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Wed 19 Jan 2011 02:37 PM

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Euro's Spanish battle needs some shock and awe

Greece and Ireland are minor skirmishes, but Spain's debt battle has the potential to turn bloody

Euro's Spanish battle needs some shock and awe

The
major battle in the fight for the survival of the euro will be fought on Spanish
soil. Greece, Ireland and soon Portugal should be regarded as skirmishes. But Spain
is different, in terms of scale and solvency.

If
the strategy implemented by European Union policy makers is appropriate, the
markets will shift their attention to other risks, such as inflation, after the
decisive event has taken place in Spain. If the EU plan is seen as inadequate,
the euro-debt drama will roll out of control and the financial risks will be so
great to cause a perfect global systemic storm.

The
financial markets are neither pro- nor anti-euro. Yet, once they have evidence
of a major inconsistency, they will press on until it is solved. In the case of
the euro, the inconsistency is between its nature - a currency without a state
- and its governance, impaired by a triple and self- defeating “No”: No fiscal
union, no bailout, no sanctions.

Private
investors will refrain from buying Spanish government bonds until they are
convinced that the euro is sustainable, even if Spain is fundamentally solvent
in the euro area. The reason is simple: If the euro were to break up, the new
peseta would fall and the Spanish government would have to renegotiate with
creditors.

Liquidity
backstops, such as the loans to Greece, Ireland and soon Portugal, have only
avoided serial failures in the European banking system, including in the UK.
But they can’t dissipate doubts about the long-term solvency of countries, such
as Greece, and they didn’t address the governance issue.

The
way to end the crisis is to convince investors that the euro is sustainable by
changing its governance. The October 29 decision by EU leaders to create a
permanent debt-crisis mechanism by 2013 was a watershed event in this regard.
For the first time, the region’s politicians acknowledged that sovereign
defaults are possible and must be dealt with in an orderly way.

To
be fair, investors have remained skeptical. First, 2013 is very far away.
Second, the future crisis-resolution system is still vague. Third, and more
importantly, investors will continue to doubt the political commitment of the
strongest members of the euro club, starting with Germany, until supranational
euro-bonds are issued on behalf of member countries. The difficulty is that
these bonds may initiate a “stealth fiscal union,” as former European Central
Bank Chief Economist Otmar Issing recently warned against. This would trigger a
popular rejection of the euro.

The
“E-bonds” solution, advocated by Italian Finance Minister Giulio Tremonti and
Luxembourg Prime Minister Jean- Claude Juncker, doesn’t pass the Issing test,
since good- and poor-quality issuers would be merged. One remedy would be to
issue bonds collateralized by taxes actually levied in each participant
country. This would by no means imply a fiscal union because each member state
would get an amount of funding equal to the collateral it would pledge. But its
“fiscal devolution” dimension still makes it politically unpalatable at this
stage.

Even
though policy makers are moving much faster than expected toward a
comprehensive governance overhaul, the speed at which the markets may choke the
refinancing of governments of large countries, such as Spain or Italy, may
overwhelm the timeframe of political negotiations.

This
is why a “shock-and-awe” strategy is indispensable to governance. Policy makers
are considering such an approach before the Feb. 11 economic summit of EU
leaders in Brussels. A combined loan of €500bn ($672bn) to Portugal and Spain
would probably cover their government-financing needs until the end of 2012, a
reasonable deadline for the completion of the euro-governance overhaul, as well
as providing them with a contingency facility to recapitalise banks in
difficulty.

This
is the essence of the time-honored principle laid out by English writer Walter
Bagehot in the 19th century for the lender of last resort: “Lend freely at a
high rate on good collateral.”

Coordinated
loans may fail to convince investors if the ECB doesn’t show a strong hand and
express its commitment to safeguarding the euro during the Spanish battle. If
the ECB is convinced that Spain is solvent, then the bank shouldn’t be
concerned by a possible deterioration in its balance sheet caused by purchases
of Spanish bonds at a price lower than fundamentals would warrant. In the end,
taxpayers would even pocket a profit, since the ECB would book a capital gain
on the sale of its Spanish bonds a few years later.

Since
the Bagehot-inspired “shock-and-awe” strategy is both rational and feasible, it
is likely to be implemented, given the economic and political stakes in the
Spanish case. Tinkering and delaying decisions would just lead to an
intractable situation. For European policy makers, taking a calculated risk to
restore the stability of the euro is a much more sensible option than praying
that nothing will happen.

(Eric
Chaney is the chief economist of Axa Group in Paris. The opinions expressed are
his own.)