Eurozone nations’ sovereignty v AAA

French and German flags Germany could follow France by having its AAA credit rating downgraded

Late last night Moody's put the eurozone's operational bailout fund, the European Financial Stability Facility, on so-called "negative outlook", which means it is at serious risk of losing its AAA credit rating.

There was nothing surprising in this announcement. It was made inevitable by Moody's earlier decision to declare that Germany, the Netherlands and Luxembourg were in danger of losing their cherished AAA ratings - in that Germany guarantees 29.1% of the EFSF's borrowings, the Netherlands guarantees 6.1% and Luxembourg 0.3%.

Among the EFSF's guarantors, only Finland retains a stable AAA. And there is no way that the EFSF's AAA can be sustained by small but fiscally super-strong Finland alone (Finland, like its non-EU neighbour Norway, has no net debt at all on a net basis).

Inevitably, eurozone leaders are grumpy with Moody's. But perhaps they should, for once, thank this member of the widely reviled credit-rating fraternity. Because Moody's may have presented an opportunity to them to frame the debate on the future of the eurozone in a way that makes the choices for the citizens of Europe easier to see.

Actually, I should slightly rephrase that. What Moody's has done is to narrow the choices available to Germany and its people - and some would see that as a good thing given that the eurozone's financial survival depends on a willingness of Germany to deploy more of its financial resources to the benefit of its over-stretched eurozone neighbours.

The simple message from Moody's to Germany is that it won't retain its AAA rating if the eurozone continues on its course of muddling through each successive crisis. Providing emergency loans to the eurozone's weaker members, each time they are locked out of markets, progressively increases the burden on Germany's public finances, because Germany is by a margin the biggest contributor to these funds.

Now that Spain looks to be in need of a full scale bailout - which to be credible would have to involve around 500bn euros of emergency loans (see my post Spain moves nearer to full-scale rescue) - the underwriting burden for Germany is looking very heavy.

Were the contagion to Italy to worsen, such that it found itself unable to borrow from commercial investors, a bailout for the Italian government would be of the order of 750bn euros or more.

Even assuming that the IMF took some of the strain of such rescues, the increase in the implied indebtedness of Germany of rescuing both Italy and Spain would be in the order of well over 10% of its GDP or output.

And that would be to ignore Germany's ever rising exposure to the emergency funding of the eurozone's ailing banks via the so-called TARGET2 payments system. Germany's de facto loans to these banks is equivalent to around 30% of its GDP (this figure is based on the assumption that, in a worst case of a eurozone breakup, Germany was unable to share the cost with other eurozone members on the basis of an official burden-sharing formula).

To put all this in simple terms, the absence of a comprehensive solution to the eurozone's woes is progressively poisoning the German balance sheet: on the "are-what-you-eat" principle, Germany is gradually turning into Italy and Spain, in a fiscal sense.

So the status quo is arguably becoming less and less sustainable for Germany.

That leaves only two options: the pronounced economic, financial and political shock (ahem) of breaking up the eurozone; or the pronounced economic, financial and political challenge (ahem) of merging the balance sheets of eurozone members in a full-scale fiscal and banking union, which would look quite a lot like the creation of a United States of Europe.

To return to Moody's for a second, it is difficult to see Germany retaining its AAA rating in the immediate aftermath of a eurozone breakup or in the transition phase to a United States of Europe - though it might well get the AAA back in both cases, in time.

In a dismantling of the eurozone, the losses on German credit extended to weaker eurozone economies would be huge, while German industry and employment would be hurt both by a rise in the value of a new German currency and by an inevitable recession in much of Europe.

As for the creation of a eurozone federation, during the implementation phase the perceived strain on German public finances would increase.

But here is the thing, at the moment that the eurozone was perceived as a credible single entity, for fiscal and monetary purposes, the whole region might enjoy AAA status - so long as, in these circumstances, the European Central Bank was put in the same position as the US Federal Reserve, Japan's central bank and the Bank of England, that is able to be the buyer of last resort of eurozone sovereign debt.

A combination of credible controls on eurozone-wide spending, taxing and borrowing, with a central bank endowed with the ability to stand in for the market when the market won't lend to governments, would allow the eurozone's public finances to be compared directly with those of the US and the UK.

The point, as many of you will know, is that seen as a single entity the deficit of the eurozone is smaller than that of the US and UK. And eurozone gross debt as a percentage of GDP is less than that of the US - which still has AAA from most rating agencies - and is comparable with that of the UK, which retains AAA from all agencies (of course, whether the UK will keep AAA is moot).

To put it in more practical terms, a monetarily and fiscally integrated eurozone should be able to borrow as cheaply and easily as the other major developed economies, namely the UK, US and Japan.

There is only one snag. For the people of Europe, would the financial benefits of this kind of federation outweigh the perceived erosion of their control over the destinies of their respective nations?

That is the European question of our age.

Robert Peston, economics editor Article written by Robert Peston Robert Peston Economics editor

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This column may be a bit quiet for a bit, because I am away from the office.

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  • rate this

    Comment number 67.

    "national institution failing ..Shame"

    Indeed. Govt needs to fulfil promise to reduce size of overeaching state; it needs to light bonfire of regulation, to cut spending harder, to be much tougher on reforming public sector/welfare & to make major changes to tax system lowering rates & broading base. Lack of bottle, its inconsistency & its utter failure to get across cohesive story is disgrace

  • rate this

    Comment number 66.

    The Euro zone will break up when the point of the loss in Germany bailing out these debt driven countries is greater than leaving the Euro.

  • rate this

    Comment number 65.

    No 'ism has ever succeeded, they all end up in the same place albeit from opposing roots...

  • rate this

    Comment number 64.

    The Euro currency was always set up as a trap for those countries using it with no mechanism for any country withdrawing from it.

    Deliberate mischief by evil eurocrat thugs - the 'chickens are coming home to roost' and the branches are giving way

  • rate this

    Comment number 63.

    Short term, China's rising importance as importer with fast-growing demand will help. Beijing has pledged to contribute US $43B, 10% of total IMF contribution to build a financial firewall. Private equity firm for Chinese investment into EU, A Capital's Andre Loesekrug-Pietri, Chairman & Managing Partner: If you believe in China, then you should believe in Europe. 2 economies ARE COMING CLOSER.

  • rate this

    Comment number 62.

    interesting but why the focus on the EU given the release of the dire UK GDP figures?

    Does the BBC has a policynotifies outragingit's business and economics editors commenting on the state of the UK economy. Better to write critical pieces about economic policy in the Eurozone than the obvious failures of Dave, George and Nick.

    A national institution failing to fulfill its primary role. Shame!

  • rate this

    Comment number 61.

    When the Euro was at the planning stage, the end game was always for a fiscally integrated eurozone as this is the only way the project could ever survive. The only viable alternative at that time was to shelve the Euro project.

    The alternative only came into play when the Euro was born - that of dismantling the Euro.

    How long will it take the eurozone leaders to choose between their 2 options?

  • rate this

    Comment number 60.

    There is more than fiscal integration-if it ever happened- to a Federal State of Europe. The states involved would have to agree about an enormous range of topics and organise a proper democratic system. That would take years to acheive if ever. In practice it would become the German Empire. It wouldn't be long before their colonies wanted out!

  • rate this

    Comment number 59.

    So, when do US/UK go on "negative outlook", since they are in worse shape than EU? It goes to show you bias of Moody's.
    Contrary to what some believe, analysts said China's foreign reserves cannot be solution to crisis in EU bloc...right now. BUT, as China's largest market (more than 15% exports), break-up of EU would have HUGE repercussions on China's economy.
    China is keenly aware.

  • rate this

    Comment number 58.

    This is a false analogy - if a centralised union could be achieved and a low interest rate regime be available to all then, like Spain's Regions, member country electorates would still vote for tax/spend local governments which would lie and disguise spending programmes in defiance of central treasury control.

  • rate this

    Comment number 57.

    Frankly after today's very poor UK GDP figures it is us who are in most danger of losing our AAA rating right now! It is time to call this economic situation by its true name of an economic depression.

  • rate this

    Comment number 56.

    The banks have overstretched themselves by lending irresponsibly to member states. They have no reserves, they are bankrupt.To hide this they demand through the “too big to fail” ploy that other member states make funds available to the disaffected who then hand it over to them. Result–bankrupt banks continue in the same rotten way and the debt has been offloaded to the taxpayer indefinetly

  • rate this

    Comment number 55.

    "That leaves only two options: .. breaking up the eurozone; or .. full-scale fiscal and banking union"

    disagree, a false dichotomy, and both impractical to boot. There are ways out of this, to leverage the underlying good fundamentals. For example, published yesterday:

  • rate this

    Comment number 54.

    #45 frankly francophone - the elite won't like this. They need division in order to rule. Sometimes I think that is the purpose of independent states.

  • rate this

    Comment number 53.

    At present watching the eurocrats is like watching people fighting over which bit of wreckage to cling to after the ship sinks and then pretending the voyage can continue as if nothing has happened.---the Euro is the problem destroying the EU, not it's saviour.... It's launch coincided with the fake money boom and it's death arrives with that boom's implosion ---- it's not a coincidence.

  • rate this

    Comment number 52.

    Finance capital versus the people

    Hang on, all this finance capital crucifying Europe and us, moaning about debt, is holed up avoiding tax in JERSEY, NY, ISLE of MAN

    The Security Council having REAL economic power is needed. Europe is still the abused plaything of US-UK capitalism (Note; US-UK CAPITALISM, not us and the US people!!)

  • rate this

    Comment number 51.

    Great analysis - thank you - but why can't the Eurozone simply copy the British tradition of devaluing, then they discuss longer term solutions without the distraction of the current crisis?

  • rate this

    Comment number 50.

    It has all been too little, too late.


    Nothing wrong with dreaming but you have to wake up now and again to take sustenance and eliminate substances.

    Europe has dreamed too much: now it is hungry and drowning in those eliminated substances.

    Surely the next elite task has to be to feed them to the people.

  • rate this

    Comment number 49.

    "a monetarily & fiscally integrated eurozone should be able to borrow as cheaply & easily as the other major developed economies, namely the UK, US & Japan.
    For the people of Europe, would the financial benefits of this kind of federation outweigh the perceived erosion of their control over the destinies of their respective nations?"

    In a word yes.
    And they would regret it bitterly afterwards.

  • rate this

    Comment number 48.

    The credit Agencies are trying to push Europe to make the banking agreement, it’s the same type of agreement that was reached in America (the federal reserve act), it gave powers for the fed to print money, and took it away from the politicians. Once this has been done Europe will print bonds, the interest rates will fall and Europe will become one of the new world reserve currencies.


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