Tags: EU | Europe | Financial | Crisis

Merkel, Sarkozy to Speak as Crisis Rages

Friday, 05 Aug 2011 02:20 AM

 

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Italy's borrowing costs rose above Spain's on Friday for the first time in more than a year, ratcheting up fears that the eurozone's third-biggest economy will need a bailout that the rest of the continent won't be able to afford.

European leaders interrupted their vacations to find a way to keep the turmoil from pushing Spain and Italy to a financial collapse that would further hobble an already-waning global recovery.

European leaders face the prospect that Italy and Spain won't be able to hold out until a new, strengthened bailout fund is in place to prop them up.

German Chancellor Angela Merkel, vacationing in the Italian Alps, and French President Nicholas Sarkozy, on the French Riviera, are interrupting their summer holidays for a phone conference on the eurozone crisis, Merkel's office said.

Sarkozy's office said he would also speak with Spain's Prime Minister Jose Luis Rodriguez Zapatero.

The worry is that Europe's debt crisis is spiraling out of control as investors lose faith in the ability of countries to get a handle on their debts and in the whole European decision-making process.

That has pushed up borrowing costs, particularly for Italy and Spain. Italy's ten-year bond yield is now running above Spain's for the first time since May 2010 in a clear sign that investors think the eurozone's third-largest economy is in trouble.

Fears that a country may default drive up the interest yields on its bonds. That can become a vicious spiral as the higher rates increase the debt and frighten away even more bond investors.

European leaders face few and difficult options. They gave their euro440 billion rescue fund new powers to prop up bond markets and rescue banks at a July 21 summit, but the changes are not in effect yet because national parliaments have not approved the measures yet.

That leaves the European Central Bank, which can buy government bonds under emergency powers but has done so only reluctantly because it does not want to be seen as supporting shaky government finances.

On Thursday, the ECB restarted its bond-buying program by making limited purchases of Portuguese and Irish bonds.

Luc Coene, the head of Belgian's central bank and a member of the ECU, told Belgian radio station RTBF that the bank was reluctant to buy Italy and Spain's until the two countries have taken additional steps to cut deficits.

Otherwise, "it's like pouring water into a bucket with a hole," Coene said.

Coene also said without stricter rules on national deficits and debt, the euro is not viable in the long-term. European officials are working on a tougher set of rules to keep governments from overspending but the EU member states and parliament have not agreed on them yet; the ECB thinks even those new rules offer too much leeway for governments.

Leaders could increase the size of the bailout fund, but that was rejected by leaders at the summit due to resistance from Germany and other countries with solid finances to having their taxpayers on the hook for overspending by others.

A longer-term option would be a eurobond whereby the 17 members of the currency union borrow jointly. That has so far firmly been rejected by Germany and others with strong finances that let them tap bond markets cheaply, and who would see borrowing costs go up.

Greek Prime Minister George Papandreou, who has long proposed the idea of eurobond, said in a letter to the head of the European Commission, Jose Manuel Barroso, that leaders need to act quickly "so that we always are ahead of developments and not behind them."

Commerzbank economists said that for now the ECB appeared the only line of defense against a nightmare ending.

If Spain and Italy cannot borrow after the summer break, he said, they will have to slash spending because they can no longer finance deficits, leading to a profound recession and possibly runs on those countries' banks.

"The foundations of economic activity would be undermined and euro area GDP would collapse, possibly on the same scale as in the winter of 2008-2009 following the Lehman bankruptcy," they said.

They assumed the eurozone governments will halt that by expanding the bailout fund or implementing eurobonds, with the ECB possibly stepping in to stabilize bond markets with much larger bond purchases, even if that meant printing money to finance government spending.

"If... finance ministers failed to act in time, the ECB might bridge the gap via massive bond purchases even if this were tantamount to financing government spending with fresh money," they said in a report.

Currently, the central bank has drained money from the financial system when it buys bonds to ensure that its purchases do not expand the supply of money in the economy.

© Copyright 2014 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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