By Mitch Yoshida, Mayme and Herb Frank Research Fellow
The Eurozone sovereign debt crisis is again roiling markets as doubts about political will in the common currency area deepen. In the past two weeks, German Chancellor Angela Merkel and her center-right coalition have come under intense pressure as they endured another defeat in a state election, crumbling public support for additional bailouts, a suspenseful wait for a court ruling on the constitutionality of last year’s bailout of Greece, the resignation of a German member of the executive board of the European Central Bank, and apparent infighting among themselves. These strains have fueled fears that the coalition will splinter in an upcoming vote on upgrading the European Financial Stability Facility (EFSF) – the temporary bailout fund that is the centerpiece of Eurozone’s latest plan to combat the crisis.
To make matters worse, economic growth has slowed across the currency area, Italy and Greece have faced significant political obstacles to deeper budget cuts, and Finland and other member states are delaying a second bailout of Greece. Altogether, these factors have contributed to dramatically higher borrowing costs for some Eurozone members and steep drops in European bank stocks. At this point, investor fear is feeding on itself and aggravating the situation.
As the crisis worsens, calls for the fiscal integration of member states are growing louder. Yet there is still no consensus on what form it should take. German and French leaders emphasize the need to institutionalize fiscal discipline at the national and EU levels. Although Italy and Spain are already in the process of amending their constitutions toward this end, both they and other Eurozone states with questionable financial outlooks have mainly called for jointly-issued Eurobonds to spread credit risk across the Eurozone and reduce their cost of borrowing. This is a step that German and French leaders have ruled out, at least in the short-term.
Despite these various political cleavages and the risks they pose to the Eurozone, there is cause for optimism. Last week, Germany’s Federal Constitutional Court removed one source of uncertainty when it struck down legal challenges to Germany’s participation in last year’s bailout of Greece. What’s more, the Italian parliament has granted final approval for a new round of deficit-cutting measures and Greek Prime Minister Georgios Papandreou is making progress on this front. It is also likely that Chancellor Merkel’s coalition will maintain its cohesion and vote to upgrade the EFSF – allowing Germany to join other Eurozone states that have already ratified the step. And, most importantly for the Eurozone’s long-term prospects, the stage has been set for the creation of a fiscal union that would diminish the risk a similar crisis in the future.
On this last point, the basic outline of an agreement already exists. The political imperative of Germany, France, and other lender states is to avoid the need for future bailouts by instituting balanced budget rules. In their view, issuing Eurobonds without such rules would encourage further profligacy in financially unstable members. Borrower states, in contrast, have little political stomach for deeper austerity and want to avoid it by creating Eurobonds. In spite of these differences, both sets of actors have a strong interest in compromising to prevent repeat of the crisis. By creating a common fiscal authority, which would have the ability to impose fiscal discipline and issue Eurobonds, they can bolster the stability of the Eurozone and attain more narrowly conceived interests at minimum cost. This is the compromise that many former leaders and economists are calling for.
This is not to say that the creation of a fiscal union is inevitable. Much will depend on how far current and future Eurozone leaders will be willing and politically able to go in reforming the common currency area. And there would be additional challenges: ensuring that the new union is democratically accountable and pushing a revised EU treaty through national parliaments are at least two. Even if the crisis worsens, accomplishing these tasks would probably take years. Investors may lament this slow and uncertain path to fiscal union, but the fact that fiscal integration is even being discussed is a far cry from debates over the Lisbon Treaty that occupied Europe not too long ago. By forcing Eurozone lender and borrower states to articulate their views on how fiscal integration should proceed, the crisis has – perhaps for the first time – opened the door to a “United States of Europe.”