Now is time to think the unthinkable on the euro zone

A broker looks on in front of the main screen at the Stock Exchange in Madrid Monday Aug. 8, 2011. The borrowing costs of both Spain and Italy dropped sharply in early trading Monday after the EuropeaShow more

It is deja-vu all over again. Bond vigilantes attack a euro-zone economy, an emergency meeting of policymakers is hastily convened, a grand statement about billions of euros of assistance is made, and the markets calm down. A few weeks later, the same eerie drama repeats itself.

And now we are there again, except, once again, the front lines of speculation have been pushed out a little further. The markets are yet again having to think the unthinkable - the breakdown of the euro zone.

The main problem in Europe has to do with the combination of stagnant growth, mounting costs of debt and inept politicians. The real worry is that, even though the union has not yet conclusively solved the problems of its three weakest peripheral economies - Greece, Portugal and Ireland - the prospects for two heavyweight countries have become rapidly worse.

I am speaking, of course, of Spain, which has a larger GDP than the three "problem children" put together, and Italy, which is the third-largest euro-zone economy.

Spain and Italy find themselves in a difficult situation. They experienced sharp slowdowns in their growth and the momentum of last year's "recovery" seems to be rapidly waning. If growth was supposed to help the two economies to bring their fiscal houses in order, its absence is having the opposite effect.

As a result, yields on Spanish and Italian government bonds have edged towards, indeed at times above, the 6 per cent pain threshold that likely marks the limit for fiscal sustainability.

Jose Manuel Barroso, the president of the European Commission stoked further nervousness with his call for expanding the €440 billion (Dh2.3 trillion) European Financial Stability Facility (EFSF) only weeks after the most recent summit decision to do just that. The overhaul of the EFSF requires approval by the parliaments of the member states, a process that would not ordinarily be completed before late next month.

But this cloud has its silver lining. The first bit of good news was the response by Italian politicians to accelerate political reforms. Spain, now in the midst of electioneering ahead of the November general election, has already taken a number of measures. Silvio Berlusconi, the Italian prime minister, has announced plans for an accelerated reform programme that would ensure a balanced budget by 2013, a year earlier than previously planned.

However, Italy's true saviour this time was not Mr Berlusconi but Jean-Claude Trichet, the president of the European Central Bank (ECB). The bank has restarted its securities market programme (SMP). By initially buying Portuguese and Irish bonds, the bank seemingly sought to reward countries that had undertaken serious fiscal reforms. This appears to have triggered the Italian response.

The ECB currently holds €74bn of euro-zone government bonds acquired under the SMP. The bond purchases are sterilised on a weekly basis as the bank withdraws a matching amount of liquidity from the system.

The move was controversial with the Germans and the Dutch claiming that it goes beyond the responsibilities of the ECB. But Mr Trichet has presented SMP interventions as ensuring the effective transmission of its regular monetary policy, claiming that an excessive divergence between the bank's policy rate and bond yields in certain member states is an anomaly the bank has the right to address even though its statutes rule out actual fiscal support (monetary financing).

Nonetheless, even Mr Trichet has indicated his preference for the EFSF to take over. The ECB, having raised rates twice this year to 1.5 per cent, has also signalled growing concern about the economic situation, something that has significantly reduced the probability of further action in the near term.

The EFSF, once its rules are approved, will be able to buy bonds of member states. The facility can in turn issue its own bonds backed up by national guarantees in proportion to the weight of individual countries in the paid-up capital of the ECB.

In other words, the EFSF offers a mechanism for "federalising" the debt of problem countries and potentially nudges the euro zone significantly in the direction of a fiscal union.

While the proposed scale of the facility would not be sufficient to allow it cope with a full-blown crisis involving Spain and Italy, the ECB actions and the potential for further modifying EFSF now mean that the contours of a potentially workable solution are coming into place, provided the political will to support it can be found. The political will is still in some doubt as many countries are both sceptical of bailouts and of attempts to undermine the ECB's orthodoxy.

But two points are worth making. First, although European politicians have not impressed with their decisiveness or unanimity, they have typically risen to the occasion when a crisis has reached a tipping point.

Second, while the ECB's orthodoxy may take a dent, its track record to date means that, compared to the US Federal Reserve, it has enormous unused firepower. A combination of euro-zone quantitative easing and a more flexible EFSF, if combined with credible steps towards fiscal sustainability, may yet restore the zone's credibility.

But there are many ifs in the equation and it is possible that "controlled defaults" may have to be part of the solution.

Dr Jarmo Kotilaine is the chief economist at The National Commercial Bank, Saudi Arabia