Commentary: Come Together

Anyone trying to predict the outcome of Europe's financial crisis should pay close attention to Jean-Claude Trichet. As head of the Bank of France in 1999, he helped create the euro. After seven years babysitting the new specie as president of the European Central Bank in Frankfurt, Trichet and the euro are as intertwined as a man and a currency can be. He is too invested to let it break apart on his watch.

Whatever emotional tug the 67-year-old Trichet may feel, though, is counterbalanced by his devotion to sound money and central bank independence. He doesn't want to debase the euro just to keep shakier members of the zone on board. Even as the financial crisis spiraled out of control, he refused to support weak governments—Greece, Spain, Portugal—by buying up their debt. That restraint burst on May 10. A run on Greek government bonds had begun to spill over into Portuguese, Spanish, and even Italian sovereign debt, raising fears of a self-feeding downward spiral. That day, Trichet reversed course and announced the ECB would begin buying sovereign bonds after all, "to ensure depth and liquidity." That, along with a 750-billion-euro loan package from EU countries, stopped the run and gave the euro some breathing room.

Skeptics and speculators are already questioning whether it was enough. What had been unthinkable—a partial dissolution of the euro zone—is now openly debated. The euro has lost 18 percent of its value since November, 7 percent in the last month alone. As Trichet sees it, there is only one way to guarantee that the euro remains strong and the bloc stays intact: Europe must integrate more tightly than ever.

Having grudgingly extended a lifeline to Greece and other shaky economies, Trichet wants to make sure the debtor nations follow through on their promised austerity measures. He's pushing a plan that would require them to submit their annual budgets to the scrutiny of their peers and ratchet up the penalties on countries whose budgets do not pass muster. Trichet told Der Spiegel that Europe needs "a quantum leap in the governance of the euro area."

It's an open question whether Europe can muster the goodwill, and the willpower, to come together in the way Trichet believes is required. German citizens are already angry at Greeks for dragging their currency down and sucking money from their coffers. For Greece, the price imposed by the EU and the International Monetary Fund for continued euro zone membership is a long walk over hot coals—deep budget cuts, steep tax hikes. "What the IMF is asking Greece to do borders on insanity. It's going to drive Greece into a deep recession and increase its debt-to-GDP ratio," says Desmond Lachman, a resident fellow of the conservative American Enterprise Institute in Washington.

European leaders from Germany to Greece are making it clear they won't let the euro zone fracture without a fight. They believe the euro is worth preserving because it encourages trade and investment among the 16 member nations while promoting financial and geopolitical stability. European multinationals such as Airbus are among the euro's strongest supporters. And from adversity comes a measure of unity: Faced with an existential threat, European political leaders have agreed to risk-sharing measures that were politically impossible in calmer times. The nearly $1 trillion in loans and guarantees announced on May 10 is the best example of this newfound cohesiveness. To the optimists, this painful time is not the death throes of a failed monetary experiment but the birth pangs of a new federation. "We were close to a very, very significant risk of collapse," French Finance Minister Christine Lagarde told CNN after the rescue. "I do think that it's restored credibility and that was the issue."

Her unspoken message: If the euro zone goes, it won't go quietly. German Chancellor Angela Merkel isn't playing around, either. Her government banned traders from buying so-called naked shorts, default protection on government bonds they don't own. Investors, wondering if Merkel knew something they didn't, started selling again.

The world and its businesses have a stake in every bit of this drama. A successful fix for the euro's woes would signal that the global financial crisis of 2008-09 is truly over. If Europe botches the euro and its economy sinks, on the other hand, companies around the world that sell to Europe will suffer, with dangerous spillover to non-European banks and investors exposed to European debt.

The direct exposure of U.S. banks to Greece is fairly trivial: only about $17 billion as of yearend 2009. The far bigger risk is that a Greek default would freeze up financial markets as big players worried about who was on the hook for bad debts. In a sign of that nervousness, the premium banks pay to borrow from one another has widened recently to about 0.25 percentage points over the risk-free overnight swap rate. That's quadruple the spread in early March, although still much lower than the 3 percent-plus spread at the height of the crisis in 2008. "The worry for me is that we're moving from a sovereign debt situation to problems in the banking sector," says Pierre-Olivier Gourinchas, an economist at the University of California at Berkeley.

The U.S. stock market is pricing in those worries, with the Standard & Poor's 500-stock index falling about 8 percent since late April. Although exports to Europe are too small to have much effect on the overall U.S. economy—they account for just 1.7 percent of gross domestic product—certain companies are feeling the pinch. On May 18 consumer products conglomerate Fortune Brands Chief Executive Officer Bruce A. Carbonari said in an analysts' call that "Europe we see continuing to be down, down probably low single digits" in revenue growth. United Technologies (UTX), which gets about a quarter of its sales from Europe, started 2010 assuming a $1.48 euro exchange rate. Now it's around $1.24. That makes it more costly to export from the U.S. to Europe and reduces the dollar value of profits earned in euros.

Even so, some companies are racing ahead, says Robert Nardelli, chief executive officer of the operating company of private equity giant Cerberus Capital Management, whose companies in Europe and elsewhere have about $50 billion in annual revenue. "If you're trying to do deals or buy back debt, the speed with which you do something has increased," he says. "You need a quick 'yes' or a quick 'no'— it's not an environment for a slow 'maybe.'"

Corporate leaders in Europe have expressed faith in the single currency, which despite its decline holds about the same value vs. the dollar as it did at inception. "I am convinced that the euro has staying power and won't fall apart," says Daimler (DAI) CEO Dieter Zetsche. Rival BMW is changing purchasing arrangements to protect profits if the euro rebounds. "The euro could be down today, but could also be up again tomorrow," says Herbert Diess, BMW's management board member in charge of purchasing.

In one important respect, the euro zone has already come partly unglued. Borrowing costs are shooting up for corporations in nations with weak government finances. According to a Bloomberg Businessweek analysis, yields on A-rated corporate bonds rose one percentage point in Greece and 0.6 percentage points in Portugal from mid-April through mid-May, while dropping about 0.1 percentage points in France and Germany. In an age of global business, banks are pricing corporate debt locally.

Clearly, stepped-up governance is required. The status quo has been a muddled, halfway affair, combining monetary integration with fiscal independence. Peripheral euro zone members including Greece and Ireland borrowed and spent themselves into trouble while losing their cost competitiveness. Rules limiting the size of deficits as a share of GDP were routinely flouted, not only by those nations but even by Germany. The EU didn't even impose the fines on violators provided for in its Stability and Growth Pact.

Extreme solutions are being bandied about now, but bank on this: The euro zone is not going to leap all the way to a unified taxing and spending authority—a United States of Europe. That would require political union, something that is impossible under the Lisbon Treaty (effectively the EU constitution) and politically unthinkable, too. Europeans are in no mood to surrender their sovereignty. "The budget law is a matter of national parliaments," Guido Westerwelle, Germany's Foreign Minister, said in early May.

The other extreme scenario, an exit of one or more countries from the euro, is also difficult. If one of the Southern European countries left the euro, warns Preston Keat, research director of consulting firm Eurasia Group, that "would lead to a sharp depreciation of the 'new' currency relative to the euro. The country's euro-denominated debt would suddenly be much more expensive to service, which would lead to an almost immediate default." Legal chaos would follow, he wrote in a May 19 note, as local companies with contracts linked to the euro are thrown into turmoil, and "all contracts—including those governing wages, bank deposits, bonds, mortgages, taxes, and almost everything else" had to be redenominated in the new currency. "In short, this would violate all kinds of laws and treaties and rules—at the national, EU, and international levels."

All the lawyers in Brussels won't stop Greece from pulling out of the euro zone if ordinary Greeks conclude that membership in the common currency is yoking them to unaffordable debts and chronic high unemployment. If Greece still used the drachma as its currency, it would have lost value against other currencies by now, propping up the economy by making Greek products and services more affordable globally.

The cheaper currency would also make imports more expensive, suppressing domestic consumption. Membership in the euro zone prevents that from occurring.

Ultimately, the euro's future comes down to the willingness of Greeks, Portuguese, Spaniards, and Irish to absorb pain now in return for the benefits of the common currency, including free trade and investment that (in the long run) reduce the cost of living and raise living standards. Spanish Prime Minister José Luis Rodríguez Zapatero has announced the deepest budget cuts in at least three decades. He vowed to press ahead even though the austerity measures dented support for his ruling Socialist Party. Portugal and Greece have also forged ahead with budget cuts and tax hikes.

Greek Prime Minister George Papandreou has one thing going for him, says Elias Papaioannou, an economist at Dartmouth College. Ordinary Greeks want to keep their euro zone membership. They don't want to be relegated to the fringes of Europe like rival Turkey. And they want the government to crack down on tax evasion by the wealthy. "The Greek people are looking for blood," he says. They got a taste of it on May 17 when the deputy culture and tourism minister resigned amid allegations that her husband owed nearly $7 million in unpaid taxes and fines.

The challenge for Greece is that budget cuts will deepen the recession and reduce the national income available to pay interest on its debt. Greece and other marginal members of the euro zone must also make structural reforms such as cutting red tape, reducing farm subsidies, and lowering barriers to entry in occupations such as law. Those crucial reforms are "really hard to monitor" and are proceeding more slowly, says Dartmouth's Papaioannou.

There are several ways this crisis could resolve itself. Harvard University economist Kenneth Rogoff says the EU should let countries like Greece step out of the euro zone temporarily, and get back in when they're ready. Or, instead of Greece dropping out, it could be Germany that gets fed up and ditches the common currency. Keat calls the prospect "unlikely" but concedes that "the political and economic logic is more interesting and compelling" than a Greek exit.

What is now clear is that a monetary union between countries with divergent fiscal policies is unsustainable. To make the single currency work, nations will have to give up more of their fiscal independence and meet stricter budgetary rules, with real penalties for noncompliance. Countries that can meet the new standard will have, for the first time, a durable currency. The challenge is to prove that all 16 nations that use the euro deserve to keep doing so.

With Diane Brady, Rachel Layne, Maria Petrakis, James Pressley, and Chris Reiter

    Before it's here, it's on the Bloomberg Terminal.