April 6, 2012

EUROPE IS supposed to be well on its way to resolving the debt crisis that threatens the coherence of the European Union and the stability of its common currency, the euro. But apparently the bond markets didn’t get the memo. Creditors balked at the latest offering of Spanish 10-year bonds, forcing Madrid to pay an interest rate of almost 5.8 percent, the highest rate since December and dangerously close to the 7 percent level believed inconsistent with national solvency.

Is Europe really back at the brink of collapse, despite wrapping up a Greek bailout and pouring the markets a soothing bath of cheap three-year loans from the European Central Bank (ECB)? Certainly the timing of the disappointing Spanish bond sale is not encouraging. It comes just after Spain’s government released details of $36 billion in tax increases and spending cuts intended to reduce the budget deficit from 8.5 percent of gross domestic product to 5.3 percent this year.

Investors seem to doubt that Prime Minister Mariano Rajoy’s conservative government can really hit that target, given that it doesn’t control regional governments’ spending and that some of the projected new revenue comes from an unpredictable amnesty for tax evaders. They may also worry that the plan will compound Spain’s real problem: a recession that has already inflicted 23 percent unemployment.

The trouble in Spain also suggests that investors are skeptical about the financial “firewall” Germany and other wealthy European countries have promised to erect. German Chancellor Angela Merkel recently agreed to a temporary boost in the European rescue fund’s lending capacity from about $700 billion to almost $930 billion. But that is still less than the $1.3 trillion that Angel Gurria, secretary general of the Organization for Economic Cooperation and Development, recently recommended. If Spain, the fourth-largest economy in Europe, really does need a bailout, even that amount might not be enough.

The truth is that Europe’s recent actions have bought time to solve the problem, as opposed to actually solving it. The continent is still plagued by a profound imbalance between the rich north and the indebted south. The latter could grow, and pay off debt more easily, if countries there could devalue their national currencies, but that’s not an option as long as they use the euro. The south could also grow more quickly if Germany would switch from an export-led growth model to growth driven by consumption. Germany has made some progress in that direction but probably not enough to boost imports from Spain, Italy and the rest significantly in the short term.

As a result, the debtor countries have no alternative to austerity, which retards their growth. Investors are entitled to be skeptical about betting on that strategy. The bailout for Greece, and the ECB liquidity bath that accompanied it, may have complicated Europe’s difficulties, in two ways: first, by relieving the pressure on governments to undertake necessary but painful pro-growth labor market reforms; and second, by giving investors an incentive to hold out for better terms, pending more official intervention. Instead of a straightforward investment in sovereign debt, European bond-buying has turned into a gamble on the future course of central-bank policy and bailout politics.