In many ways Europe is stuck as moving to a greater union will likely be marred with the same issues, however, scrapping the Euro has prohibitive costs at this point. As there is no obvious clear path to solve the crisis, it is likely that we will muddle through from summit to summit and politicians will reassess the situation along the way. However, in order to come to a solution the debate needs to shift.
Accept that debt capacity in Eurozone is limited
It is important that nations and markets realise that the debt capacity of the Eurozone is limited. Haggling and hoping for the next bail-out or concession is not a plan out of the crisis. All European nations, including Germany, are highly indebted and the constant calls for greater firewalls and packages are not financeable. Italy might not be too big to fail, but it is surely too big to be rescued with its EUR 2 trillion pile of debt. Ideas of how to leverage up the rescue packages are rather a reminder of the follies of structured credit than comforting solutions. Once the debt capacity of sovereigns is exhausted, there is little that can be done. Hence rescue programs can buy time, but resources are limited and their use needs to be carefully considered. The focus needs to shift to more structural and fiscal reforms, instead of relying on the unrealistic expectation that Germany will bail everybody out.
Growth vs. Austerity debate is not helpful
Europe needs not growth or austerity, it clearly needs both. Having a polarized debate is not helpful. We need some austerity as governments have built up some unsustainable welfare states, so making changes sooner rather than later is important. Equally important is to create growth which, however, can be created by structural reforms and does not necessarily require governments to go on a spending spree. Ultimately companies and not governments create economic growth and it is crucial that governments create a framework where companies want to invest and are enabled to compete globally. When the Northern nations talk about structural reforms they mean growth, when Southern nations talk about growth they mean government spending.
Appreciate the positive side of spiking yields
There seems to be an unwritten rule that 7% yields for 10 yr government paper should be the threshold for initiating sovereign bail-outs. Were weaker sovereigns immediately to roll-over all their debt at 7% that would be indeed a problem, however, this is not the case . So far, spiking yields seem to have been the only instrument to pressurize politicians to initiate change. Neither voters nor fellow EU politicians managed to push Italy to initiate reforms until spiking yields triggered the start of reforms in 2011. While high yields can only be sustained over a limited time, they seem to be our best hope that politicians will keep their foot on the pedal when it comes to reforms as voters and fellow EU nations seems to have limited impact. Hence the buying of government debt because of spiking yields should only happen at the margin whilst reforms continue.
In addition, we should say good bye to the idea that individual Euro government debt should trade right on top of Bunds. Just because markets decided to largely ignore the credit risk of Euro government debt for most of the Euro area, it does not mean it is the right thing to do. So, higher spreads between Bunds and other sovereigns sounds like a sensible idea.
Stop believing that pooling debt is the solution
Markets are very enthusiastic about Eurobonds as it would extend the creditworthiness of Germany to Eurozone debt markets. I don’t share this view as it would likely degenerate the monetary union into a debt union with nobody being clearly in charge. Most rational investors would probably not find this a very appealing investment option. However a more important argument is that ultimately the outcome of the sovereign crisis is highly uncertain, given the size and complexity of the problem. Therefore the best firewall in my mind is to keep the sovereign debt of individual states separate, after all that leaves at least the option to cut certain nations loose if it all goes terribly wrong.