Twelve months ago it seemed inconceivable that any European Union member could face a sovereign debt crisis. It would have been the stuff of fantasy to argue that Ireland or Austria could be among those at risk. Yet such an outcome is now within the realm of possibility. And if one country suffers a crisis, it will almost certainly trigger a wave of crises, plunging the EU, and especially the euro zone, into turmoil.
There is nothing inevitable about this. But a way out requires Germany and other fiscally sound but highly export-dependent economies, such as the Netherlands, to show more vision.
Some members of Europe's common currency euro zone -- including Italy and Spain -- are vulnerable because they have lost competitiveness over the years and investors are skeptical that they will be able to regain it. Others -- like Austria and Belgium -- have disproportionately large banking sectors and/or banks with huge exposures to crisis-hit regions such as Eastern Europe.
The tensions within the euro zone are evident in the government bond market. A year ago, all eurozone governments faced similar borrowing costs. However, there is now a big -- and growing -- gap between the interest rate on German government bonds and those of struggling members of the euro zone. For example, the Greek and Irish governments are now forced to pay an interest rate on bond issues that is 2.5 percentage points higher than what Germany has to spend to borrow funds.
This trend partly reflects temporary phenomena: In times of financial distress investors want the most liquid and safest assets, so they pile into German bonds. But the widening spreads also reflect the concerns of investors over the solvency of some member states, and conceivably even over their continued membership of the euro.
One way forward might be for governments to collectively issue euro zone bonds, rather than their own national bonds. Initially, euro zone bonds would complement rather than supplant the government bonds of the individual member states. Euro zone finance ministers would have to agree how to allocate the debt burden among the member states. Over time, however, national bonds would be fully replaced by euro zone bonds. The integration of euro zone government bond markets would help address the problem of poor liquidity that has bedevilled many of the smaller euro zone financial markets. And it would reduce borrowing costs for most euro zone countries.
An important obstacle is that German and Dutch borrowing costs would rise as they shared their fiscal credibility with the rest of the euro zone. It might be hard for governments in those countries to convince taxpayers that they should help pay for other countries' mistakes.
However, the opposition of the German and Dutch governments to the pooling of bond issuance -- that it would cost them too much money -- is parochial. The alternative, failing to help their neighbors, would be much more costly for Germany, the Netherlands and Europe. Berlin and The Hague are mistaken if they think a fiscal crisis in one member state would be a cleansing experience, with other countries learning the lesson of their errant ways.
First, one sovereign crisis would almost certainly lead to others as investors rapidly turned their attention to the next weakest link. The direct costs of a bailout could be surmountable in the case of Ireland or Greece, but would pose a much bigger challenge in the case of larger member states, such as Spain or Italy.
Second, there would be indirect costs to Germany and Holland from fiscal (and then economic) crises in neighboring countries. Both economies depend heavily on exports to the rest of the euro zone. Dutch and German exports are already falling rapidly. The last thing the two countries need is a further collapse in external demand.
Third, there is a worst-case scenario. If Italy or Spain were to default on their sovereign debt, the repercussions for the euro zone could be dramatic and could well lead to its breakup. For large, inflexible economies, it is far from clear that default within the currency union is more plausible than a default and a move to leave it. A member state could decide that having defaulted, it may as well exit the euro zone and devalue. This would at least help to restore competitiveness and get the economy growing again.
Export-dependent economies like Germany and the Netherlands should not be complacent about such an outcome. German (and to a lesser extent Dutch) companies have spent years holding down costs. The result has been improved competitiveness compared to the rest of the euro zone. If the euro zone were to unravel, Germany and the Netherlands would experience a huge real appreciation, reversing almost overnight the competitiveness gains they have ground out.
A move to issue euro zone bonds may help prevent such a worst-case scenario. And it would not mean the Germans and the Dutch were sacrificing their own interests for the good of Europe. Countries as export-dependent and politically reliant on the EU as Germany and the Netherlands cannot afford to be blasé about economic crises in neighboring countries.