LONDON – The eurozone’s institutional weaknesses have been laid bare. The attempt to run a common monetary policy without a common treasury has failed. Investors do not know what they are buying when they purchase an Italian bond – is it backstopped by Germany or not?
We now know that the best credit must stand behind the rest, or else bear runs, such as those that have derailed Greece, Ireland, and Portugal – and that now threaten to do the same to Italy and Spain – are inevitable. Debt mutualization alone will not save the euro, but, without it, the eurozone is unlikely to survive intact.
The eurozone’s July 21 summit was a small step forward. Leaders agreed to lower interest rates on loans made by the European Financial Stability Fund (EFSF) and they recognized that Greece’s debt burden is unsustainable. But this falls far short of what is needed to arrest the currency union’s deepening crisis. Borrowing costs remain unsustainably high for many eurozone economies – and not just those in the periphery. The economic growth potential of Spain and Italy, for example, now hovers around 1%, but their borrowing costs exceed 6%. By contrast, German sovereign yields have fallen sharply, lowering public and private-sector borrowing costs.
This is a recipe for further economic divergence and insolvency in the eurozone. To prevent this, the eurozone needs a “risk-free” interest rate. The struggling economies need lower borrowing costs, or they will suffocate economically (and political support for eurozone membership will evaporate).