Financial Crisis: can the euro hope to survive?

If you look at how the markets reacted, you might think the past week was one of positive progress towards a resolution of Europe’s financial crisis.There was, after all, plenty of talking – from last weekend’s G7 get-together in Marseille to Friday’s ‘‘Eurogroup’’ finance ministers’ conclave in Wroclaw, with some multi-national conference calls in between.

Angela Merkel of Germany and Nicolas Sarkozy of France reassured Greek prime minister George Papandreou that his country had a future in the eurozone, while EU and IMF officials felt able to give Greece breathing space by deferring until next month a decision on whether to release an €8 billion tranche of bail-out money that is conditional on progress in spending cuts.

The Eurogroup, with US Treasury secretary Timothy Geithner in attendance, agreed a so-called “six-pack” of tougher budget rules for member countries. And the European Central Bank was joined by the Bank of England, the US Federal Reserve and the central banks of Switzerland and Japan in a co-ordinated exercise to provide sufficient dollar liquidity for European banks to see them through to the end of the year.

The key people behind these moves also agreed that one topic was off the agenda: the possibility of a break-up of the euro and, more immediately, the ejection of Greece, was not to be spoken of in public. Chancellor Merkel warned wayward German MPs to “weigh their words very carefully”. Geithner urged EU policy-makers to avoid “loose talk”. Luxembourg prime minister Jean-Claude Juncker, presiding over the Eurogroup, called for “verbal discipline”, lest saying the wrong thing should trigger “irrational” market responses.

In reply, the euro strengthened against the dollar while the gold price – the best indicator of investor pessimism – fell back. The FTSE and continental stock markets rallied strongly, with bank shares making much of the running. The markets’ mood music was that this had been a week of constructive activity: for all its tensions, Europe was at last trying to work as a team, with American encouragement and global central bankers’ support.

But the market bounce was itself an irrational, wishful-thinking response – a misreading of an unprecedentedly dangerous situation. There is a far more persuasive argument that what we have just seen was another week of denial of the reality and imminence of the eurozone’s existential meeting with destiny; another week, to use a currently popular cliché, of kicking the can down the road, rather than facing Europe’s big issues head-on.

Look behind each of the week’s news items and it’s hard not to feel a sense of despair. Geithner was in Wroclaw not to slap his European counterparts on the back for their efforts to date, but to warn them to stop bickering and address the “catastrophic risk” inherent in a widespread state of unsustainable debt and fiscal delinquency.

It is apparent not only that US banks have lost confidence in their European counterparts and have started shutting them out of inter-bank funding markets, but also that US officials are busy making matters worse by seeking to shift blame for America’s dire domestic performance on to influences from this side of the Atlantic. “Seventy-five per cent of the dark things happening in the world economy are because of the eurozone,” one of Geithner’s team said at Marseille.

And it is because of that widely held sentiment in the US financial community – the belief that European banks are sitting on crippling losses on their government bond holdings, and could go down like dominoes if Greece and others default – that the central banks’ dollar funding scheme was necessary to stave off the onset of another credit crunch. Another freezing-up of the international banking system is the quickest possible way to turn current near-zero growth performance in the industrialised world into a global double-dip recession, with the second dip likely to be deeper, longer and more painful than the first.

As for the “six-pack” of stronger sanctions against EU members who flout budget rules, it was a diversion that is wholly irrelevant to the immediate crisis. The compromise reached on Friday came after more than a year of haggling – and is tainted before it comes into effect by a history of flagrant budget rule-breaking even by the EU’s core members.

Much more significant is what was not agreed. An increase in the muscle of the European Financial Stability Facility – the central bail-out fund – was supposedly fixed in July, but requires parliamentary approval for each member nation’s contribution, which is by no means a certainty. The Slovaks won’t vote on it until December; the Finns are demanding “collateral” for any new loans to Greece; the Austrians are against the Finns; and Merkel may only win a German vote at the end of this month with opposition support, while her own coalition kicks up trouble.

And the notion of ‘‘euro bonds’’ – central borrowings to fund all eurozone member governments but effectively guaranteed by the strongest of them, Germany – is so far from being agreed that it is almost as taboo as the notion of dismantling the currency itself.

European Commission president José Manuel Barroso was brave enough to say in the week that it was time to look at options for such a mechanism. But German voters generally, and some of Merkel’s coalition MPs in particular, are fiercely opposed to taking on such a bottomless commitment, while Merkel herself – far out of her depth and hounded by short-term electoral considerations – has declared that the concept of “collectivising” eurozone debt is “absolutely wrong”.

It is in this argument about euro bonds that the irreconcilable flaws of the euro structure become so apparent. As George Osborne has argued from a Eurosceptic perspective, but with unchallengeable logic, the only way for the eurozone to achieve long-term stability is to move towards fiscal integration, centralising major tax and budgeting decisions and subsidising poorer members by means of fiscal transfers from richer ones. That, after all, is how things are done in both the United Kingdom and the United States, which successfully operate single currencies across widely differing economic regions.

Centralised borrowing, at the low rates applicable to the guarantor states rather than the non-performing ones, would be a part of that package. But the bonds only work if Germany is prepared to accept the huge implied cost of the guarantor role – and if every member state accepts that fiscal integration is just a step away from ever-deeper political integration, and the loss of national sovereignty. Few, if any, EU members are actually ready to make that leap.

And that brings us back to Greece, which has been let off the hook until mid-October with a bland assurance from Merkel and Sarkozy that its place in the eurozone is unassailable. That was surely the week’s most shameful refusal to face the coming storm.

Markets are convinced of several things: that Greece is politically incapable of meeting the austerity demands imposed by the EU and the IMF, and is now locked into a spiral in which its debt position can only become worse as its economy deteriorates; that a default on Greek sovereign debt is therefore inevitable sooner rather than later, and will impose losses on European banks, including the likes of Société Générale and Crédit Agricole of France, which may in turn need to be bailed out by their governments; and that the eviction of a bankrupt and incorrigibly irresponsible eurozone member is not only a technical possibility but an economic necessity if the single currency is to survive at all.

The best hope now is for a managed Greek default and departure. As German transport minister Peter Ramsauer said this week, before Angela Merkel urged him to silence, “it might be risky and painful for Greece to leave the euro, but it would not be the end of the world”.

At the other end of the spectrum, the worst fear is of a final, chaotic Greek episode provoking defaults by Ireland, Portugal and, conceivably, Italy and Spain in its wake. That would be Armageddon – and no one knows what appalling political consequences might follow.

Refusing to talk about these issues was the most pathetic of last week’s gestures by European leaders, who seem wholly lacking in the statesmanship and political courage appropriate to the mighty task that has fallen into their hands. And how irritating it must be for them to be lectured by the Eurosceptic George Osborne. But he is right to point out that by addressing Britain’s own debt problem so robustly, he deflected the market scepticism and hostility with which Europe is now wrestling so ineffectually.

He is right, too, that we are by no means immune from the economic shockwaves of a eurozone implosion. There is no schadenfreude for us in Europe’s troubles – but every reason to be thankful for our increasingly semi-detached EU status.

Indeed, having acknowledged that Britain is bound to pay an economic price for this debacle however it plays out, we might also note the possibility of a political silver lining. If the outcome is a new alignment of eurozone membership, with stronger fiscal ties than ever before, there will surely be a new treaty to cement those arrangements. And that treaty negotiation will be an opportunity for Britain to formalise the semi-detached (or even, on the basis of an in-or-out referendum, wholly detached) relationship we actually want and would feel more comfortable in.

But that is for the future. For today, the lesson of the banking crisis of three years ago is that denial is ultimately useless. The moment comes when only swift, muscular and co-ordinated international action by governments provides the catharsis that quells the market panic. That moment for Europe may come in mid-October.

* Martin Vander Weyer is business editor of ‘The Spectator’