Can the Euro Zone's New Rules Cure Its Ills?

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Andrew Medichini / AP

Italian premier Silvio Berlusconi, right, shakes hands with European Commission president Jose Manuel Barroso at Palazzo Chigi in Rome, on March 14.

It has been more than a year since financial markets began buffeting the euro and threatening its very viability, yet Europe is still battling to fix the system and restore confidence in the single currency. At a summit in Brussels on March 11, the euro zone's 17 leaders took a step toward overhauling their bailout mechanism for beleaguered members, while throwing in groundbreaking new rules to coordinate their economic policies. But looming over the so-called Pact for the Euro was the gnawing question of whether the leaders are prescribing the wrong medicine for the currency's ills. Ireland and Greece are already locked into bailout plans aimed at guiding them back to fiscal health, yet there was little sense of how or when either of them might expect to pay back their mountainous debts.

In the short term, the euro zone has staved off the prospect of collapse. At the summit, leaders agreed to expand the main bailout fund in scope and size, boosting its current lending ability from 250 billion euros ($350 billion) to 440 billion euros ($615 billion) for crisis-stricken counties. And they agreed to the foundations of the permanent euro stability fund that will replace it in 2013: it will be slightly bigger, at 500 billion euros ($700 billion), and financed through a combination of credit guarantees and cash capital. The deal, said European Central Bank president Jean-Claude Trichet, "goes in the right direction." German Chancellor Angela Merkel said it strengthened the political pledge to fight for the euro's stability: "I hope that this will also be a good message to the world in terms of the euro as a major currency."

Yet these measures are essentially firewalls. What the euro zone needs in the longer term is a structure that promises solid growth, and the prospect that the debts — which, in Greece's case, amount to a staggering 140% of GDP — will eventually be paid. And for Germany, at least, the Pact for the Euro is the route to lasting salvation.

It is a grand bargain: in exchange for fronting more cash to bail out errant euro-zone members, Merkel wants any recipients to agree to a disciplined program of economic rigor that would re-engineer them to a common standard to make them more competitive. She sees the pact as a way to harmonize budgetary, tax and social policies by making recipient countries raise the retirement age, end any pegging of wages to inflation and agree to deeper budget scrutiny. Indeed, it is an agenda to make the rest of the euro zone resemble Germany, with its enviably low debt and deficit record and its world-renowned economic dynamism.

Although backed by French President Nicolas Sarkozy, the pact was widely seen as a diktat trying to foist German priorities on the rest of the euro zone. Belgium, Austria, Spain, Ireland and Portugal all said the proposals intruded too far into national economic decisionmaking. Other critics said it was cynically designed to reassure German voters that Europe's laxer economies would be held to account.

Daniel Gros, director of the Brussels-based Centre for European Policy Studies, notes that although the new mechanisms for economic-policy coordination might be useful to push euro-zone member countries to adopt more sensible policies, until recently Ireland and Spain were held up as the shining examples of competitive economies. "It is thus doubtful that tighter economic-policy coordination will prevent new bubbles from emerging," he says. "Financial markets, at any rate, do not care much about the future setup for economic-policy coordination in the euro zone. They need to know how the existing debt overhang will be dealt with today."

In the face of these objections, Merkel's proposals were watered down at last week's summit, leaving only a general appeal for wage restraint and an increase in the retirement age, a commitment to rigorous budget and labor-market reforms, and a harmonization of the corporate tax rate. The summit's closing statement referred to "a new quality of economic-policy coordination in the euro area." But these remain voluntary commitments to reform, and the pact does not contain any binding targets or sanctions.

This setback did not, however, dampen Merkel's mood, as she showed when Ireland and Greece sought an easing of their bailout terms. The other euro-zone leaders agreed to lower the interest rate charged to Greece, and Athens in turn accepted that it has to reduce its debt further by selling various public properties worth an estimated 50 billion euros. But Merkel rejected Ireland's pleas, suggesting that Dublin could secure a lower interest rate only by raising its corporate tax rate, which, at 12.5%, is half that of most European Union member states and attracts the lion's share of E.U. foreign direct investment. "We weren't very pleased with what the Irish had to offer," Merkel said after the meeting, which reportedly involved fierce exchanges with newly elected Irish Prime Minister Enda Kenny.

All this, however, still leaves many unanswered questions about the euro zone, particularly the unsustainable sovereign and banking debts held in many members. Jacques Cailloux, chief euro-zone economist at the Royal Bank of Scotland in London, says that for all the summit claims about a breakthrough, the Pact for the Euro is essentially a distraction from the bigger challenges. "None of the measures announced will reduce the debt overhang in some parts of the euro area," he says. But at the moment, they are the only measures the 17 euro-zone leaders are able to agree on.