The Eurozone’s Strategy of Pain

BRUSSELS – For the third year in a row, the eurozone is the weakest link in the world economy. In 2010, attention was focused on responses to the crisis on the eurozone periphery – Greece, Portugal, and Ireland. In 2011, the crisis moved to the core, with Italy and Spain feeling the heat, and concerns mounting about the viability of the eurozone itself. The question for 2012 is whether those tensions will abate or reach a new climax.

Once again, the Greek crisis is the focus of attention and epitomizes Europe’s failings. Once again, hard decisions have to be made about debt restructuring and the provision of further assistance to Athens. And once again, the Europeans have to accept that the situation is more serious than they thought.

But the depth of Greece’s woes should not obscure the fact that it is a small economy and, in many respects, an extreme, special case. No other country flouted the European Union’s budget rules the way Greece did, or has accumulated as large a public-debt burden, and no other EU country combines to the same extent a dysfunctional state and an uncompetitive private economy.

The real battle is being fought in Italy and Spain. Both countries’ borrowing conditions deteriorated in the second half of 2011. Both are so large – accounting for 17% and 11% of eurozone GDP, respectively – that financing them through multilateral assistance would strain, if not exhaust, the resources of the eurozone and the International Monetary Fund. Both recently installed new, reform-minded governments. And both are struggling to rebuild competitiveness, foster growth, restore fiscal soundness, and clean up banks’ balance sheets. If they succeed, the euro will survive; if they fail, it won’t, at least in its present form.

That is why discussions over the last few months have largely, if implicitly, been about how to support adjustment and reform in Italy and Spain. Proposals to permit the European Central Bank to intervene more decisively in bond markets, or to increase the size of the firewall by leveraging the European Financial Stability Facility (EFSF), were intended to set an upper limit on interest rates paid by Italy and Spain on their debt emissions.

Similarly, proposals to create common bonds were intended to quell expectations of insolvency by ensuring that these countries would eventually be able to borrow against their eurozone partners’ guarantee. All of the discussions were couched in general terms, but everybody had the same specific countries in mind.

None of these proposals, it seems, will be implemented anytime soon. The ECB has bought some Italian and Spanish bonds, and it might buy more, but it has made clear that it is not ready to commit to a ceiling for long-term interest rates. The EFSF’s size will be increased by accelerating the creation of the permanent European Stability Mechanism, and by letting it overlap with the EFSF. But the EFSF’s capacity will remain at roughly Ђ500 billion – well below the Ђ1 trillion-plus envisaged by those who advocate bringing massive financial firepower to bear (the so-called bazooka solution).

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