strike systemically important countries like Italy and Spain.

The starting point of the contagion was investors’ realization that Europe’s rescue fund, the European Financial Stability Facility, was designed to provide emergency financial support only to the peripheral countries. It simply does not and will never have enough funds to undertake the massive bond purchases required to stabilize the debt markets of large economies such as Spain and Italy. The EFSF will have at most €440 billion at its disposal (any increase would endanger France’s AAA rating), while the combined public debt of Italy and Spain is more than €2 trillion.

In early August, the domino effect of the eurozone periphery’s sovereign-debt crisis started to kick in, because financial markets do not wait for country after country to be downgraded. Instead, they tend to anticipate the endgame, or at least one potential scenario, namely the unraveling of the entire crisis-containment structure.

Markets noticed that the euro seemed caught between a rock (the EFSF’s limited borrowing capacity) and a hard place (the European Central Bank’s great reluctance to engage in large-scale purchases of financially troubled governments’ bonds). It later turned out that the ECB was not that hard after all, though it emphasized that it would stop intervening as soon as the new EFSF became operational. And, given the EFSF’s limited firepower, the market would have been left without support.