Yesterday was rough for the eurozone. Government bond yields rose sharply. Countries that thought they were immune from the crisis - France, Austria and the Netherlands - are now seeing their borrowing costs rise. No one is now safe from the contagion.
There is "almost unanimous agreement" that only the ECB can save the eurozone. The rescue plan is disarmingly simple. The central bank should bail out eurozone governments directly through direct purchases of bonds.
There is only two difficulties with the plan. First, that "almost unanimous agreement" does not extend to Germany or the ECB itself. Second, the ECB is legally prevented from providing credit to member state governments, the EC or any other EU institution. So, an ECB-centered bailout isn't happening, and there is no other credible bailout plan on the table. So where does the Eurozone go from here?
Broadly speaking, there are two answers to this question. The first tries to re-establish the ECB bailout plan by designing an elaborate financially engineered scam whereby the ECB provides credit indirectly to illiquid governments. Almost weekly, these plans emerge. They stir up excitement in financial markets and policy circles. Then an official from the German finance ministry or the ECB describe the plan as either unworkable or illegal and the excitement dies down.
The second answer is austerity. Illiquid governments like Italy and Spain have to balance their books. They have to rein in expenditures and raise more taxes. If austerity results in a recession that reduces tax revenues, and increases the fiscal deficit, then another round of cuts and tax hikes are required. Governments just have to keep cutting and taxing until they can convince bond markets that their fiscal position is sustainable. Greece, Ireland, and Portugal have all gone down that road. So far, none of these countries have been able to successfully return to the bond market.
Many Eurozone policy makers balk at the idea of supervising brutal cuts in living standards. However, the bond market has no time for squeamish polititicans. The choice is cut the fiscal deficit or face being shut out of capital markets. Slowly, European politicians are getting the message.
But what of Germany and the ECB? Wouldn't things be so much easier if they quietly acquiesed and allowed the ECB to fund eurozone fiscal deficits? Once the central bank begins printing money to keep those Southern European wastrels afloat, when will it stop? Will it be any easier to adjust after two years of funding Italian public sector wages than it is today? Once the ECB starts bailing out Southern Europe, the incentive to cut deficits will vanish. Germany knows that a bailout will only prolong the crisis. The ECB knows it too.