Whilst the short-term solution to the Euro-zone’s sovereign debt problem is for the ECB to bring out its “superwaffe / bazooka” and buy bonds of solvent euro-zone countries in unlimited quantities (or lend to the EFSF or IMF), the only long-term solution is for the members of the Euro-zone to get their budget deficits down and to set their debt outstanding on a downward trajectory when measured as a percentage of GDP.  How about numbers such as below 3% of GDP for their budget deficits and down towards a target of 60% of GDP for their sovereign debt?

Of course these were the aims of the original Stability & Growth Pact (SGP) which every Euro-zone country solemnly promised to adhere to when the Euro was originally created.  Almost every Euro-zone country has broken the SGP at some stage, fines which were supposed to be levied on rule-breakers were never actually applied and now the Euro-zone finds itself in a complete mess which would have been avoided if only they had stuck to their own rules.

It goes without saying that politicians will never keep their promises so what is needed is an ironclad mechanism whereby they will be made to stick to the rules of the SGP in future.  This is where the EFSF and IMF come into play.  They are both independent and therefore able to play hardball with euro-zone countries who do not behave as the SGP says they are supposed to.  As was argued in the previous post, the EFSF is likely to end up, in the fullness of time, financing every Euro-zone country which buckles in the current sovereign debt panic.  Countries which can borrow as cheaply (or cheaper) than the EFSF will continue to fund themselves through their own domestic bond markets.  The rest will become ever more dependent upon the EFSF/IMF which will therefore be able to threaten to cut countries off from funding if they don’t adhere to the rules of the SGP.  This gets around the frustration of the ECB which has no leverage over Euro-zone countries and explains why it has been highly reluctant to backstop their bond markets because the ECB only gets politicians’ promises in return (which we all know they will break as soon as the current crisis goes away).

The Euro is a work-in-progress and it will emerge from the latest panic with a strengthened architecture of the EFSF, SGP and the ECB behind it.  Note that Germany will remain its biggest economy with the ECB headquartered in Frankfurt and a German in charge of the EFSF.  Merkel has been briefing the press this week, saying “I believe that those who give us money for government bonds in Europe expect that we have to ensure enforcement of the Stability & Growth Pact more strictly than in the past” – and Merkel is clearly calling all the shots.  A quote from July 1990 by the Right Honourable Nicholas Ridley MP on the subject of European Monetary Union: “This is all a German racket designed to take over the whole of Europe. It has to be thwarted. This rushed take-over by the Germans on the worst possible basis, with the French behaving like poodles to the Germans, is absolutely intolerable”.  Mr Ridley had to resign, but the rest of the Euro-zone’s politicians may as well start learning to recite the Stability & Growth Pact and rehearse blaming their annual budget woes on the Troika.