Eurozone nations’ sovereignty v AAA
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.