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Tuesday, Oct. 4, 2011

EDITORIAL

A 'Band Aid' for Europe?

The German Parliament's vote to approve expansion of the European bailout fund does not solve the continent's debt woes but it is a vital step forward. Every one of the 17 countries that uses the euro must approve the agreement and several have already voiced opposition. They are most likely to swallow their complaints, however, and back the deal since the consequences of its collapse are potentially catastrophic. The real problem is that this is likely only a stopgap measure and a comprehensive solution is still a long way off.

The problem in Europe is simple. Countries have lived beyond their means. Governments have made expensive promises to citizens and funded them with future promises to pay. When the U.S. economy crashed in 2008, creditors and markets started looking hard at debt held by European governments, did the math and realized that the numbers did not add up. Governments were not taking in sufficient revenue to pay for those promises.

There have been two problems as governments have struggled to deal with the crisis. First, the scale of the adjustment has been wrenching, far beyond the level of what any voting public is prepared to support. Demonstrations are a daily event in Greece — where the pain is most acute and the risk of default most immediate — but other European nations have witnessed protests as well.

Discontent has been fueled by the second big problem: The general public is suffering so that banks and financiers can be paid off, perpetuating the notion that capital is being rewarded on the backs of ordinary citizens.

The optics of this situation is not misleading. The biggest holders of European debt are Europe's banks. That means that the calls for creditors to take a "haircut" and get paid back less than their originally anticipated return on investment will hurt the balance sheets of Europe's biggest banks.

That in turn could trigger another financial crisis in Europe when financial institutions have to constrain their own lending to make up for those losses. That in turn will drive interest rates up and strangle economies. The alternative is government bailouts, which will require tax increases, which is another way of squeezing economies.

Neither solution is pretty, but something has to be done to end the uncertainty that is generating its own instability. The longer Europe waits and fails to cap the current crisis, the greater the risks that contagion will spread to other economies. Italy is already being buffeted by the situation in Greece and markets are also watching developments in Portugal and Spain.

That is why the German decision to contribute another 211 billion euros ($287 billion) to the 440 billion euro ($586.5 billion) European Financial Stability Facility (EFSF) is important. It is an important signal of commitment by a — if not the — key government. Last week's vote was followed by a similar approval from Austria, leaving just three countries — Malta, the Netherlands and Slovenia — to weigh in on the deal.

Slovenia, a former Communist country whose population has little inclination to indulge Greek profligacy after it struggled to join the euro, has been quite vocal in its opposition to the deal. But as Finland, another skeptical government, swallowed its reluctance and voted to approve the package, the Slovenes have been left exposed and are unlikely to want to go down in history as the government that sunk the euro.

German Chancellor Angela Merkel emerges from this episode strengthened. While the vote in favor of the contribution was lopsided — 523 to 85 — the key number was 315, the number of votes from her coalition and four more votes than a majority. Ms. Merkel has come under pressure for her leadership and a vote that commanded less than majority support from her own coalition would have meant that she had lost control of her government.

In truth, Ms. Merkel's position reflects the ambivalence of the German public about bailing out spendthrift governments with their own hard earned savings. At the same time, the Germans know how important the euro is to the future of Europe and Germany's own strategic interests. Support for Greece, and other irresponsible governments, is a price worth paying.

But this battle is not yet won and not just because three votes remain. Rather, the real concern is that even with the new contributions, the EFSF remains "a Band Aid." It temporarily meets Greek finance needs, but it does not address Europe's bank problem.

Financial institutions remain dangerously exposed to sovereign risk and they cannot clean up their books without plunging the continent into a crisis. At the same time, European economies have to begin growing again for governments to acquire the revenues needed to clean up their own accounts. In the absence of both conditions — clearing the debt overhang and restoring growth — another crisis remains likely.

Last week's votes will restore confidence, but symbolic gestures must be matched by substantive ones. There is little sign that European leaders are ready to make those hard choices. Until they do, the continent is likely to lurch from crisis to crisis.



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