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Return of the Eurozone Crisis

Author: Christopher Alessi
September 7, 2011

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The eurozone sovereign debt crisis is again feeding European market volatility. After a steep drop Monday and Tuesday, stocks recovered somewhat Wednesday following a ruling by the German high court (Guardian) upholding the constitutionality of the country's participation in recent eurozone bailouts.

But political considerations (Reuters) continue to compound the continent's economic uncertainty. Italy is facing rising government bond yields--raising the amount it must pay to borrow in markets--as it struggles to push through strict austerity measures to tackle its mounting public debt. The so-called troika--the European Union, European Central Bank (ECB), and International Monetary Fund (IMF)--signaled that Greece has been stalling on the implementation of its austerity program, while investors worried once again about an imminent Greek default. At the same time, German Chancellor Angela Merkel is facing resistance (WSJ) from within her own party over a recent EU decision to enlarge the temporary eurozone bailout mechanism, the European Financial Stability Fund (EFSF).

Markets have responded negatively (FT) to the policy inaction in Greece and Italy, undermining the value and long-term health of the euro. "The [European] economic situation is worsening fast because the markets feel a political lack of will on the part of the countries that have to get their accounts in order," EU expert and John Cabot University President Franco Pavoncello told CFR. Greece's lack of progress has put it at risk of not receiving the next tranche of a $155 billion EU-IMF bailout, due at the end of September, and a second bailout agreed upon this summer.

A Greek default could force the country to leave the eurozone, or drag the rest of its members down with it. As a result, the European banking sector (DerSpiegel) could face a liquidity crisis, with profound effects for the U.S. financial system. The European banking crisis could spread rapidly from Greece throughout the eurozone and beyond, just as the 2008 U.S. subprime mortgage crisis "worked its way to Bear Stearns and Lehman Brothers, and eventually hit AIG, Citi, Bank of America, and everybody else," Barry Ritholtz, CEO of equity research firm Fusion IQ, told PBS NewsHour. In August, U.S. money market funds (FT) cut their exposure to European banks for the second month in a row.

Simultaneously, Germany has become increasingly frustrated at underwriting the debt of southern EU states that have failed to rein in spending, leading some experts to suspect that the eurozone's economic powerhouse could choose to exit the euro. "If Europe does not manage to cope with the sovereign debt crisis, the cost of remaining in the currency for some countries may develop in a way that they find it more interesting to leave," Daniela Schwarzer, of the German Institute for International and Security Affairs, said in a recent interview with CFR.

European leaders are divided over how to stem the accelerating crisis. ECB President Jean-Claude Trichet and incoming president Mario Draghi have called for more centralized economic governance structures through the development of a federalist system akin to that of the United States. At a conference in Paris on September 5, Trichet called for an expansion of the European Stability and Growth Pact, saying that the sovereign debt crisis had "clearly revealed that governance (AFP) within the eurozone was absolutely essential."

Advocates of greater fiscal integration have called for the creation of so-called eurobonds--the equivalent of U.S. treasuries--which would spread credit risk across the eurozone. This would require a European ministry of finance to manage the fiscal policies of all member states--a move some believe more urgent than others. "If there is not in the next twelve months real progress [with creating a] federal budget, euro bonds, and strict coordination of nation-state budgets, the euro will disappear; Germany will get out," Jacques Attali, former president of the European Bank for Reconstruction and Development, said in a recent interview with CFR.

However, Wolfgang Schäuble, the German finance minister, cautions against a "sudden leap into fiscal union and joint liability." In a September 5 Financial Times op-ed, Schäuble writes that the eurozone can only escape the sovereign debt crisis if indebted states implement economically and politically painful austerity measures, such as cuts in expenditures and tax raises to increase revenues. Fiscal integration, he explains, should come gradually.

European officials hope to ratify (Reuters) July's deal to give new powers to the EFSF by the end of September, but a date has not been set.

Background Reading

"Hang on to Your Purse, Ms. Merkel," Gideon Rachman, Financial Times

"Half-Hearted Austerity," Der Spiegel

"Europe Inches Closer to a Fiscal Union," Louise Story & Matthew Saltmarsh, New York Times

"Is the Greek Bailout Falling Apart?", Michael Schuman, TIME

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