The markets want the European Central Banks to start buying Spanish and Italian bonds, but for the buying to be effective the ECB would have to buy bonds on a massive scale.
Given that the ECB already has an exposure of €444 billion to the peripheral countries, such a move would send it into the realm of fiscal policy—which is against its own rules. Germany would strongly oppose such a move. Several members of the ECB’s Governing Council even voted against the comparatively modest decision to start buying Portuguese and Irish government bonds.
Of course in return for taking on this role and the risk it involves the ECB would want a large say over fiscal policy in the euro zone, and would probably push for even more massive austerity. This would lead to it being heavily involved in political decisions—an undemocratic situation but one that Merkel in particular might see as advantageous if elections were not looming.
It could also increase the size of the bail-out fund, the EFSF.
The present size of the fund, €440 billion, is far too small to cover Italy or Spain (or both). The Italian bond market is €1.6 trillion and Spain’s is about €600 billion, with both having large amounts of debt maturing over the next few years. To be effective the lending capacity of the EFSF would have to be at least quadrupled, and to have any impact in this crisis it needs to be doubled, at least.
But both options are politically problematic.
As a AAA rating needs to be guaranteed for the EFSF, the entire burden of this increase would in reality fall on the six AAA-rated countries, which would be forced to provide loan guarantees amounting to more than a quarter of each of their GDPs. This in turn could have a negative effect on their own financial position and rating.
Crucially, such an arrangement cannot be agreed without completely ignoring voters in these countries, who are vehemently opposed to putting more cash on the line. Any increase would need to be ratified by national parliaments; and, given the opposition in the Dutch, Finnish and German parliaments over the existing loan guarantees, which have been on a far smaller scale, this is unlikely to happen.
The prospects are that Italy and Spain can withstand rising interest rates for a few months. But in the longer term these rates will significantly add to their deficits and will force further austerity—which will be very unpopular domestically and will kill off any prospects of growth.
Both countries suffer from low growth, with Italy in particular lacking a credible plan for getting out of its debt problem: interest payments on debt outstrip growth, meaning that debt continues to grow relative to GDP. Italy and Spain would somehow have to find a way to make the long-term changes necessary to boost their growth and competitiveness, within the restraints of a flawed currency union.
The impossible short-term choices, pitting the need to soothe the markets against national democratic restraints, perfectly illustrate the flaw that was built into the euro zone from the beginning. The choice that was always inevitable is therefore drawing closer—appease markets but ignore voters and create a full fiscal union—or break up the euro zone