As 2009 drew to a close, Europe's common currency appeared to have weathered the worst global financial crisis since the Great Depression with barely a scratch. Countries outside the euro area, from Iceland to Ukraine, had seen their economies collapse, but most of those within the zone were basking in the glow of their 11-year-old currency and hailing it as an "anchor of stability". The euro had shot above $1.50, approaching a record high against the dollar, which appeared to be in a state of terminal decline.
For much of the 2000s, it seemed that markets had effectively mutualised the risk of euro zone debt by treating all government bonds as equal. Spreads between German bunds and the debt of countries such as Greece, Italy and Belgium were minuscule, even though the latter states had debt-to-GDP ratios of close to 100 percent — far above the 60 percent ceiling prescribed by the Maastricht Treaty.
The first clear sign of trouble came in October, when a newly elected Greek government shocked financial markets and its euro zone partners by announcing a huge upward revision of its budget deficit forecast. After years of barely distinguishing between the debt of different euro zone countries, investors could suddenly see the massive fiscal divergences within the bloc.
Markets turned on the euro and began demanding higher interest rates to buy the debt of struggling southern European countries — first Greece and then Portugal and Spain. "It was like something gathering pace, rolling down a hill, and then falling off the edge of a cliff," said a currency trader in London.
In crucial ways, the euro zone has always been a defective system. From the beginning, monetary union had more to do with political accommodation than fiscal integration. Yes, there were strict rules governing a member state's deficit and debt levels. But even Germany, long a stickler for fiscal discipline, had successfully pushed for a loosening of the rules after it repeatedly breached them in the early 2000s.
The bloc's flaws had been hidden by a decade of growth, itself fuelled by low credit and, in places such as Spain and Ireland, a real estate bubble.
Now the shock of the global financial crisis and the economic downturn had exposed those flaws for all to see. In hindsight, the real surprise is not that investors began to charge a risk premium to hold the bonds of high-deficit countries from late 2008, but that it took them a full decade to notice that Greece was not Germany.
TEUTONIC ORDERS
Can the euro zone fix those flaws and win back the confidence of the markets? The answer depends to a large extent on whether Berlin and Paris can agree on a way forward. France and Germany have always been the engines of monetary union, but their visions of how the euro zone should function were very different, even before the bloc's founding.
Germany's most recent thinking was laid out in a May 19 memorandum drawn up by Schaeuble's finance ministry. In the nine-point document, sent to European governments, Berlin called for quicker and harsher sanctions for countries that fail to keep their deficits in check, including denying violators access to EU structural funding and suspending their right to vote on matters of bloc-wide importance.
Berlin also wants a procedure for orderly state insolvencies to be an "integral" part of any fix for this and future crises. Economists such as Deutsche Bank's Thomas Mayer say that is code for a managed Greek default within the euro zone — a scenario that many consider inevitable at some point, despite the 750 billion euro rescue package. Greece's public debt is forecast to climb above 130 percent of Gross Domestic Product this year and its budget deficit could exceed 9 percent. Portugal's debt is projected to top 85 percent of output with a deficit of more than 7 percent. The pressure to make creditors share the pain with taxpayers in those countries may become overwhelming.
Another possible solution to the euro zone's flaws might be to mutualise the bloc's debt. Jean-Claude Juncker, chairman of the group of euro zone finance ministers, proposed such a scheme in late 2008. A common bond, he said, should cover the first 40 percent of overall euro zone sovereign debt and come guaranteed by the whole euro area. Anything above that level would be junior debt, and more costly for governments to issue nationally. That would encourage governments to reduce their debt levels toward a manageable 40 percent.
Germany, though, has nixed the idea, arguing that it would raise the borrowing costs of virtuous nations while rewarding Europe's spendthrifts by giving them lower borrowing costs.
To ensure all of Berlin's proposed reforms are written in stone, Merkel wants to amend the Lisbon Treaty, a process that could take years if its initial ratification by all 27 member states is anything to go by.
European Commission President Jose Manuel Barroso has called the Germans "naive" for thinking they can change the treaty without others seeking to unpick the parts they dislike. But Merkel insists the changes are necessary to ensure the German public — staunchly opposed to aid for Greece and fearful it will open the door to more bailouts — does not turn against the European project.
Germany also worries that its own Constitutional Court would not tolerate a second case like Greece. The threat of a court veto directly shaped Merkel's tough stance on aid for Athens and her negotiating position on the euro zone rescue mechanism. Merkel and her circle of advisers were beside themselves when French Europe Minister Pierre Lellouche told the Financial Times late last month that the rescue scheme violated EU law — a comment they feared the court in Karlsruhe might seize on to justify blocking the mechanism.
Though Sarkozy's office apologised for Lellouche's remarks, heads are still shaking in Berlin. "The knowledge in Paris about how German politics works is surprisingly limited," said one bitter German official.
