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Wall Street Journal Europe

Pop Gun Hasn’t Graduated to Big Bazooka

The last man standing has fallen. With the replacement of José Luis Rodríguez Zapatero's Socialist party by Mariano Rajoy's conservative Popular Party, all the governments in office in the PIGS--Portugal, Ireland, Greece and Spain—--have been turned out.

Throw in Italy, where Silvio Berlusconi has been succeeded by economist Mario Monti, and perhaps even France, where President Nicolas Sarkozy is trailing badly in the polls, and the winds of change will have blown away a significant portion of Europe's ruling class. It is almost as if a government's political fortunes are inversely related to the interest rate the market forces it to pay on its sovereign debt. When rates rise, governments fall.

The problem is that the games of political musical chairs are not impressing the markets. While investors are glad to see the last of Mr. Berlusconi's act, and have great regard for Mr. Monti, they are more impressed with the huge refinancing that Italy will be undertaking, its lack of growth, continued opposition by leading politicians and trade unions to reform of its sclerotic labor market, and impediments to the growth of the many family-owned enterprises that dot Italy's economic landscape.

The assured election of Mr. Rajoy's PP could not bring the rate Spain had to pay for 10-year money last week below an unsustainable 7%. Nor does anyone believe that Lucas Papademos, the economist who now heads the Greek government, can do anything other than preside over a default, orderly if possible, disorderly if necessary.

There are two layers of structural weakness with which the new boys in power must cope. The first is the home-grown variety: Economies so burdened with regulations, high taxes, entitlements, and labor-market rigidity that growth is almost impossible, high unemployment is virtually assured, and interest rates hundreds of basis points above bunds a certainty.

The second is the structure of the euro zone and, indeed, the European Union, a bloated bureaucracy that sits atop the bureaucracies of the individual member states, which in turn sit atop the bureaucracies of regional governments that resist reforms or spending cuts. Spain might have a new government, but it will be a while if ever before it can rein in spending by the regions.

The European Union is blessed with multiple presidents, none with the power to override the wishes of German Chancellor Angela Merkel, and has a creaking decision-making process capable of producing communiqués but not actionable decisions.

Most important, it has no lender of last resort, at least not yet, and the European Central Bank will not have such a role foisted upon it if its president, Mario Draghi, and Ms. Merkel have anything to say about it.

Mr. Draghi insists his support of the bond prices of the overly indebted nations is a temporary and limited program that will not morph into quantitative easing, the inflation-producing dragon Germans so fear. Mr. Sarkozy would like to change that, and politicize the ECB while at it, but his standing is weakened by the uncertainty of his tenure, rising interest rates on French bonds that threaten the country's 
triple-A bond rating, and the absence of any weapon with which to persuade Ms. Merkel of the error of her prudent ways.

With changes in governments unlikely to do anything to ease the current crisis, and conversion of the ECB into a lender of last resort unlikely, the last thing the euro zone needs is a recession--—which is what is about to befall it.

Higher interest rates on sovereign debt are translating into tighter credit for businesses, and even into rating downgrades of 10 German banks; austerity programs are drying up consumer demand; slowdowns in the Chinese and American economies are putting downward pressure on exports, except in Germany, which specializes in stuff other countries don't make. Not a pretty picture, especially but not only for countries that have signed too many IOUs.

Hope that the European Financial Stability Facility, or EFSF, can be leveraged to increase its firepower from the €250 billion ($338 billion) remaining available to €1 trillion by selling IOUs to China or other investors have been dashed. By the time the EFSF's chief executive, Klaus Regling, finishes rewriting his failed prospectus, France might well have lost its triple-A rating, and therefore be ineligible as a backer of EFSF paper. That would leave Germany, Finland, the Netherlands and Austria as possible EFSF guarantors; in effect, Germany.

The EFSF pop gun has not been converted into the "big bazooka" needed to back up the more than €I trillion Spain and Italy will have to borrow in the next three years.

Perhaps worst of all, the medicine being administered to sick countries seems to come with unacceptable side effects. Austerity is designed to force countries to rein in spending and increase tax revenues so as to bring down their deficit-to-GDP ratios. So far, austerity seems to be having such a negative effect on growth that it throws slow-growing economies into recession, making it more difficult than ever to cover government outlays. Those programs might work in the long run, but John Maynard Keynes told us where we will all be by then.

Meanwhile, it will be politically difficult to sustain a program that has little moral justification. Old Polonius warned, "Neither a borrower nor a lender be," suggesting both should bear the cost if things go wrong.

So far, with the exception of the derisory losses banks have offered to accept on Greek sovereign debt, the borrower is being asked to bear the consequences both of his unwise borrowing and the banks' equally unwise lending. Like 7+% interest rates, that is not sustainable. So we await Ms. Merkel's next move.