Hugo Dixon

Solving the euro crisis is a race against time. Can peripheral economies reform before the people buckle under the pressure of austerity and pull the rug from their politicians? After two months of optimism triggered by the European Central Bank’s plans to buy government bonds, investors got a touch of jitters last week.

The best current fear gauge is the Spanish 10-year government bond yield. After peaking at 7.64 percent in late July, it fell to 5.65 percent in early September. It then poked its head above 6 percent in the middle of last week because there were large demonstrations against austerity; because Mariano Rajoy’s government was dragging its heels over asking for help from the ECB; and because the prime minister of Catalonia, one of Spain’s largest and richest regions, said he would call a referendum on independence.

But by the end of the week, the yield was just below 6 percent again. That’s mainly because Rajoy came up with a new budget which contains further doses of austerity. The move prepares the way for Madrid to ask for the ECB to buy its bonds and so drive down its borrowing costs.

Rajoy didn’t want to be seen to be told to do anything by his euro partners. Hence, this elaborate dance – where he has now done what he knew he would have been told to do but can claim it was his choice. It’s hard to believe that anybody is fooled by this subterfuge; indeed, from investors’ perspective, it looks childish. But, at least the show is on the road again: the government has had the guts to press ahead with reform despite the immense unpopularity of the measures.

The question is whether Madrid and other governments in Lisbon, Dublin, Rome and Athens can keep up the reforms long enough to restore their economies to health. That, in turn, depends on three factors: how much farther they have to travel; how unruly their people are going to get; and how much help they will receive from their partners.

Economic health requires both that fiscal deficits are eliminated and that competitiveness is restored. The peripheral economies have made some progress on both fronts. But shrinking economies makes it hard to balance their budgets while fiscal squeezes undermine growth. The austerity vicious spiral is still whirring away.

That’s why Spain is unlikely to hit its target of cutting its deficit to 4.5 percent of GDP next year. It can get there only on the optimistic assumption that the economy will shrink by just 0.5 percent in 2013. The same could be said of France, not yet a full member of the periphery, whose budget unveiled last Friday calls for a deficit of 3 percent of GDP next year. Paris is assuming 0.8 percent growth. The French prime minister describes the projection as “realistic and ambitious”. Just ambitious would have been a more accurate description.

Meanwhile, restoring competitiveness is painful because it involves cutting people’s pay. Ireland and Spain have made good progress, covering respectively 80 percent and 50 percent of what they needed to achieve by the end of last year, according to a report last week by Open Europe, a British think-tank. Portugal and Greece have done less well.

Current account deficits paint a similar picture. Spain’s had shrunk to 3.5 percent of GDP last year while Ireland actually had a small surplus. Portugal, though, had a deficit of 6.4 percent of GDP and Greece was struggling with one of 9.8 percent.

Big falls in pay are forecast for the deficit countries over the next two years by Eurostat. It sees unit labour costs dropping 4.7 percent in Spain between end-2011 and end-2013; 3.8 percent in Portugal; and 9.5 percent in Greece. If that happens, competitiveness could be restored. Citigroup forecasts that Spain and Portugal will have current account surpluses next year while Greece’s deficit will have shrunk to 2.8 percent.

The snag is that such pay cuts – especially when combined with higher taxes and rising unemployment – provoke howls of outrage from the population. Short of leaving the single currency and devaluing, the only other medicine for improving competitiveness is so-called fiscal devaluation. This involves cutting the social security contributions paid by employers and, in return, putting up other taxes.

Germany succeeded in pushing through such a fiscal devaluation in 2007. But that just made it more competitive vis-a-vis the weaker euro zone economies. More recently, Spain did a mini fiscal devaluation. But the most ambitious attempt, by Portugal, provoked such a massive backlash earlier this month that the government backed down.

Help from abroad is the main way of easing the pain of adjustment. The ECB’s promised bond-buying plan is the most dramatic example. But solidarity has its limits. There has been a backlash in the German media over the central bank’s plan. Meanwhile, Berlin has been trying to persuade Madrid not to ask for help. The German finance minister also clubbed together with his Dutch and Finnish counterparts last week, proposing rules that will make it harder for Spain to shift the cost of bailing out its banks onto the euro zone.

The consequences of a breakup of the euro zone would be so ghastly for both the periphery and the core that they will probably pull through what looks like it is going to be at least another year of hell. But the risks have certainly not vanished.

The European Central Bank’s bond-buying scheme has bought Spain and Italy time to stabilise their finances. But if they drag their heels, the market will sniff them out. It will then be almost impossible to come up with another scheme to rescue the euro zone’s two large problem children and, with them, the single currency.

Mario Draghi’s promise in late July to do “whatever it takes” to preserve the euro has already had a dramatic impact on Madrid’s and Rome’s borrowing costs. Ten-year bond yields, which peaked at 7.6 percent and 6.6 percent respectively a few days before the ECB president made his first comments, had collapsed to 5.7 percent and 5.1 percent on Sept. 7.

Most of the decline came before Draghi spelt out last Thursday the details of how the plan will work. What makes the scheme powerful is that the ECB has not set any cap to the amount of sovereign bonds it will buy in the market. The central bank’s financial firepower is theoretically unlimited, whereas the euro zone governments’ own bailout funds do not have enough money to rescue both Spain and Italy.

But the new type of intervention, christened “Outright Monetary Transactions”, has three important limitations.

First, the ECB will only buy a country’s bonds if its government agrees to a bailout programme with the euro zone, and sticks to “strict and effective” conditions detailed in such a deal. Second, the central bank will focus its purchases on bonds with a maturity of one to three years. Finally, Draghi has not specified how much he wants to drive down Madrid’s and Rome’s borrowing costs.

This fine print makes sense. But it also means that there is no free lunch. While the ECB seems unlikely to dream up new economic reforms for Spain and Italy, it will probably want their governments to put more precise time frames around what they are already supposed to be doing. The involvement of the International Monetary Fund, which has a somewhat unfounded reputation as a bogeyman, will also be sought. No wonder neither Spain’s Mariano Rajoy nor Italy’s Mario Monti is rushing to take advantage of the scheme.

Meanwhile, the ECB’s focus on short-term bonds means that Madrid and Rome would have to find some other way of issuing long-term debt – which accounts for 66 percent and 62 percent of outstanding debt respectively. If they lost access to the markets, the zone’s bailout funds would have to ride to the rescue. But they still wouldn’t have enough money for both countries.

What’s more, Spain’s and Italy’s borrowing costs are still too high for comfort. The ECB’s main justification for bond-buying is that investors are unfairly punishing them because of fears that the euro will break up. But it also recognises that the spread between their bond yields and Germany’s 1.5 percent 10-year borrowing costs is only partly due to such “convertibility risk”. It is also because of bad economic policies.

While there aren’t any scientific measures of convertibility risk, it seems like the bulk of it has disappeared since Draghi’s comments in late July. A reasonable guesstimate is that the risk of euro breakup might still be inflating Spanish yields by 1 percentage point and Italian ones by perhaps 0.75 percentage points. If the ECB used those numbers to guide its bond-buying programme, 10-year borrowing costs would drop to 4.7 percent and 4.4 percent respectively. To fall further, the countries would need to take more action themselves.

Although investors are currently relatively bullish about Spain and Italy, they are notoriously fickle. Rajoy and Monti should remember how the good mood, engineered at the start of the year by the ECB’s 1 trillion euros of cheap long-term loans to the zone’s banks, vanished with the spring. What’s more, both are facing tougher political challenges than they did at the start of the year when they were enjoying their honeymoons as new prime ministers. Each of their economies has declined this year and will continue to do so next year – shrinking roughly 5 percent over the two-year period, according to Citigroup.

For all these reasons, it is vital that Rajoy and Monti don’t dawdle. Assuming the German constitutional court this week backs the creation of the European Stability Mechanism, the zone’s permanent bailout fund, the Spanish prime minister should apply immediately for a programme.

Italy, a rich country, should still be able to avoid a bailout. But to do so it needs to cut its public debt, ideally with a vigorous privatisation programme and the creation of a wealth tax. With elections due next April and no guarantee that an effective government can be formed thereafter, there is only a tiny window for action. Monti’s technocratic government needs to jump through it.

The ECB has put its credibility on the line with its new bond-buying plan. Germany’s central bank, the Bundesbank, has attacked it on the grounds that it has come close to breaking treaty provisions banning the ECB from bailing out governments. For now, Draghi can withstand the criticism, as long as Angela Merkel keeps backing him. But if Rajoy and Monti don’t move fast, the ECB’s magic will wear off. And if its medicine then fails, it will be hard to conjure up the political will for an even more powerful concoction.

The break-up of the euro would be a multi-trillion euro catastrophe. An interest subsidy costing around 50 billion euros over seven years could help save it.

The immediate problem is that Spain’s and Italy’s borrowing costs - 6.3 percent and 5.8 percent respectively for 10-year money - have reached a level where investors are losing confidence in the sustainability of the countries’ finances. A vicious spiral - involving capital flight, lack of investment and recession – is under way.

Ideally, this week’s euro summit would come up with a solution. The snag is that most of the popular ideas for cutting these countries’ borrowing costs have been blocked by Germany, the European Central Bank or both.

Take euro bonds, under which euro zone countries would collectively guarantee each others’ debts. They would allow weak countries to borrow more cheaply. But Germany won’t stand behind other countries’ borrowings unless they agree to a tight fiscal and political union which prevents them racking up excess debts in future. Such a loss of sovereignty France, for one, will find hard to swallow.

Or look at pleas for the ECB to buy Italian and Spanish government bonds in the market. That too would cut their borrowing costs – for a while. But when the bond-buying ends, the yields would just jump up again. Private creditors would merely use the opportunity to offload their bonds onto the public sector. The ECB has already spent 220 billion euros buying sovereign debt with no lasting impact, and is reluctant to do more.

Italy’s idea that the euro zone’s bailout funds should buy bonds in the market has the same drawbacks. What’s more, the bailout funds only have 500 billion euros left. If they use their firepower to bail out private creditors, they will not have enough to fund governments. Giving the bailout funds banking licences and allowing them to borrow from the ECB would solve that problem. Unfortunately, both Germany and the ECB are against the idea.

But what about a direct interest subsidy? Core countries - such as Germany and France – could pay into a pool an amount that depended on how much their cost of funding was below the euro zone’s average. Peripheral countries – such as Italy and Spain – would then take a sum out of the pool depending on how much their cost of funding was above the average.

The idea recently surfaced in an article by Ivo Arnold, programme director of the Erasmus School of Economics in Rotterdam. It has also been touted by Pablo Diaz de Rabago, economics professor at the IE Business School in Madrid. But it has not yet had much oxygen.

Under such a scheme, the final cost of funds paid by all countries could be equalised or just narrowed. The key questions are: would it work, would it be politically acceptable and is it legal?

First, look at workability. An interest subsidy would help the peripheral countries in two ways. They would benefit from cash payments from the core. But the yield they pay on their own bonds would also drop as worries about the sustainability of their finances eased.

The yields on core bonds, by contrast, would rise. Investors would be worried that Germany and others were shouldering part of the burden of bailing out their neighbours. What’s more, some of money that has rushed into German bonds in recent years would flood out. But, in a sense, this would just be giving back to the periphery a windfall Berlin has enjoyed as investors have panicked over the possibility of a euro collapse.

My colleague Neil Unmack and I have crunched the numbers. Suppose the yield on Spanish and Italian bonds fell by one percentage point as a result of the scheme, and that the yield on the bonds of core countries rose by 50 basis points.

Also assume that core countries were willing to make up half the remaining difference between their interest rates and those in the periphery. That would limit the scale of the subsidy while maintaining pressure on peripheral countries to reform. In this scenario, Spain’s cost of borrowing for 10 years would drop to 4.4 percent, while Italy’s would drop to 4.1 percent – no longer worrying levels.

Now look at political acceptability. The interest subsidy would start off being cheap. On the above assumptions, the first year cost would be only 1.9 billion euros, about 60 percent provided by Germany. Each year, of course, the cost would mount, as countries added new debt to the scheme. But the cumulative cost over the first seven years would still be a manageable 53 billion euros.

The core wouldn’t have to guarantee the periphery’s debt. And subsidies could be provided one year at a time. So if a country didn’t keep up with its reform programme, it could be kicked off the scheme. What’s more, if markets settled down, the operation could be wound down.

Such limitations mean the scheme would be unlikely to fall foul of the German Constitution or the no bailout clause in the EU treaty. Of course, investors may not be convinced that the safety net is strong enough. So it wouldn’t remove the need for Europe’s leaders to come up with a credible long-term vision as well as continue with their reforms. But interest subsidies are still a reasonably cheap and practical answer to the zone’s most pressing problem.