Analysis: Tighter euro zone gains ground as debt crisis exit

Tell me how this ends, U.S. General David Petraeus asked memorably of the 2003 invasion of Iraq.

Political leaders and economists in the euro zone are searching frantically for answers to the same question as a bond market rout of European sovereign debt accelerates, putting the future of the single currency in jeopardy.

Until a few weeks ago, the most likely outcome appeared to be that the 17-nation currency area would muddle through. The euro zone would bail out a few highly indebted small peripheral states, patch up its rickety fiscal governance and avoid either a break-up or a major shift toward federal integration.

That was then. Now it seems that without a radical game-changing initiative within weeks, the crisis may no longer be controllable.

Efforts to construct a financial firewall to protect Italy, Spain and potentially France are running behind the curve, shackled by legal and political obstacles to using the European Central Bank or issuing joint euro zone bonds.

This summer, I thought the muddling through scenario had a 50 percent chance of success. Now it's clearly less, said Jean Pisani-Ferry, director of the Brussels-based Bruegel economic think-tank and an adviser to the French government and the European Commission.

Leaders everywhere are now aware of the very high risk if they let things run out of control, that it can lead to a financial catastrophe for Europe, he said in an interview.

We are much more likely to see bold decisions to save the euro project than the opposite, which would be to let the constraints prevent any solution.

SOLIDARITY

Pisani-Ferry sketches the outlines of a much more closely integrated union of the euro in a book on the crisis and how to overcome it, entitled Le Reveil des Demons (The Demons' Awakening), to be published this week in France.(*)

His vision involves greater economic integration, a federal regulation of banking and finance within the euro zone, and a budgetary union combining greater discipline with solidarity.

He also calls for a political union in which decisions would be taken by qualified majority vote instead of unanimity, which has slowed action in the two years of the crisis.

And he warns against the current drift toward a more intergovernmental euro zone in which Paris and Berlin call the shots while the European Commission and European Parliament are sidelined, saying that is a recipe for paralysis.

Because of the unanimity principle, Finnish demands for collateral on loans to Greece, and a Slovak coalition party's objections to widening the role of the euro zone bailout fund caused long weeks of delay in approving a recent rescue package, undermining investor confidence.

All this goes back to the incomplete foundations of the single currency, Pisani-Ferry argues. From the outset, European leaders settled for a minimal utopia, refusing to give the euro the political underpinning it needed, and systematically doing too little, too late, once it started to get into trouble.

Europe has to start behaving as if it accepts the responsibilities of having a common currency, he said.

His vision of a much more deeply integrated euro zone would require an overhaul of the European Union's governing treaty that is bound to meet resistance from non-euro EU states such as Britain and Sweden. It also faces objections from eastern EU members such as Poland who aim to join the currency eventually and do not want to see the entry bar raised higher.

Pisani-Ferry is at least as critical of his own country, France, as of Germany, often blamed for impeding a solution to the crisis through excessive caution and dogmatism.

If France were ready to accept a loss of budget sovereignty with greater European intrusion to ensure EU fiscal rules are respected, Germany might be willing to drop its opposition to issuing common euro zone bonds, he argues.

LAST RESORT

Such a new deal would inevitably take months to negotiate and years to enshrine in an amended EU treaty, or a separate pact among euro zone countries.

So even if it offers a more solid longer-term basis for running a currency union, it is no quick fix for today.

In the short term, Pisani-Ferry says, only the European Central Bank can arrest the crisis by finding a way of providing unlimited support to restore confidence in euro zone government debt.

A Franco-German bargain on a more tightly integrated euro zone, with more intrusive economic discipline, may be the price for Chancellor Angela Merkel's assent to such ECB action.

At least in Germany these issues are being thrashed out in fierce debate in parliament, the media and among economists, he notes, whereas there has been scant public discussion in France except on the political fringes of left and right.

President Nicolas Sarkozy, and his Socialist challenger in next year's election, Francois Hollande, have both called for a stronger European economic government, but neither is keen to discuss the consequences for national sovereignty.

Is France, which voted against a proposed EU constitution in a 2005 referendum and often rails against European Commission interference, really willing to accept far-reaching political and economic integration that transfers more sovereignty to Europe, Pisani-Ferry asks.

Germany, he argues, will only be prepared to share the benefits of its low borrowing costs and high credit rating with its euro zone partners if it receives guarantees of better fiscal behavior, especially from France.

Yet when the Commission last week said France's economic growth forecast for 2012 was unrealistic and it should take new measures to ensure it meets its pledge to reduce the public deficit to 3 percent of gross domestic product in 2013, Paris rebuffed the call.

For this country, which was at the origin of the euro and constantly pushed the project, the question is simple: does it still care about it? Pisani-Ferry concludes.

(*Le Reveil des Demons, La Crise de L'euro et comment nous en sortir; Fayard, Paris, 2011, on sale November 16)

(Writing by Paul Taylor)