D DAY

Plan D stands for default . . . and the death of the euro

By Wolfgang Münchau

The biggest single danger in the eurozone crisis now is that events are moving too fast for Europe’s complacent political leadership. Last week, the crisis reached Italy. And the European Union looked the other way.

It was a huge mistake to postpone an emergency EU summit until Thursday this week. The European Council should by now have doubled or trebled the size of the European financial stability facility, the rescue umbrella. It should have made the facility more flexible, allowing it to buy bonds in the secondary markets. The council should have forced a closure of the debate on how to handle private investors, who bought Greek sovereign bonds.

Instead, the council allowed its finance ministers to get stuck in tedious technical details, unable to take a decision. Angela Merkel said there was no need for a summit right now. The German chancellor did what she has been doing throughout the crisis: hiding behind procedure. And since last Friday’s stress tests for banks was another cynical exercise in obfuscation, the council will need to take the first steps to sort out the banking mess at eurozone level. It will not. The crisis is moving too fast. Within a few weeks, the necessity moved from plan A to plan B to plan C. Plan A was austerity. Plan B acknowledges the need for debt relief, through some combination of a fiscal transfer and a contribution by bondholders. Plan C would widen the EFSF umbrella, to make it big enough to shelter Spain and Italy.

The EU is still fussing over plan B, and Germany rules out plan C. The hope among officials is that plan B will obviate the need for a plan C. That might have been the case four weeks ago. But why should a decision to inflict losses on banks help market sentiment on Italy now?

It is hard to comprehend why markets decided to panic over Italy at this particular time. There was a trigger, for sure, but Italy’s problems are not new. The country needs to grow by 2-3 per cent a year in the long run to be able to remain in the eurozone. Or it needs lower interest rates. The markets understand that Italian politics makes the first difficult, and German politics makes the second tough. If you accept the constraints of eurozone membership, low productivity growth, and high interest rates as given, Italy is insolvent. One of those constraints will have to give.

Five years ago, I was among those who argued that the probability of a collapse of the eurozone was close to zero. Last year, I wrote it was no longer trivial, but small. The odds have risen steadily since, not because of the crisis itself, but the political response. I now would put the odds of a break-up of the eurozone at 50:50. This is not because I doubt the pledge by the European Council to do whatever it takes to save the euro but because I fear it has left things too late. The council may be willing but it will not be able to deliver. As I argued last week, a eurozone bond is the only solution to the crisis. But this gets progressively more expensive, and politically less realistic, once bond spreads of large countries widen.

Europe’s political leadership has been, and still is, committing a category error in its approach. This is not a crisis of a small country at the edge of the eurozone. Nor is this a crisis brought on by rating agencies or speculators. This is a systemic crisis of a monetary union that refuses to be a fiscal union.

I often hear that Ms Merkel in particular has moved a long way from her original position 18 months ago, when she ruled out any money for Greece. This is true. But the crisis now moves at a rate that exceeds her political speed limit.

Giulio Tremonti, Italian finance minister, last week compared her with a first-class passenger on the Titanic. His anger is understandable. Her phlegmatic response itself is now a driver in this financial crisis, and people will rightly blame her for any serious accident.

My advice to Mr Tremonti is to confront Ms Merkel. His government should now adopt a two-pronged strategy. The first part is what I would call “plan D”. This is an emergency plan, the one to pull out of the drawer if Ms Merkel, like Martin Luther, continues to say she “can do no other”.

“D” stands for devaluation or default. To be clear, I am not saying that Italy should exit the eurozone. I am saying that Italy should prepare for that eventuality. In particular, Italy should signal to Ms Merkel that it can only remain a member of the eurozone if its interest rates are reduced. And I struggle to see that anything other than a eurozone bond can manage to achieve this.

No matter what happens, Italy will also need a credible programme to raise productivity growth in the long run.

Plan D would probably mark the end of the EU as we know it. I suspect that even Ms Merkel might not wish to go that far. Procrastination means collapse.

The EU has important choices to make in the next few days.