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5 December 2011 By Hugo Dixon

The euro zone will probably get another short-term fix at its summit this week. Exactly how the fix will work isn’t clear. But both Germany and the European Central Bank have softened their positions so much that some sort of solution is in the works. The ECB will probably cut interest rates and spray more liquidity at the troubled banking system; it may also step up its purchases of government bonds; and some scheme for assembling enough money to bail out Italy and Spain -probably by getting national central banks to lend money to the International Monetary Fund, which could then pass it on to Rome and Madrid – may be unveiled.

All this would be cause for celebration. The problem is the price that Germany and seemingly the ECB are demanding for their help: fiscal discipline, embedded in a treaty. Merkel wants the European Commission in Brussels to have the power to overturn irresponsible national budgets and for the European Court of Justice to fine governments that step out of line.

This idea for a treaty is stirring up all sorts of problems. One is that Britain, which is not part of the euro zone but is a member of the European Union, wants a quid pro quo for signing a revised treaty – probably in the form of returning powers over social and judicial affairs to London or getting some veto over the regulation of financial services, the UK’s largest industry.

An even bigger problem is the objection of many people in the euro zone to Disziplin being imposed by Berlin. Even France’s Nicolas Sarkozy, who is backing Merkel’s plan, has had to swallow hard before embracing a policy which would involve a loss of sovereignty and is still wrangling over the details. The opposition socialists, which look likely to defeat Sarkozy in May’s presidential elections, have been quick to dub the plan an “austerity treaty”.

Handing powers to Brussels at Germany’s insistence isn’t popular with France’s right-wing parties either. In fact, it is likely to be pretty unpopular right across the euro zone. Even the president of the European Parliament, a body which normally supports anything that increases the European Union’s power, has said treaty change could be “dangerous” because citizens were unlikely to warm to the idea.

This is not to say that Europe’s governments won’t sign up to the German plan. Fear over what would happen if the euro collapsed is now so high that they will probably fall into line if this is what is needed to unleash the ECB. But a marriage based on fear is not the most attractive or most sustainable one. It will breed resentment. This could be expressed in the growing popularity of right-wing nationalist parties. There is even a chance that the proposed treaty changes, which will require unanimity, would be voted down by at least one parliament or torpedoed in at least one national referendum.

Merkel says she wants “more Europe”. But she is offering a lot less than the fiscal union that many pundits outside Germany are clamoring for. They want the euro zone’s governments to guarantee each others’ debt, by issuing euro bonds. A fully functional fiscal union would also have a large central budget that would transfer resources from booming regions to struggling ones. Germany’s chancellor is against these ideas for the simple reason that her people are not remotely ready to bail out other parts of Europe on a permanent basis. Nor, for that matter, are the Dutch, the Finns and some other nations.

Merkel’s idea of discipline is not in itself a bad idea, mind you. Governments ought to run their finances responsibly. The problem is that she is trying to achieve this through rules. An alternative would be to impose discipline through the market. If bond investors knew that profligate states might have to restructure their debts in future, they might rein governments in before their debts got out of hand in the first place.

It might be objected that the markets did a terrible job holding governments to account during the bubble years. This is true. But that’s partly because governments gave investors artificial incentives to buy their bonds. There’s now a golden opportunity to set a new baseline for market discipline by making clear that investors will have to share the pain if a euro zone country racks up excessive debts. To be fair, Germany has been pushing this idea, but France wants it abandoned. Even if Berlin gets its way on this, it won’t be giving ground on the need for rules.

The discipline of the bond markets may not be an appealing slogan. But it is less unpalatable than the discipline of remote bureaucrats dictated to by Berlin. Europe’s citizens can probably understand that, if you borrow too much money, you have to dance to your creditors’ tune. Unfortunately, this doesn’t seem to be the way the debate is going. The price for a short-term fix could be a long-term problem.


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