Hugo Dixon

European leaders nudged forward plans for a fiscal union with discipline as its leitmotif at last week’s summit. But such a “Disziplin union” is neither desirable nor necessary. It may not even be politically feasible.

The consensus among the euro zone political elite is that fiscal union is needed to complete the crisis-ridden monetary union. There are two rival views of what this should consist of: a panoply of rules to prevent and punish irresponsible behaviour; or financial payments to help weaker economies. The former view, espoused by Germany, is in the ascendant. It involves lots of sticks but not many carrots.

The summiteers’ main achievement was to give further impetus to the idea that the European Central Bank should act as the zone’s central banking supervisor from the start of next year after Berlin dropped its insistence that its own savings banks should be excluded from the regime. That was an important political concession. It’s also conceivable that the new supervisor will be better able to clean the cesspits in parts of the euro zone than the current often-conflicted national supervisors.

However, banking supervision is only part of what the experts call “banking union” which, in turn, is only part of a planned fiscal and political union. Just looking at banking union, what has been agreed is the stick. Back in June, when the plan was first agreed, there was also supposed to be a carrot: the euro zone would inject capital directly into struggling banks in countries such as Spain. But Angela Merkel, Germany’s Chancellor, made clear after the summit that this would not happen retroactively.

Full banking union would also include a common deposit guarantee scheme. But there was no mention of this carrot in the summit’s communiqué. There were, though, more sticks to ensure budgetary discipline and economic reform.

First, the summiteers called for the “two-pack” to be implemented by the end of the year. Even aficionados of euro-speak find it hard to stay up-to-date with the whirlwind of rules designed to keep countries on the fiscal straight and narrow. The original “stability and growth pact” was augmented by first the “six-pack”, then the “fiscal compact” and now, if everything goes to plan, the “two-pack”. The basic idea is that there will be coordination of countries’ budgets and enhanced surveillance of those experiencing financial difficulties.

Mind you, this is not sufficiently tough for Wolfgang Schaeuble, Germany’s finance minister. He wants a new European Commissioner to be have the power to veto a national budget if he or she feels the deficit is too large. While that’s not yet a euro-wide consensus, the summit did give some support for the idea that individual countries should be required to enter contracts with the centre spelling out what reforms they would commit to undertake.

Counterbalancing these potential new sticks, one new carrot was dangled: what the eurocrats call an “fiscal capacity”. This is code for a centralised budget which could be used to help countries adjust to economic shocks or even as an inducement to persuade them to move ahead with unpopular reforms. This may turn out to be an important idea. But, as yet, there is no detail on how big such a central budget would be, where the money would come from or what exactly it would be used for.

Plans for yet more bureaucratically-mandated discipline are not desirable. They would hard-wire austerity into the circuitry, potentially deepening the recession in parts of the euro zone. They would also involve a further transfer of sovereignty to the centre, even from those countries that are not in trouble. That is a mistake. It is one thing to turn Greece or even Spain into a quasi-protectorate for a temporary period; it is quite another to centralise partial control of all countries’ budgets permanently.

It may not even be feasible to push through such a Disziplin union. While Germany and other northern countries want rules, the southerners are much keener on a “transfer union” involving ideas such as joint guarantees for their debts. Such mutualisation of debt didn’t get mentioned in the summit’s communiqué, because the southern countries’ bargaining position vis-a-vis Germany is weak. But even if their leaders are eventually browbeat into signing up to a Disziplin union, there must be some doubt over whether the people – who may be asked to vote in referendums sanctioning loss of sovereignty – will agree to it.

A fiscal union is, in fact, not even necessary. There clearly has to be some discipline in order to prevent countries running up excessive debts. But that can be better achieved by making clear that insolvent governments can go bust. The Greek debt restructuring earlier this year was a step in the right direction. But it should have been deeper and occurred earlier. If bondholders know they will suffer a haircut when debts spiral out of control, they will have a stronger incentive to hold countries to account in the first place.

There also has to be some sort of support system for countries in trouble. And the quid pro quo should be a loss of sovereignty for the period of the rescue operation. Deficits have to be cut and economies reformed. But that is quite different from either permanent rules for everybody or permanent mutualisation of debt. The euro zone needs neither a Disziplin union nor a transfer union.

The art of politics is about squaring circles. In the euro crisis, this means pushing ahead with painful but necessary reforms while hanging onto power.

In Spain, where I spent part of last week, these circles are getting harder to square. Mariano Rajoy isn’t at any immediate risk of losing power. His 10-month old government has also taken important steps to reform the economy – cleaning up banks, liberalising the labour market and reining in government spending.

But the recession is deepening, the prime minister is a poor communicator and his political capital has plummeted. Madrid will also find it harder than thought to access help from its euro zone partners.

GDP will shrink by 1.5 percent this year and another 1.8 percent next year, according to Funcas, the Spanish savings bank association. That is a result of both a severe fiscal squeeze and private-sector deleveraging. An austerity spiral is in operation. As the International Monetary Fund argued last week, so-called fiscal multipliers across the world are bigger than forecasters had previously estimated.

The severity of the downturn means the government seems destined to miss its deficit reduction targets again. This year, Madrid economists think it will end up with a deficit of around 7 percent of gross domestic product, against a revised target of 6.3 percent. Next year, the deficit could be in the 5-6 percent range rather than the new, 4.5 percent target.

It might seem that these slippages matter less now that the IMF and even some euro zone policymakers are softening their demands for austerity. Foreign governments are less likely to demand Madrid tighten its belt further if a failure to hit targets is not its fault.

However, Spain will have to sell 207 billion euros of bonds, equivalent to 20 percent of GDP, next year – to fund the deficit and rollover maturing debt. That’s even more than the 186 billion scheduled for this year – an amount Madrid has only been able to shift because the European Central Bank lent 230 billion euros of cheap long-term money to Spanish banks, much of it recycled into buying government bonds.

Spain should be able to sell the remainder of this year’s bonds because investors have been lulled by the ECB’s promise to purchase unlimited amounts of sovereign paper. For example, they brushed aside last week’s two-notch downgrade of the country’s credit rating by Standard and Poor’s. But as next year approaches, the mood could turn ugly – especially if Madrid hasn’t by that time taken advantage of the central bank’s security blanket and its credit-rating is junked.

Investors could start worrying about the fact that the state’s debt could well reach 100 percent of GDP in 2015 after including the cost of injecting capital into the banking system. They may also focus on the fact that the ECB’s bond-buying plan is partly a confidence trick because it is limited to the secondary market and short-term bonds – and would end if Madrid couldn’t sell bonds in the primary market. A loss of confidence could be self-fulfilling.

Why doesn’t the government just get on with it and ask for ECB help? That would lower the risk of a renewed “Spanic” attack and cut both the government’s and the private-sector’s borrowing costs – taking the edge off the recession.

Before I went to Madrid, I thought Rajoy’s misplaced pride was the main reason he was not asking for help. This, and the desire to wait until after regional elections in Galicia later this month, may be minor factors. But the two more important reasons for delay are lack of clarity over what the ECB will do and concern that Germany will block the bailout.

Does the ECB just want to cap Spanish 10-year bond yields at around the current level of 5.7 percent? Or does it want to drive them down to, say, 4.5 percent – the level that might be justified if there weren’t residual fears about a break-up of the euro? Rajoy hasn’t asked Mario Draghi, the ECB’s president. Even if he did, he wouldn’t get a straight answer. But it should still be possible to get some rough sense of what the ECB wants.

The bigger issue is Berlin. The ECB’s bond-buying scheme is contingent on a parallel programme being agreed between Madrid and the other euro zone governments. Unfortunately, Germany has been saying that it doesn’t think Spain needs help. That, in turn, seems to be mainly because Angela Merkel, the chancellor, doesn’t want to have to push another bailout programme through the Bundestag only three months after it got parliamentarians to agree to a mega-loan for Spain’s banks. Sentiment in Germany towards bailouts in general and the ECB’s bond-buying plan in particular is negative.

Madrid has seen how Berlin is seeming to renege on an earlier plan that would have allowed it to transfer the cost of bailing out its banks to the euro zone rather than just receive a loan. It now doesn’t want to ask for help only to be turned down.

If there is another panic, Merkel will presumably decide to get parliamentary approval for Spanish aid. It is also possible that she will push a package deal through the Bundestag next month covering not just Spain but also Greece and Cyprus. But it would be far preferable to act before then. Sadly, that isn’t the way Europe, despite its new Nobel Peace Prize, normally works.

The credit crisis burst into the open five years ago. The euro crisis has been rumbling for over two years. The term “crisis” isn’t just on everybody’s lips in finance. Wherever one turns – politics, business, medicine, ecology, psychology, in fact virtually every field of human activity – people talk about crises. But what are they, how do they develop and what can people do to change their course?

The first thing to say is that a crisis is not just a bad situation. When the word is used that way, it is devalued. The etymology is from the ancient Greek: krisis, or judgment. The Greek Orthodox Church uses the term when it talks about the Final Judgment – when sinners go to hell but the virtuous end up in heaven. The Chinese have a similar concept: the characters for crisis represent danger and opportunity.

A crisis is a point when people have to make rapid choices under extreme pressure, normally after something unhealthy has been exposed in a system. To use two other Greek words, one path can lead to chaos; another to catharsis or purification.

A crisis is certainly a test of character. It can be scary. Think of wars; environmental disasters that destroy civilisations of the sort charted in Jared Diamond’s book Collapse; mass unemployment; or individual depression that triggers suicide.

But the outcome can also be beneficial. This applies whether one is managing the aftermath of Lehman Brothers’ bankruptcy, the current euro crisis, the blow-up of an oil rig in the Gulf of Mexico or an individual’s mid-life crisis. Much depends on how the protagonists act.

Students of crises are fond of dividing them into phases. For example, Charles Kindleberger’s Manias, Panics, and Crashes identifies five phases of a financial crisis: an exogenous, normally positive, shock to the system; a bubble when people exaggerate the benefits of that shock; distress when some financiers realise that the game cannot last; the crash; and finally a depression.

While there is much to commend in Kindleberger’s system, it is too rigid to account for all crises in all fields. It also downplays the possibility that decision-makers can change the course of a crisis. A more flexible scheme that leaves space for human agency to affect how events turn out has two just phases: the bubble and the crash.

The bubble is typically characterised by mania and denial. Things are going well – or, at least, appear to be. Feedback loops end up magnifying confidence. In corporations or politics, bosses surround themselves with lackeys who tell them how brilliant they are. In finance, leverage plays a big part.

This is not healthy. Manic individuals don’t know their limitations and end up taking excessive risks – whether on a personal level or in managing an organisation or an entire economy. As the ancient Greeks said, hubris comes before nemesis.

But before that, there is denial. People do not wish to recognise that there is a fundamental sickness in a system, especially when they are doing so well. For example, back in 2007 at the World Economic Forum in Davos, the greed was palpable. Market participants had such a strong interest in keeping the game going that they turned a blind eye to the unsustainable buildup of leverage.

The ethical imperative in this phase is to burst the bubble before it gets too big. That, in turn, means both being able to spot a bubble and having the courage to stop the party before it gets out of hand. Neither is easy. It’s hard to recognise a sickness given that there is usually some ideology which explains away the mania as a new normal. The few naysayers can be ridiculed by those who benefit from the continuation of the status quo.

What’s more, politicians, business leaders and investors rarely have long-term horizons. So even if they have an inkling that things aren’t sustainable, they may still have an incentive to prolong the bubble.

The crash, by contrast, is characterised by panic and scapegoating. People fear that the system could collapse. Negative feedback loops are in operation: the loss of confidence breeds further losses in confidence. This is apparent on an individual level as much as a macro one.

Events move extremely fast and decisions have to be taken rapidly. Witness the succession of weekend crisis meetings after Lehman went bust – or the endless euro crisis summits. The key challenge is to take effective decisions that avoid vicious spirals while not embracing short-term fixes that fail to address the fundamental issues. With the euro crisis:, for example, it is important to improve competitiveness with structural reforms not just rely on liquidity injections from the European Central Bank.

In this phase, there is no denial that there is a problem. But there is often no agreement over what has gone wrong. Protagonists are reluctant to accept their share of responsibility but, instead, seek to blame others. Such scapegoating, though, prevents people from reforming a system fundamentally so that similar crises don’t recur.

Crises will always be a feature of life. The best that humanity can do is to make sure it doesn’t repeat the same ones. And the main way to evolve – both during a bubble and after a crash – is to strive to be honest about what is sick in a system. That way, crises won’t go to waste.

Solving the euro crisis is a race against time. Can peripheral economies reform before the people buckle under the pressure of austerity and pull the rug from their politicians? After two months of optimism triggered by the European Central Bank’s plans to buy government bonds, investors got a touch of jitters last week.

The best current fear gauge is the Spanish 10-year government bond yield. After peaking at 7.64 percent in late July, it fell to 5.65 percent in early September. It then poked its head above 6 percent in the middle of last week because there were large demonstrations against austerity; because Mariano Rajoy’s government was dragging its heels over asking for help from the ECB; and because the prime minister of Catalonia, one of Spain’s largest and richest regions, said he would call a referendum on independence.

But by the end of the week, the yield was just below 6 percent again. That’s mainly because Rajoy came up with a new budget which contains further doses of austerity. The move prepares the way for Madrid to ask for the ECB to buy its bonds and so drive down its borrowing costs.

Rajoy didn’t want to be seen to be told to do anything by his euro partners. Hence, this elaborate dance – where he has now done what he knew he would have been told to do but can claim it was his choice. It’s hard to believe that anybody is fooled by this subterfuge; indeed, from investors’ perspective, it looks childish. But, at least the show is on the road again: the government has had the guts to press ahead with reform despite the immense unpopularity of the measures.

The question is whether Madrid and other governments in Lisbon, Dublin, Rome and Athens can keep up the reforms long enough to restore their economies to health. That, in turn, depends on three factors: how much farther they have to travel; how unruly their people are going to get; and how much help they will receive from their partners.

Economic health requires both that fiscal deficits are eliminated and that competitiveness is restored. The peripheral economies have made some progress on both fronts. But shrinking economies makes it hard to balance their budgets while fiscal squeezes undermine growth. The austerity vicious spiral is still whirring away.

That’s why Spain is unlikely to hit its target of cutting its deficit to 4.5 percent of GDP next year. It can get there only on the optimistic assumption that the economy will shrink by just 0.5 percent in 2013. The same could be said of France, not yet a full member of the periphery, whose budget unveiled last Friday calls for a deficit of 3 percent of GDP next year. Paris is assuming 0.8 percent growth. The French prime minister describes the projection as “realistic and ambitious”. Just ambitious would have been a more accurate description.

Meanwhile, restoring competitiveness is painful because it involves cutting people’s pay. Ireland and Spain have made good progress, covering respectively 80 percent and 50 percent of what they needed to achieve by the end of last year, according to a report last week by Open Europe, a British think-tank. Portugal and Greece have done less well.

Current account deficits paint a similar picture. Spain’s had shrunk to 3.5 percent of GDP last year while Ireland actually had a small surplus. Portugal, though, had a deficit of 6.4 percent of GDP and Greece was struggling with one of 9.8 percent.

Big falls in pay are forecast for the deficit countries over the next two years by Eurostat. It sees unit labour costs dropping 4.7 percent in Spain between end-2011 and end-2013; 3.8 percent in Portugal; and 9.5 percent in Greece. If that happens, competitiveness could be restored. Citigroup forecasts that Spain and Portugal will have current account surpluses next year while Greece’s deficit will have shrunk to 2.8 percent.

The snag is that such pay cuts – especially when combined with higher taxes and rising unemployment – provoke howls of outrage from the population. Short of leaving the single currency and devaluing, the only other medicine for improving competitiveness is so-called fiscal devaluation. This involves cutting the social security contributions paid by employers and, in return, putting up other taxes.

Germany succeeded in pushing through such a fiscal devaluation in 2007. But that just made it more competitive vis-a-vis the weaker euro zone economies. More recently, Spain did a mini fiscal devaluation. But the most ambitious attempt, by Portugal, provoked such a massive backlash earlier this month that the government backed down.

Help from abroad is the main way of easing the pain of adjustment. The ECB’s promised bond-buying plan is the most dramatic example. But solidarity has its limits. There has been a backlash in the German media over the central bank’s plan. Meanwhile, Berlin has been trying to persuade Madrid not to ask for help. The German finance minister also clubbed together with his Dutch and Finnish counterparts last week, proposing rules that will make it harder for Spain to shift the cost of bailing out its banks onto the euro zone.

The consequences of a breakup of the euro zone would be so ghastly for both the periphery and the core that they will probably pull through what looks like it is going to be at least another year of hell. But the risks have certainly not vanished.