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Vicious spirals

Hugo Dixon 

Europe: Europe is dancing with danger. The region’s leaders have been consistently behind the curve when addressing problems from Italy to Greece. The more credibility shrivels, the more they need to do to restore confidence. This week's summit is the last good chance to stop the rot.

A vicious cycle is in operation. As investors get increasingly anxious about the ability of governments to solve the euro zone’s debt problems, borrowing costs shoot up — and that makes it even harder to solve the problems.

The vicious cycle is now whirling in a frightening number of different places. The first concerns Greece, which needs a second bailout. Europe’s leaders have been going round and round, trying to find a way of making sure that private-sector creditors bear some of the pain. The fact that as of last Friday officials were still tossing around three very different schemes suggests they still haven't got their act together.

The politicians only now seem to be giving serious consideration to how to minimize the fallout if the rescue involves a Greek default. Greek banks, up to their eyeballs in their own government's debt, would need to be recapitalized. A way also needs to be found to ensure they can fund themselves. Given that these issues are technical, one wonders whether Europe has really given itself long enough to crunch out proper solutions.

The problem isn’t just that the politicians can't agree among themselves; they’ve also been in open warfare with the European Central Bank which has been resisting any private-sector involvement. Comments by Ewald Nowotny, the Austrian central bank governor, suggest the ECB’s opposition to a Greek default might finally be softening. But the impression left by the months of wrangling is that the euro zone is a dysfunctional entity, that will always be doing too little, too late.

Meanwhile, in Italy, Silvio Berlusconi's antics can no longer be considered a joke. His fractious government has been unable to cut its deficit rapidly enough. Although parliament has passed an austerity programme, the damage had already been done — and the markets are now demanding more, largely because the austerity has been delayed. Bond yields are likely to ratchet higher until Rome delivers the goods. The worry is that by the time the government makes its next step, the market will have moved on even further.

Similarly, Spain's lame-duck government is still seen by investors to be in denial about the problems in its savings banks. Last Friday's sham European bank stress test, after which Spain's central bank said the country's banks didn't need to raise any capital, will probably damage credibility even more. The best hope is that a new government led by the conservative opposition will grip the problem. But unless there are early elections, that won't be until next year. In the meantime, a huge amount of damage could be done.

At Thursday’s summit, Europe’s leaders have got to prove their doubters wrong — and tackle all these problems. If they come up with more half-baked solutions, the markets will punish them severely.

First Published: Wed, July 20 2011. 00:33 IST