Whatever It Takes to Save the Euro

The day was rich in symbolism. Sunday, May 9, was the 60th anniversary of the moment when the European states shattered by World War II began to pursue renewal in a peaceful, supranational community pooling their resources of coal and steel, a vision that eventually led to the European Union and the adoption of the euro as most of Europe's currency. The message that strength comes from unity was clearly on the minds of Europe's Finance Ministers as they met in Brussels to confront a new challenge to the continent's welfare. Sparked by a sovereign-debt crisis in Greece, investor confidence in other profligate and vulnerable euro-zone members was rapidly deteriorating, threatening the viability of the European monetary union itself. After months of waffling, Europe's leaders promised intensified resolve to combat the financial contagion and preserve the euro. "We will not let others undo what generations have created," said French President Nicolas Sarkozy.

And they may have succeeded. In a dramatic and unexpected step, the European Union nations agreed to create a colossal $950 billion rescue fund for the euro zone's weaker economies a gargantuan package representing 8.2% of the zone's GDP. It was the most powerful display of European camaraderie since the launch of the euro itself 11 years ago. The rescue fund "proves that we shall defend the euro, whatever it takes," proclaimed E.U. Economic and Monetary Affairs Commissioner Olli Rehn.

The crisis fund does much more than that. It instantly changes the way in which the euro zone works and the relationship between its 16 members. Throughout the history of the E.U., Europe's individual states have tempered their wish to gain the benefits from economic integration with a reluctance to give up too much sovereignty. They insisted on their right to decide on certain important policies (like fiscal budgets) themselves. Most of all, the euro-zone governments definitely didn't want to take on financial responsibility for other members' liabilities. That reluctance was clearly outlined in no-bailout clauses in E.U. treaties.

But in a mere weekend, those long-standing attitudes went out the window. With the rescue package, the euro zone took another major leap toward greater integration. The majority of the funds some $560 billion will be guaranteed by member states. (Much of the remainder will come from the International Monetary Fund.) In return for that financial commitment, the E.U. will likely place greater controls on the fiscal policies of member states. On May 12, the European Commission, the E.U.'s executive body, proposed an advance review process of national budgets to better coordinate fiscal policy across the euro zone and stricter sanctions on countries that break deficit guidelines. André Sapir, an economist at Bruegel, a Brussels-based economic think tank, says that "an element of fiscal union" is being forged by the rescue plan. "There is a new level of solidarity, but it also means there is a degree of control [by the E.U.] over finances," he says.

The plan also envisions an enhanced role for E.U. institutions. The rescue funds would be coordinated by the European Commission. In a major shift of policy, the European Central Bank (ECB) has already agreed to help troubled members by buying their sovereign bonds. In doing so, the ECB is behaving more like the Federal Reserve, stepping in to provide stability in a Europe-wide crisis just as the Fed does within the U.S.

Perhaps such steps were inevitable. Some economists critical of the euro have always claimed that Europe's monetary union is doomed to fail without matching political integration. There have been louder calls in recent weeks from countries like France for the creation of a euro-zone "economic government" to better coordinate policy across the zone. Yet it is still unclear how far Europe is willing to go. The euro zone already has penalties for countries that flout debt and deficit rules, but the E.U. has continually failed to enforce them. "It is uncertain if the mechanisms will work," says David Aserkoff, strategist at independent brokerage Exotix in London. "The E.U. doesn't have many sticks." And the whole idea of using national resources to bail out wayward euro-zone neighbors remains politically charged. Voters in Germany have already rebuked Chancellor Angela Merkel for her support of a $145 billion joint E.U. and IMF bailout for Greece, which was finalized in early May. Her party got trounced in a state election on May 9, which cost Merkel a majority in the upper house of the national parliament.

Potential political opposition to further bailouts is only one of many problems left unresolved. The formation of the giant rescue fund doesn't change the need for major reform in the euro zone's weaker states. Portugal, Ireland, Italy, Greece and Spain the so-called PIIGS still must undertake painful reductions in fiscal spending to get their debt under control. On May 12, Spain announced cuts in civil-servant pay and social-welfare programs to reduce its deficit. Measures like those are likely to suppress growth not just in the PIIGS, but in the euro area overall. There is also a widespread belief among financial analysts that the fiscal reforms Greece must take on to ensure solvency may be almost impossible to achieve. Barclays Capital figures that Greece must completely reverse its fiscal position, from a primary deficit of 8.5% of GDP in 2009 to a surplus of at least 5% by 2014. Fears remain that Greece will eventually require a restructuring of its debt to reduce the burden on its feeble finances. That would hit European banks and other Greek bondholders with significant losses and potentially restart the euro-zone-wide debt crisis. "It has to be realized that the underlying debt problem is still there," says Carmen Reinhart, a specialist on financial crises at the University of Maryland. "You don't solve debt with debt."

Such harsh realities have kept financial markets nervous. The euro continued its slow decline against the U.S. dollar even after the rescue package was announced. But if anything, the plan shows that Europe sees its future as a united whole more than ever, and that it possesses the will to defend that unity. "People who say that [the monetary union] is going to break down are missing the underlying political imperatives and forces" in Europe, says Richard Portes, an economist at the London Business School. There was "a realization that if it was to disintegrate, the E.U. itself would be under severe threat. They'll do whatever is necessary to save it." That is undoubtedly true, but Europe may yet need to do much more.

With reporting by Leo Cendrowicz / Brussels