Europe's Neverending Crisis: Can the Euro Still Be Saved?

In the time since European leaders named the Belgian politician Herman Van Rompuy president of the European Council a year ago, the public has taken little notice of the reserved native of Belgium's Flanders region. But that changed last Tuesday, when Van Rompuy made headlines across Europe with a brief remark.

"We all have to work together in order to survive with the euro zone, because if we don't survive with the euro zone we will not survive with the European Union," Van Rompuy said during a panel discussion. With his comments, he expressed what many people in Brussels had been thinking but few had dared to say out loud.

As it happens, Van Rompuy would also have preferred not to say what he said. Two days later, he claimed that he had been misunderstood. He had apparently stuck his neck out too far. But that doesn't change the fact that the statement itself was correct.

Euro-zone governments have spent months trying to end the crisis facing their common currency, but the danger has not been averted. On the contrary, the crisis meetings have returned and billions in emergency funds are needed once again. And there is still no end in sight to the crisis.

Merely Temporary Relief

European leaders have tried all kinds of measures in the bid to save the euro. They approved a bailout program for Greece and a massive rescue fund for the entire euro zone, they whipped legislation through their parliaments and they expanded the articles of the Lisbon Treaty to their legal limits (and beyond, many would argue). The European Central Bank (ECB) has even violated an ironclad taboo by buying up the bonds of ailing countries in an attempt to stabilize their prices.

But those steps only brought temporary relief, which only lasted until the next piece of bad news emerged. Yesterday it was Greece, and now it's the sorry state of Irish banks that poses a threat to the common currency. Each new report fuels the suspicion that the problems may be so pervasive that they can no longer be solved with conventional methods and by taking on more and more debt. Fears are growing that the crisis could lead to the default of individual countries or possibly even the collapse of the euro zone.

A deep divide between two almost irreconcilable camps runs through Europe. German Chancellor Angela Merkel heads one camp, consisting of the northern European countries. Merkel sees herself as the defender of a culture of stability of the sort that Germany has maintained since the days of the deutschmark. Her goal is to prevent the monetary union from becoming a kind of transfer union, with Germany as paymaster.

The second camp consists of the so-called PIIGS states, which have accumulated too much debt in the past and are now hoping for help: Portugal, Italy, Ireland, Greece and Spain. They want the thing that Merkel wants to prevent: a union in which the strong pay for the weak. Europe's institutions are now maneuvering between these two camps.

Causing a Stir

The first act of the current crisis began in the chic French beach resort of Deauville in mid-October. To the consternation of their allies, Merkel and French President Nicolas Sarkozy announced the end of their ambitious goal to enforce a stricter stability pact with automatic sanctions for nations that break the deficit rules. In return, Sarkozy supported the German idea to assign some of the liability for future financial crises to private-sector creditors like banks and to accept the possibility of bankruptcy for an insolvent country. The 27 heads of state and government approved the deal at the European summit in late October.

The plans, and the horror stories about Irish banks, caused a stir in the financial markets, pushing up risk premiums for the government bonds of all the ailing countries. "Merkel and Sarkozy apparently didn't think about the second act," comments Luxembourg Foreign Minister Jean Asselborn.

The yields on Irish government bonds rose as high as 8.6 percent at times -- 6.2 percentage points higher than the rate Germany pays to borrow money. This prompted Irish Prime Minister Brian Cowen to angrily note that Merkel's actions were "not helpful."

The German plan to automatically force bondholders to pay up when financial aid packages are approved "might seem attractive from a theoretical point of view," says ECB executive board member Lorenzo Bini Smaghi, but it would "in practice destabilize markets and have severe effects on economies in the euro area." It could ultimately achieve the opposite of what was intended, says the central banker, because "speculators would take advantage of the situation, while many small investors would suffer losses."

Responding to the accusation that it triggered the Ireland crisis, the government in Berlin said that the German proposal to involve private-sector investors has no effect on current market behavior because it focuses on the period after 2013. It insists that even government bonds purchased today would remain unaffected by any new rules. "In fact, this has nothing at all to do with the current debate over Ireland," says German Finance Minister Wolfgang Schäuble.

Misjudging Reactions

None of this has reassured the players in the financial markets. Once again, the German government was confronted with the realization that it cannot take action relating to the euro crisis without taking the reactions of investors into account. It misjudged this reaction once before, when it opposed financial aid for Greece for so long. In those weeks of uncertainty, the risk premiums for Greek government bonds continued to rise, while speculators began setting their sights on the bonds of the other PIIGS countries.

In the end, the euro-zone countries approved a comprehensive bailout package, leaving Chancellor Merkel in a losing position -- and looking like she was to blame. Her many adversaries in Europe argued that by taking such an uncooperative approach, Merkel made the crisis worse and drove up the costs of the bailout. The chancellor justified her actions by arguing that if it hadn't been for her tough stance, the Greeks would not have agreed to a strict austerity program and the involvement of the International Monetary Fund (IMF).

Merkel's reputation in Europe has been battered since then. Many see her as a betrayer of European ideals who stubbornly pursues German national interests. These critics feel vindicated by recent developments.

There is a rising tide of anger directed at the chancellor. Greek Prime Minister George Papandreou has criticized Merkel, saying that her reform plans could break the backbone of entire countries, while the Portuguese finance minister likens her plans to a foul in the game of soccer.

Wait-and-See Approach

All this criticism prompted the Germans to avoid taking a leading role in the current crisis talks in Brussels. They took a wait-and-see approach, even when they were put under pressure, especially by Portugal and Spain. Both countries are afraid of being sucked into the Irish crisis.

Unlike the Greeks, who implored their fellow Europeans to come to their aid, the Irish needed more persuasion. They didn't want the Europeans' money, because they fear it could weaken their sovereignty. And they argued they didn't need it either, because they won't need to borrow money on capital markets until the middle of next year.

This is true in theory. Ireland's problems are not its government finances but the balance sheets of its banks. However, the two things are closely related, because the country issued a comprehensive government guarantee for its banks after the financial crisis -- without suspecting how big the problem could turn out to be.

There has been a quiet exodus of billions from Ireland in recent weeks. Most international investors were no longer willing to lend Irish banks as much as a cent. The Irish banks repaid €55 billion ($75 billion) to their international creditors, mainly German, French and British banks, because the corresponding bonds had matured. But those creditors took the money and fled from the country. Only government-owned banks were still willing to lend money.

By the end of October, the Central Bank of Ireland had extended "extraordinary liquidity assistance" in the amount of €20 billion without the Irish banks providing the corresponding collateral. Also by the end of October, Irish banks had borrowed €130 billion from the ECB, which is more than the Greek banks borrowed. ECB experts have been hard at work at the Irish Department of Finance since September.

Even though the government has already taken a considerable portion of their risks off their hands, Irish banks are still dragging around property loans valued at €200 billion, which have not yet been adequately written down. Even the reserves of the better financial institutions have been used up, and the entire Irish banking system is on the verge of collapse.

In internal talks early last week, ECB President Jean-Claude Trichet made a far-reaching proposal. To solve the problem once and for all, he said, both Ireland and Portugal, which is also in financial trouble, ought to be provided with sufficient funds. These ideas went over well, especially with smaller member states.

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• Part 1: Can the Euro Still Be Saved?
• Part 2: Multi-Billion Bailout for Ireland Announced
• Part 3: Internal Government Document Outlines Planned Crisis Mechanism