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It would be unwise to ignore the magnitude and significance of the changes now taking place in the eurozone. Governments in Greece and Italy have been replaced in the space of a week because they were unable to guarantee the rapid implementation of economic reforms. Italy has accepted IMF and EU monitoring of reforms including deep liberalisation measures that had so far seemed out of reach, notably on labour legislation. Spain, Ireland, Portugal and Greece are undertaking ambitious fiscal and structural adjustment measures—in Ireland these are already paying off in terms of economic performance and credibility. Eurozone governments have agreed to enshrine balanced budget rules in their national legislations.
All this is impressive; all of it started since early October – much of it after the 27 October 2011 package of reforms was agreed by eurozone leaders.
Once it is forced to choose between acting as a lender of last resort to governments or allowing the eurozone to disintegrate, the ECB will bite the bullet and commit to buy as much sovereign debt as necessary. And at that point, I believe it will have the open blessing of Germany, without which the ECB’s move would be neither credible nor sustainable. Before taking that step however, Germany and the ECB will force as much progress as possible in terms of fiscal and structural reforms at the national level, and institutional reforms at the EU level to make macro policy discipline enforceable and sustainable.
Market discipline is still the most powerful weapon they can wield to force these changes – and it is a very dangerous weapon because they can control it only up to a point. In Italy, high bond yields strengthen the hand of new Prime Minister Monti as he presents ambitious reforms to Parliament.
In Europe, widening contagion strengthens countries’ incentives to give up policy sovereignty in exchange for mutual insurance in the form of eurobonds. Ideally, limits to national policy sovereignty would be enshrined in Treaty changes. That would take time, but in the interim the pragmatic proposals put forward by the European Commission would constitute a very significant step towards stronger fiscal integration.
Conclusion
This brinkmanship game is not for the faint of heart. Eventually the solution will have to encompass greater ECB purchases, eurobonds, eurozone rule changes, and stronger reforms at the national level. In short, it will require a quantum leap towards fiscal and political union.
Waiting till the very last moment before deploying the safety net raises the risk that the situation might spin out of control. Greater mutual support implies a sharing of risks and of costs – including borrowing costs. It must go together with a sharing of decision-making power. The trick is how to accelerate the latter so that the former can be launched quickly enough.