How to Save the Euro

Can the euro be saved? Is it possible to stem the flight of money from the periphery into the core? With a botched German auction in mind, investors are now wondering whether it's possible to prevent a flight out of "all things euro." We examine the dual challenges of fiscal sustainability and bank solvency in this analysis, with the not-so-modest title "Guide to Save the Euro."

Fiscal sustainability is about revenue and expenses, but also about perception. As the housing bubble in the US proved, what is affordable at low interest rates may become a nightmare when rates go up. Similar rules apply to governments: If there is a perception that obligations won't be paid back, the cost of borrowing will skyrocket. Spain is the most recent case study.

Recent elections in Spain kicked out the socialist government, giving an absolute majority to the party of conservative prime minister-elect Mariano Rajoy. You would think that Rajoy would give a speech, declaring how his party will use its mandate to ensure Spain's obligations will be met, how the rigid Spanish labor market will be opened up, how Spain -- with one of the lowest debt-to-GDP ratios in the developed world -- will have a strong comeback.

You would expect his team would give an update on how to clean up the Spanish banking system; how his administration will be transparent and give frequent updates on progress. However, in proof that politicians globally are utterly clueless about all things finance, Rajoy pronounced in an interview that Spain would be unable to come to a sound financial footing if it has to pay 7% on its debt. The market's response was swift: Spain had to pay 5.1% to sell three-month Treasury Bills in late November, versus 2.3% just a month earlier.

While Rajoy has lined up what some consider extremely competent people, he is not known to make tough decisions. Overlay this with the concern that members of his party are responsible for some of the policies that have led to the current malaise, and you can see why the market seriously questions whether there is the determination to make the necessary tough decisions -- decisions that will likely step all over the toes of regional decision-makers in his own party.

But fear not! The market will bring Rajoy and other policy makers to their knees. By imposing punitive borrowing costs on Spain, the Spanish government will get the message. The question then will be whether the medicine will be too tough to swallow. Regaining market confidence after destroying it is rather difficult. It took former Federal Reserve Chairman Paul Volcker the herculean task of raising interest rates to 20% to convince the market that he was serious about fighting inflation. In contrast, when there is confidence, a Fed official only needs to utter a few words to appease concerns in the market. Similarly, what would have historically been a regular budget battle to balance the books may become a struggle for survival.

To achieve a sustainable budget, the obvious levers are to increase revenue or to cut spending. As Greece has shown, raising revenue through tax increases does not necessarily work; governments can also liberalize their labor market, cutting red tape. They can sell off government property to reduce debt levels, but in the absence of other structural reform, such sales might only be a short-term patch up. The expense side, of course, is where real progress can be made. All governments of developed countries face the risk that they have made too many promises. Some of those commitments can be renegotiated in an orderly fashion, others through default.

Policy makers believe that if there is some magic elixir -- such as an insurance scheme or an unlimited Chinese checkbook -- governments will have the breathing room to clean themselves up. However, our dear policy makers have proven that the moment the pressure abates, the willingness to push through tough reforms evaporates. That's not a European trait, but a universal one: in the US, there is no pressure applied by the bond market and, as a result, there is no agreement to tackle fiscal sustainability in the US.

What about calling it quits; leaving the euro? We have long argued that it isn't in anyone's interest to leave the euro. Take Germany -- a currency dragged down by weaker peripheral countries helps German exports. Germany is effectively operating with an artificially weak deutschemark. More importantly, if Germany were to leave the euro, money might be sucked out of the financial systems of weaker Eurozone countries and into Germany, thus exacerbating a collapse of the periphery. Just because this isn't in Germany's interests, it doesn't mean the market isn't pricing it in. In the third quarter, large Italian and Spanish banks reported double-digit percentage declines in deposits from corporate and institutional clients, although their overall deposit levels only dropped by approximately 2%.

Generally speaking, there are two paths that may lead to fiscal sustainability: surrendering sovereign control over the budgeting process, or embracing the brutal pressures imposed by the bond market.

Read Axel Merk's entire "Guide to Save the Euro" on the Merk Website.