How to solve the eurozone debt puzzle

Although the second bailout of Greece may have calmed markets in the short-term, the recent volatility in Italian and Spanish bond markets signalled the beginning of a new and critical phase.

Europe’s policymakers had always hoped that by bailing out Greece, Ireland and Portugal, the crisis could be restricted to these relatively small economies.

This strategy has clearly failed and the measures taken at the recent summit recognise this fact.

Slow progress

The future shape of the eurozone will likely be determined by how events unfold in Italy and Spain.

Investors are generally making the assumption that what happens today in Greece in terms of bailouts and haircuts on bonds could happen tomorrow in Italy or Spain.

Both countries are making efforts to reduce their borrowing and reform their struggling economies but it is a process which could take years and patience is wearing thin.

Of course, the problem with Italy and Spain is that Europe cannot afford to bail them out should they lose access to market funding.

Typically, a bond yield of 7% has been seen as unsustainable in a eurozone country and in the past, a breach of that level has rapidly led to a rush for the exits, followed by a bailout.

The situation has not deteriorated to that extent yet, but if it does, the eurozone’s bailout mechanism, the European Financial Stability Facility (EFSF), could probably fund Italy and Spain for about six months before the money ran out.

How will it play out?

So what is the endgame for this crisis going to look like?

Given the general lack of cohesion in policymaking, a messy divorce is a real option and this would have hugely negative implications for the banking sector, the global economy and risk assets in general.

The only real alternative in my view is much closer fiscal integration and the launch of a single eurozone bond, jointly guaranteed by all members of the single currency. While it may be hard to imagine at the moment, I think this could be an attractive proposition for investors.

With the launch of a eurozone bond, highly-indebted countries would be able to access market funding at significantly cheaper rates, giving them the breathing space to reduce their deficits and reform their economies.

This is because markets would focus on the creditworthiness of the eurozone as a whole and not just worry about the risk of lending to Greece, for example.

The joint guarantee would come at a price, namely a further loss of sovereignty, because there would need to be centralised oversight of tax and spending decisions in individual countries.