As Europe’s South Spirals, North Fiddles and Chaos Looms

Anyone who thought the euro crisis was coming under control might want to think again.

Only three weeks after the European Central Bank calmed markets with its open-ended promise to support sovereign bonds and hold down borrowing rates throughout the euro area, harsh reality is reasserting itself: Greece, Spain and other struggling governments are being compelled to stick to austerity measures that are thwarting their economies, while Germany and other core euro countries remain unwilling to do what’s needed to prevent the euro area from breaking up.

Spain has taken the spotlight as Prime Minister Mariano Rajoy pushes through the country’s fifth austerity budget in nine months amid a new wave of protests in Madrid and secessionist rumblings in Catalonia. It’s an impressive feat of fiscal responsibility: Rajoy is trying to make sure ahead of time that Spain’s finances will satisfy the European Stability Mechanism, the European Union’s bailout fund, with which his government must have an understanding before it can access the promised ECB support.

Rajoy’s government, in office less than a year, is walking a political tightrope. It needs to convince furious Spaniards that it’s acting at its own initiative and isn’t merely capitulating to the EU’s demands. Problem is, its belt-tightening efforts could prove self-defeating. They will weigh further on an economy that forecasters already expect to shrink by 1.3 percent next year, narrowing the tax base and increasing demands on government spending.

Backing Away

Meanwhile, relatively well-off governments are backing away from the bank recapitalizations needed to revive Spain’s deeply troubled financial system. This summer, European leaders reached what appeared to be a crucial agreement on a banking union, which would allow the ESM to inject capital directly into distressed banks, rather than making more loans that would only add to governments’ debt burdens. For its part, Spain went ahead and obtained an of its banks’ capital needs: 59.3 billion euros (about $76 billion).

Now Finland, Germany and the Netherlands are suggesting that the recapitalization plan applies only to the future, and that governments are responsible for all their banks’ current problems. What’s more, Germany is saying that the plan, which investors had hoped could go into effect by the end of this year, won’t be fully operational until a new euro-area supervisory system has been created and demonstrated its effectiveness.

In short, the EU’s crisis management is a mess -- a failure of coordination and a formula for uncertainty, political instability and fiscal overkill. This has real repercussions. The further the economies of strapped countries are allowed to sink, the closer they get to the point where even the ECB’s support won’t make their governments solvent.

European leaders need to get the banking union back on track, and work toward finding a way out of the downward spiral of budget cuts and shrinking output, such as the fiscal transfers we have advocated. Financial markets have shown extraordinary patience in recent months, perhaps believing that, in the end, Europe will get its act together. The longer it takes, the more damage will be done.

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