Analysis: Euro zone on bumpy road to fiscal union

PARIS, Jul Fri Jul 22, 2011 10:50am EDT

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PARIS, Jul (Reuters) - Angela Merkel will deny it, but Thursday's euro zone deal to rescue Greece again from the brink of bankruptcy puts Europe on the bumpy road to a fiscal union.

By giving their bailout fund new scope to help countries before they are shut out of credit markets, recapitalize banks and buy bonds in the secondary market, leaders of the 17-nation currency area laid the foundations of a European Monetary Fund.

They also made clear this was not the final stage in fiscal integration, with French President Nicolas Sarkozy promising new Franco-German proposals on economic governance by September.

"The EU summit was a historic victory for the French vision of EMU (Economic and Monetary Union)-- meaning that it is now on course to turn into a fiscal/transfer union," said analyst Brendan Bowen of Mitsubishi UFJ Securities International.

The German Chancellor accepted a leap forward which she had blocked in March, when a promised "comprehensive package" to solve the euro zone's sovereign debt crisis was reduced to half-measures that failed to stop contagion spreading.

In return, Merkel scored a political victory by forcing her partners and a reluctant European Central Bank to accept that the private sector should share the burden of a second Greek bailout, at a high cost to the public purse.

Banks and insurers will have to write down about 21 percent of the value of their holdings of Greek bonds. Many economists doubt whether the resulting reduction in Greece's debt pile will

be sufficient to avoid a hard restructuring at a later date.

POLITICS TRUMPS FINANCE

Private sector involvement was politically essential to secure parliamentary backing in Germany, the Netherlands and Finland, where public hostility to any further bailout is high, even though it will cost taxpayers more than it saves Greece.

The political need to show that banks and insurers were being made to pay trumped the financial logic, participants in the negotiations said.

Merkel played down the implications of the Brussels deal, insisting on Friday that Europe should not become a union in which wealth is redistributed from richer to poorer states.

"A transfer union would be an automatic financial rebalancing ... and this shall not happen according to my conviction," she told a news conference.

But other European officials are convinced that the euro zone is moving toward some form of mutual debt guarantee and common debt issuance in the longer run.

That is bound to heighten a euroskeptical backlash which is already vocal across northern Europe.

Conservative German economist Hans-Werner Sinn, head of the respected Ifo institute, said of the summit outcome: "The socialization of debt in Europe is merrily continuing. The extra money for Greece is almost a gift and will never come back."

Euro zone member states are already on the point of enacting much closer mutual fiscal surveillance, giving Brussels the power to review national budgets before they go to parliament.

The EU/IMF assistance programs have already put Greece, Ireland and Portugal under much more intrusive international supervision, cramping their sovereignty in the name of ensuring that reform commitments are respected.

This is leading the euro zone deeper into what Harvard political economist Dani Rodrik calls the "globalization paradox." Rodrik argued in a book this year that economic globalization, national sovereignty and democratic politics are incompatible. You can have any two, but not all three.

A common euro bond would reduce the borrowing costs of most euro zone member states and make it harder for markets to speculate against individual countries.

Experts say it might not significantly raise borrowing costs for the euro zone's six AAA-rated sovereigns because of the benefits of creating a deep, liquid pool of high-grade debt instrument that would be attractive to big Chinese, Japanese, Arab and U.S. investors.

Italy, Greece, Spain and Luxembourg have all publicly advocated the emission of common euro zone bonds, Germany's Social Democratic and Greens opposition parties support them, and the European Commission will publish a report on the idea before the end of the year.

"The Germans will go on saying "nein" until in the end they say "ja,"" a European Commission official involved in the project said.

PENULTIMA RATIO

Henrik Enderlein, assistant dean of the Hertie Business School in Berlin, said Merkel had made numerous U-turns during the euro zone crisis and would eventually accept euro bonds.

The chancellor, he noted, had changed her mind on aiding Greece in the first place, creating a euro zone rescue fund, increasing its effective lending capacity, allowing the fund to buy bonds in the primary market and now removing penal interest rates for assisted states, intervening in the secondary market, recapitalizing banks and giving precautionary credit lines.

For more than a year, Merkel's mantra was that the fund could only be used, in her favorite Latin phrase, "ultima ratio" -- as a last resort.

Now she has accepted that it makes sense to help floundering swimmers before they are drowning. Call it "penultima ratio."

Other steps toward closer euro zone fiscal integration are also being actively debated.

ECB President Jean-Claude Trichet called in May for the creation of a European finance minister to oversee a more integrated economic and fiscal policy of the euro zone.

Another senior ECB policymaker, Lorenzo Bini Smaghi, suggested this month that euro zone states should hand over their debt-issuing powers to Brussels while bailouts should no longer require unanimous support.

It will take a long time, if ever, before Germany, the EU's biggest paymaster, gives up its veto over European financial rescues, but Bini Smaghi noted that European states accepted the principle of weighted majority voting when committing funds to International Monetary Fund bailouts.

Jacques Delors, who headed the European Commission in the heyday of European integration in 1985-94, observed that the EU historically takes its biggest steps forward in crises.

The French "empty chair" crisis of the 1960s hastened the common agricultural policy, the 1970s oil crisis and the end of the Bretton Woods monetary system brought about the European Monetary System, a currency grid with limited fluctuation bands.

The fall of the Berlin Wall spurred the creation of the euro and led to the EU's "big bang" eastward enlargement. The September 11, 2001, attacks on the United States prompted a pan-European arrest warrant, sweeping away lengthy extradition procedures.

For a long time, it has looked as if the sovereign debt crisis would bring about a disintegration of the EU, with fiscal strains loosening the bonds of solidarity and strengthening the forces of Euroskepticism.

The rise of parties such as the True Finns in Finland and the Freedom Party in the Netherlands which have made spectacular gains by opposing euro zone bailouts has put new constraints on mainstream political leaders.

Those forces may grow stronger, but this week's summit shows that when euro zone governments have their backs to the wall, their commitment to preserve monetary union through greater European integration can prevail.

The dogs bark, but the European caravan goes on its way.

Strikingly, it was a British outsider rather than a euro zone insider who drew the lesson of the sovereign debt crisis.

British Chancellor of the Exchequer (finance minister) George Osborne said this week the "remorseless logic" of the single currency was greater fiscal union. While Britain did not want to take part, it had an interest in a stronger, more integrated euro zone, he said.

(Editing by Mike Peacock)

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