Germany Must Defend the Euro

NEW YORK – Financial markets abhor uncertainty; that is why they are now in crisis mode. The governments of the eurozone have taken some significant steps in the right direction to resolve the euro crisis but, obviously, they did not go far enough to reassure the markets.

At their meeting on July 21, the European authorities enacted a set of half-measures. They established the principle that their new fiscal agency, the European Financial Stability Fund (EFSF), should be responsible for solvency problems, but they failed to increase the EFSF’s size. This stopped short of establishing a credible fiscal authority for the eurozone. And the new mechanism will not be operative until September at the earliest. In the meantime, liquidity provision by the European Central Bank is the only way to prevent a collapse in the price of bonds issued by several European countries.

Likewise, Eurozone leaders extended the EFSF’s competence to deal with banks’ solvency, but stopped short of transferring banking supervision from national agencies to a European body. And they offered an extended aid package to Greece without building a convincing case that the rescue can succeed: they arranged for the participation of bondholders in the Greek rescue package, but the arrangement benefited the banks more than Greece.

Perhaps most worryingly, Europe finally recognized the principle – long followed by the IMF – that countries in bailout programs should not be penalized on interest rates, but the same principle was not extended to countries that are not yet in bailout programs. As a result, Spain and Italy have had to pay much more on their own borrowing than they receive from Greece. This gives them the right to opt out of the Greek rescue, raising the prospect that the package may unravel. Financial markets, recognizing this possibility, raised the risk premium on Spanish and Italian bonds to unsustainable levels. ECB intervention helped, but it did not cure the problem.