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Europe’s Small Steps and Giant Leaps

BRUSSELS – The world was expecting Eurobonds to come out of last week’s Franco-German summit; instead, the eurozone will get economic governance. According to German Chancellor Angela Merkel and French President Nicolas Sarkozy, the great leap forward to the creation of Eurobonds would perhaps be the culmination of that process, but for the moment small steps remain the order of the day. The question, obviously, is whether or not these small steps serve any purpose.

To answer this, we need to go back a little in time. Until this summer, the sovereign-debt crisis was confined to three small countries – Greece, Ireland and Portugal. Spain had succeeded in limiting the spread between its interest rates and those of Germany to about two percentage points.

By mid-July, however, the cost of borrowing for Spain and Italy was nearing four points, and France’s borrowing conditions were rapidly deteriorating. The specter of a full-blown crisis was starting to haunt markets. But the eurozone was not equipped to deal with this. The European Financial Stability Facility, established in 2010, had a lending capacity of a little more than €300 billion – ample for the peripheral countries, but too little to help even Spain alone. Disaster beckoned.

On July 21, European leaders attempted – belatedly – to redress this vulnerability by increasing the EFSF’s capacity to allow it to counter the increased Spanish and Italian risk. And, while the EFSF is not equipped to confront simultaneous crises in Spain and Italy, it has now been authorized to prevent such crises – or will be once national parliaments ratify the agreement reached on July 21 – by intervening on secondary debt markets to reduce interest-rate spreads on national bonds. In the meantime, the European Central Bank is intervening in the EFSF’s stead, and quite successfully so far: market tensions have eased markedly since the ECB began buying bonds on August 8.