For the foreseeable future, the European Central Bank seems to be the only actor able to arrest this vicious cycle by serving – in one form or another – as a backstop for Italian and Spanish debt.
So far, though, this idea is being rejected by the central bank and by Germany, out of worry that lax monetary policy could lead to higher inflation and take reform pressure off of debtor countries.
Should Europe, despite this bleak outlook, succeed in stabilizing the situation for the time being, it still faces a formidable long-term challenge. It must fix the flawed design of the euro, which lacks the backing of a common fiscal policy among the 17 countries that use it.
Several proposals seek to remedy this. One idea favors introducing jointly issued “eurobonds” that would be backed by the full faith and credit of all eurozone governments. Presumably, this less risky investment will satisfy investors and take the pressure off of interest rates.
Another idea is being put forth by Germany and France. On Monday, French President Nicolas Sarkozy and German Chancellor Angela Merkel proposed closer fiscal cooperation among the 27 members of the European Union. The two leaders favor tighter budget rules and automatic penalties for those who break them. They also both reject a eurobond (for now).
