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MARKETS

AUGUST 19, 2011

A Shaken Europe Looks for Bolder Fixes

By CH ARL ES FO REL LE

Reuters

Demonstrators in Madrid in late July protesting austerity measures.

A dramatic selloff in European financial markets on Thursday renewed fears that Europe's banks are too weak to withstand the Continent's debt crisis, increasing the chances that the region's leaders will be forced to pursue radical steps toward fiscal union in order to preserve their common

currency. For more than a year and a half, the euro zone's strategy has been to buy time for its weak nations to regain the confidence of financial markets, while taking tentative steps toward closer cooperation on the bloated budgets that got them in trouble. A Trail of Turbulence
Euro-zone efforts to buy time for weaker nations have fallen short.

That strategy was on full display on Tuesday in Paris, where the leaders of Germany and France presented the latest in a series of initiatives aimed at bolstering the euro zone's architecture. Investors immediately criticized the plan, which included steps toward tax harmonization and stricter budget controls, as inadequate. The Franco-German proposals, critics complained, laid bare the political inertia within the euro zone that has allowed the crisis

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to fester for months. If the region's banks remain under pressure, however, the countries at the euro zone's core, in particular Germany and France, will be left with no choice but to embrace the deeper fiscal union that they have rejected for more than a year. If they don't, the common currency could collapse, thrusting the Continent into political and economic chaos. "There remains an ongoing tension between a quick fix regarding the debt crisis on the one hand and on the other the policy makers that are working on a step-by-step process," said Nick Matthews, economist at Royal Bank of Scotland. "You are going to have market dynamics forcing the action." That realization has in recent days prompted Germany, the region's economic powerhouse and an opponent of fiscal union, to reconsider proposals that would force it to accept responsibility for the debts of its neighbors. Thursday's markets rout, the worst in Europe in more than two years, suggests Berlin and Paris may have to act quickly. If investors lose confidence in the region's banks, Europe's financial system could seize up, tipping the euro zone into another recession. The soundings on Thursday were bad across the board. Morgan Stanley cut its euro-zone growth forecasts for this year and next. Plans for the second Greek bailout, once thought firm, were jostled by demands from Finland, Austria and others that Athens post collateral for its rescue borrowings. The benchmark indexes in Paris and Frankfurt both fell more than 5%; each suffered its steepest one-day percentage drop since late 2008. The Milan bourse fell 6.1%. Some of the worst carnage hit Europe's banks. France's Socit Gnrale SA fell 12%. Germany's Commerzbank AG fell 10%. In Italy, Intesa Sanpaolo lost 9%.
Reuters

Reuters

A trader at the Frankfurt stock exchange on Thursday reacting as equities across Europe fell sharply.

July 21 European leaders agree to a second bailout of Greece after insisting that privatesector banks shoulder some of the costs, which will likely lead to a default rating for Greece. July 29 Under pressure for more economic reforms, Spanish Prime Minister Jos Luis Rodrguez Zapatero sets early elections for November. Aug. 2 Yields of Italian bonds reach crisis highs compared with German benchmarks. Aug. 3 Italian Prime Minister Silvio Berlusconi disappoints investors with an economic speech that sets out little new action to repair Italy's finances. Aug. 4 The European Central Bank restarts its dormant bond-buying program, but excludes Spanish and Italian bonds. It also extends lending programs for banks until at least the end of 2011.

ECB President Jean-Claude Trichet at an August briefing

That is particularly dangerous. Weakening banks could choose to hoard cash, crimping liquidity. In the extreme, banks could require money for recapitalization from their governments. (The cost of massive bank recapitalization doomed Ireland last year.) With the euro zone's weaker countries scrambling to find low-cost financing, the currency union can't afford either of those things. Economists and analysts say the bloc is running out of small steps. The shockingly sudden rise in the yields of Italian government bonds earlier this month made clear how quickly an indebted country could unravel if markets freeze it out of financing. For now, the European Central Bank is propping up bond markets in peripheral countries by stepping in to buy

Aug. 5 U.S. loses triple-A rating from S&P, raising concerns that Europe's triple-A countries such as France could be at risk, too. Italian 10-year bond yields hit euro-era high. Aug. 5 Mr. Berlusconi, in a bid to shore up confidence, pledges to balance the Italian budget a year earlier than planned. Aug. 7 The ECB agrees to buy Spanish and Italian bonds. Aug. 9 The cost of insuring German bonds against default rises above the cost of insuring U.K. bonds for the first time.

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Aug. 16 Data show German and euro-zone economic growth slowed sharply in the second quarter, adding to worries about the economic outlook. French-German summit yields no action on euro bonds, disappointing investors. Aug. 10 Shares of French bank Socit Gnrale lose 15%. Aug. 18 Stock markets plunge on concerns over the global economy, European banks and the debt crisis. Source: WSJ research

government bonds. But the ECB has made clear it won't do this indefinitely.

Economists and analysts say the bloc is running out of small steps to combat its debt crisis.

Among potential steps debated in Europe is a system of centralized borrowings by all 17 members of the euro zone, with debt issued by an EU agency and every member vouching to stand behind the bonds used by its peers. Such euro bonds would dispel concerns Italy or Spain might not be able to get the financing they need, as it would be provided centrally. As a unit, the euro zone has relatively attractive fiscal prospects: Government deficit of 4.3% of gross domestic product is expected this year and debt of 88% of GDP. But euro bonds would come with a huge political cost. French President Nicolas Sarkozy on Tuesday rejected them, saying they would lead to strong countries being "in the position of guaranteeing debt they do not control." That, Mr. Sarkozy said, would be politically difficult to justify in strong countriesbut also ineffective at curbing the fiscally imprudent. As they could borrow freely at low cost, there would be little incentive to stop. Thus, Mr. Sarkozy said, a euro-bond system would need to come with strictures: each government saying to its peers what it can and can't borrow, and thus what it can and can't spend. Butpowers of taxation and spending are prerogatives of national governments, and, Mr. Sarkozy said, European institutions "don't have the democratic legitimacy" to forbid individual states from spending. Without a euro bond, European policy makers must craft a solution that achieves three aims: Removing the need for the ECB to buy bonds continually on secondary markets; ensuring that troubled countries have access to financing; preventing the strong countries from being dragged down by the weak.

Getty Images

A statue holding the symbol of the euro common currency stands in front of the European Parliament building in Brussels.

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A number of solutions are under consideration but all of them carry risks. In Europe's wealthier northern tier, discontent over paying for the profligate south could give rise to populist Inflation Rise Puts Fed in Bind far-right parties that reject putting Europe's needs above Upheaval Reduces Home Buyers' Urgency to Do a Deal national interests. And Europeans in the south would likely bristle at being forced to relinquish national sovereignty over government spending as a condition to receiving support.
Treasury Yields Fall to Historic Lows

Brian Blackstone contributed to this article.

Write to Charles Forelle at charles.forelle@wsj.com

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