The Spread hits grassroots with a bang

Getting Europe's economic policy and currency back on the rails will be the first challenge of the new year. Photo / AP

Year-end festivities in Naples are not for the faint-hearted. The locals' idea of fun is to light illegal firecrackers and toss them from windows and rooftops in china pots.

These home-made mini-bombs are usually dubbed after weapons, film stars or football players as a sign of their potency. But the latest concoction marks a break from this naming tradition. A banger of reputedly monstrous strength, it is called "The Spread" after the difference in interest rates between 10-year Italian bonds and their benchmark German equivalent.

When something as obscure as the bond market has entered public language, you know that something big has happened.

The spread indicates the cost of a country's borrowing: every percentage-point increase translates into a bill that can be billions of euros. It tips a hugely indebted, struggling economy that bit closer to bankruptcy - unless a government musters the resolve to cut welfare programmes, reduce bureaucratic payrolls or increase taxes.

This year the spread became the force that shaped Europe's political landscape. It destroyed the careers of several leaders and made the European Union tremble like a serf in the presence of a mediaeval baron.

In Italy, it wrecked the career of Prime Minister Silvio Berlusconi, who had happily ridden out any number of votes in Parliament and scandals involving financial sleaze, corruption and "bunga bunga" sex parties.

It ended the ambitions of seven-year Spanish Prime Minister Jose Luis Rodriguez Zapatero and his Irish counterpart, Brian Cowen, and could well skewer French President Nicolas Sarkozy. He has vowed to defend his country's so-called AAA credit rating, which guarantees the lowest spread. The triple A now faces a downgrade ahead of elections next April and May.

"Financial markets and the governments of advanced economies around the world are inextricably tied together in an unbreakable marriage. The two sides need each other," noted Douglas Elliott, an expert on financial policy at the Brookings Institution.

"Governments borrow huge sums of money and, for its part, the financial system requires a large base of safe, liquid assets to function efficiently. In some times and places, however, that marriage is very troubled. Right now, the eurozone is a prime example.

"The financial markets do not seem to understand or trust the governments and those sentiments are returned by many policymakers, including key ones."

The cruellest humiliation has been reserved for European governance.

At the start of this year, the EU exuded the sunny confidence that it could fix Greece's sovereign debt crisis and save European banks from the storm. But as the months passed, this self-belief melted away. Again and again, measures to shore up Greece and provide a bailout fund for other sickly economies were faulted by the markets as too puny and too slow.

By this month, the mood turned to near panic. The very future of the euro, the hallmark of European integration, seemed to be at stake. Behind the scenes, nightmarish scenarios were debated. One rumour was that European countries were mulling how to swiftly reprint their national currencies. The euro had been cherished as a jewel after it was created under the Maastricht Treaty of 1991.

But what became apparent 20 years afterwards was a terrible flaw at its heart: the euro is a currency union, but not a fiscal union. In short, countries pool their currency but retain control over their own spending, for national budgets remain a jealously guarded area of sovereignty. As a result, countries with rickety governments such as Greece, Italy, Spain and Portugal have been able to gorge on low-interest loans and scoff at the flimsy rules supposed to stop excess borrowing.

Some European banks have lent so extensively to these economies that they, too, could go bust if these borrowers default. The latest EU rescue bid seeks at last to address this fundamental risk of contagion. This month 26 of the 27 European leaders decided to back a Franco-German plan for a "new fiscal compact" with tighter budget policing.

The first EU summit to discuss the plan will take place on January 30, with Britain as observer. How many summits this quest will need - and even the precise destination - is unclear. The debate will be coloured by pro-nationalists, who will fight against closer integration, and by pro-democrats, who will worry that a hastily assembled package will lack transparency and accountability.

In other words, the process will be lumbering at a time when the spread requires governments to move with agility. Integrationists are fond of arguing that Europe only progresses through crisis. Next year will see that belief tested to the core.