Latest euro sticking plaster may prompt more radical surgery

Well, that euro fix didn't last long, did it? It took global markets about a week to rumble the fact that the latest attempt to shore up the single-currency zone had the same defects as all the other "cures" of the past two years: it was too late, inadequate or just plain wrong, writes Frank Kane.

Angela Merkel, the German chancellor, with François Hollande, the French president, in Reims, France. Yoan Valat / Reuters

Well, that euro fix didn't last long, did it? It took global markets about a week to rumble the fact that the latest attempt to shore up the single-currency zone had the same defects as all the other "cures" of the past two years: it was too late, inadequate or just plain wrong.

When Angela Merkel, the German chancellor, and François Hollande, the new French president, were pictured after the recent Brussels summit shaking hands and announcing a deal that they would have us believe finally ended the crisis in the euro zone, the money men gave them the benefit of the doubt.

European equities had a strong surge, key yield rates in the Spanish and Italian bond markets headed back down to reasonable levels.

That brave new world lasted until Friday, when the yield on Spanish long-term debt rose above the psychologically important 7 per cent barrier. Italian yields were nestling above 6 per cent. That squeeze on both countries' debt continued this week, casting a sinister backdrop to the meeting of euro-zone finance ministers.

So what went wrong?

Markets were (temporarily) impressed by the apparent agreement that the euro zone's €500 billion (Dh2.25 trillion) rescue fund could put money directly in member countries' creaking banking systems, rather than channelling the cash through national governments.

This looked like a strategic change of direction by Mrs Merkel, who has long argued against direct recapitalisation of the banks without strict conditions. She also seemed to bless the idea of a banking union in which institutions could prop each other up through the bad times.

The flaws in the plan became apparent within a few days.

A banking union could take several years to put in place, and in the meantime the governments of Spain, Italy and others would still be on the hook for credit guarantees, which their tottering public finances could not justify. And it also emerged that the Germans were by no means united behind their chancellor on the basic principle of extending German credit to the economies of the south.

Many members of the Bundestag as well as a sizeable chunk of public opinion are dead set against handouts to the profligate nations Portugal, Italy, Ireland, Greece and Spain. If push came to shove in German politics, the government would find it hard to win the day.

Euro-zone ministers are left with two immediate problems: hammering out the terms of a €100bn rescue for Spanish banks, and beginning to quantify the needs of Cyprus, which admitted just recently that the Greek contagion had contaminated it beyond repair, and that it too needed a bailout.

Given the track record, it seems unlikely that efforts on either problem will provide anything more than a temporary sticking plaster.

Increasingly, many in the European Union are contemplating more radical surgery. The odds are still short that Greece could exit, perhaps within the year. Britain (though of course not in the euro zone) is talking openly about leaving the EU altogether. The departure of either could be a game-changing event for the European project.

There is a growing body of opinion that the whole strategy of European financial and economic integration was flawed from the outset; that the flow of cheap credit from the cash-rich north to the spendthrift south created a huge, debt-fuelled asset bubble in "peripheral" Europe; and that the German insistence on fiscal austerity is just making a bad situation worse.

Advocates of this view believe the solution can only come with a freeing up of the peripheral economies, adding economic stimulus to get them working again and halting the threat of recession.

It will be a decision of political economy in the end. Capital Economics, the London consultancy that has consistently called the crisis correctly, argues in a recent paper that while exit from the euro zone could lead to a 10 per cent drop in real incomes over the first two years outside the zone, many voters in peripheral countries might accept that as part of a strategy to get out of the straitjacket of austerity.

It's a fine line.