Something Is Rotten at the Heart of the Euro

(Bloomberg) -- It's Groundhog Day again for the euro.

It doesn't really matter whether talks in Italy between the Five Star Movement and the League still include plans to seek a write-off of 250 billion euros ($295 billion) of the nation's debts and secure an exit mechanism from the euro, as the Huffington Post reported. The fact that these ideas were even mooted shows that the common currency remains deeply flawed almost two decades after its introduction.

On Wednesday, German Chancellor Angela Merkel called on the governments of the 19-member euro zone to accelerate efforts to integrate the bloc, including enhancing the European Stability Mechanism to create a "common backstop" in the region. The idea of common debt obligations gets revived repeatedly in Brussels.

But aren't such moves to ever-closer union exactly what Italian voters rejected by voting for populist anti-European parties in their most recent election?

The unpalatable truth is that both Italy and Greece cheated to get into the euro, using the swaps market to mask their true debt and deficit ratios. And their continued membership poses an existential threat to the project that erupts with such regularity that's becoming predictable.

Greece, which until recently was on the verge of being kicked out of the common-currency club, remains trapped in the economic straitjacket of the euro fraternity because the populist Syriza government decided that the alternative of exiting was far, far worse. I've argued in the past that it would be kinder to cut the country free from its fiscal shackles.

And while Italy is economically stronger than Greece, it shares one important characteristic: Their debt-to-gross-domestic-product ratios are miles away from the levels that were initially demanded of euro affiliates.

Something Is Rotten at the Heart of the Euro

The target was relaxed at the outset of the euro project. Rather than a hard limit of 60 percent of debt-to-GDP, a ratio approaching that ceiling "at a satisfactory pace" was deemed sufficient. Neither Italy nor Greece, however, can be said to be respecting even that less onerous stipulation.

As my Bloomberg Economics colleague Stephanie Flanders argued last week, investors can't ignore Italy's debt arithmetic forever: the fastest road to another euro zone crisis still runs through Rome, she wrote.

Something Is Rotten at the Heart of the Euro

The European Central Bank's current status as an effective monopsony in the government bond market helps explain the muted, albeit still visible, reaction in Italian debt, which yields about 141 basis points more than 10-year German bunds — about 10 basis points below its average for the past year. But there's only so much the central bank can do to defend the euro.

What's needed is what Ivan Rogers, a former U.K. envoy to the EU, described last year as "not a two-speed Europe, where you're trundling on a slow train to the same destination, but a two-tier Europe where you say we're happy with a market-based membership living on the outer tier, but we don’t want to be a member of a significant chunk of the rest."

Such a system would probably come too late to salvage the U.K.'s membership of the EU. But it might be the only way to salvage the euro project, damping the economic and political tensions between the core euro zone participants and the wider EU group.

It's more than a quarter of a century since the representatives of 12 countries gathered in the Dutch city of Maastricht and signed the Treaty on European Union. At a time when the three poorest members of the EU are hoping to join the euro, it would be better instead to shrink its membership. Germany, France and the other strongest members could then form a coalition of the willing and get on with a full fiscal union, a centralized European treasury and common bond sales — and by curbing the euro's ambitions, preserve its integrity.

To contact the author of this story: Mark Gilbert at magilbert@bloomberg.net.

©2018 Bloomberg L.P.