Time of reckoning for the euro zone

.. WASHINGTON (Reuters) - Failure by European leaders at their summit this week to fix the fatal flaw in the euro zone, its lack of political union, would risk tremendous market upheaval, a rupture of the common currency and global economic fallout. The world economy already is slowing, leaving it increasingly vulnerable to shocks reverberating from Europe. China cut reserve requirements for banks last week for the first time in three years and its factory sector shrank to levels not seen since February 2009. Brazil also lowered rates for the third time since August. Only the United States has enjoyed a steady stream of improving data. The unemployment level dropped to 8.6 percent in November, the lowest level in 2-½ years, factories expanded and retail spending accelerated, pointing to a slow and gradual pick-up in growth. But Europe casts a pall over everything. So serious are the risks that it could disrupt three years of painful global economic recovery that politicians, central bankers and market strategists are starting to compare the danger of European leaders deadlocking to the collapse of Lehman Bros in September 2008. That shock plunged the world into its deepest recession since the 1930s. "Let us not hide it: Europe may be swept away by the crisis if it doesn't get a grip, if it doesn't change," French President Nicolas Sarkozy said on Thursday. Bank of England Governor Mervyn King warned of a "systemic crisis," adding that "none of us really know" how the euro zone would survive if the crisis explodes into sovereign default. "This is Lehmans, Take Two. Cubed," said Kathleen Gaffney of Loomis Sayles, a part of Natixis Asset Management. Leaders got a peak into the abyss when credit lines froze over the last 10 days after Germany failed in late November to sell all its bonds and yields jumped, not only for heavily indebted Italy and Spain, but also for countries at the very heart of the euro project -- France and Germany. It took five major central banks cutting interest rates on currency lines last Wednesday and extending those lines to restore a measure of calm to financial markets. But the uneasy peace will not last unless Sarkozy and German Chancellor Angela Merkel, who meet on Monday to discuss changes to the EU Treaty, can finalize a fiscal deal that imposes tough budgetary rules on the 17 euro-zone members and then convince all 27 EU leaders on Friday to back the plan. Their summits are littered with a history of half-baked solutions and broken promises. Few have illusions that this one will produce a definitive solution to the euro crisis. But investors want to see the famously fractious European leaders make significant progress and show they are willing to give up some national control over budgets and march toward political union. Though it will be a long and trying road, only then can the future of the decade-old euro zone project be assured. To do less would invite market upheaval, and eventually could lead to bank failures and sovereign default, said Mark Geitler, professor of economics at New York University. "Global recession would likely follow and there would be pressure to break up the euro zone. An unpredictable chain of negative events would then likely follow," Geitler said. Treasury Secretary Timothy Geithner is flying to Europe next week to press the urgency of the matter, meeting politicians from France, Germany, Spain and Italy, as well as the European Central Bank. His assistant secretary for economic policy, Jan Eberly, said a European recession would blight U.S. recovery and is "absolutely a source of concern." BIG BAZOOKA Even if a political deal for fiscal union is struck on Friday, it likely will require EU treaty changes and take many months to implement. Meanwhile, the world economy will remain highly vulnerable to further market stress unless a second step is taken to guarantee solvency of governments and stabilize the European government debt market. There are several ways of taking that second step: The European Central Bank could unleash a massive round of bond buying, dubbed using the "big bazooka." The International Monetary Fund could agree on backstop funding programs for indebted countries that are having trouble tapping bond markets, such as Italy and Spain; or a beefed-up Europe's bailout fund could buy up the debt. The ECB made an important move last week by signaling flexibility if leaders move forward on a fiscal compact. The central bank is widely expected to cut interest rates and expand its liquidity facilities when it meets on Thursday. More focus will be on ECB President Mario Draghi's news conference, where he could expand on the ECB's readiness to act as lender of last resort -- a path urged upon it by the United States and France, but staunchly resisted by Germany on grounds it discourages budget discipline. But if the scaffolding toward a German-led fiscal union can be erected at the EU summit, the ECB may be willing to bend. It also would provide some assurance to investors that the fatal flaw in monetary union will be fixed, averting a cataclysmic end to the euro project and return to Great Recession. ..

Europe races for debt solution = Euro in danger 1

PARIS (AP) — European leaders rushed Monday to stop a rampaging debt crisis that threatened to shatter their 12-year-old experiment in a common currency and devastate the world economy as a result. One proposal gaining prominence would have countries cede some control over their budgets to a central European authority. In a measure of how rapidly the peril has grown, that idea would have been unthinkable even three months ago. World stock markets, glimpsing hope that Europe might finally be shocked into stronger action, staged a big rally. The Dow Jones industrial average in New York rose almost 300 points. In France, stocks rose 5 percent, the most in a month. More relevant to the crisis, borrowing costs for European nations stabilized. They had risen alarmingly in recent weeks — in Greece, then in Italy and Spain, then across the continent, including in Germany, the strongest economy in Europe. The yields on benchmark bonds issued by Italy and Germany rose, but only by hundredths of a percentage point. The yield fell 0.1 percentage point on bonds of France, 0.14 points for those of Spain and 0.22 points for Belgium. Allowing a central European authority to have some control over the budgets of sovereign nations would create a fiscal union in Europe in addition to the monetary union of the 17 countries that share the euro currency. Some analysts have said that would be a leap toward creating a United States of Europe. More delicately, it would force the nations of Europe to swallow their national pride, cede some sovereignty and agree to strengthen ties with their neighbors rather than fleeing the euro union during the crisis. "The common currency has the problem that the monetary policy is joint, but the fiscal policy is not," Germany's finance minister, Wolfgang Schaeuble, said in a meeting with foreign reporters in Berlin. The monetary union has existed since the euro was created in 1999, but the European Union, which includes the 17 euro nations and 10 others that use their own currencies, has no central authority over taxing and spending. Countries like Ireland, Portugal, Spain, Greece and Italy overspent wildly for years and racked up annual budget deficits that have left them with monstrous debt. Italy holds €1.9 trillion in debt, or 120 percent of the size of its economy. A fiscal union could prevent excessive spending in the future. More important, it would be a step toward addressing today's debt crisis: It could provide cover for the European Central Bank to stage a massive intervention in the European bond market to drive down borrowing costs and keep the debt crisis under control. So far, the ECB has resisted, in part because of concerns that bailing out free-spending countries would only encourage them to do it again, a concept known as moral hazard. Enforced budget discipline would ease those concerns. A fiscal union would also pose a practical problem — how to make such a body democratically accountable. Another option is for the 17 nations in the euro group to sell bonds together, known as eurobonds, to help the countries in the deepest trouble because of debt. Germany has resisted such a plan, because it would raise borrowing costs for it and other nations that have good credit ratings. While Europe buzzed over the possible solutions, finance ministers of the euro nations prepared for a summit beginning Tuesday evening in Brussels, to be joined the following day by ministers from the rest of the European Union. Italy readied an auction of bonds designed to raise €8 billion, or about $10.6 billion, and steeled itself for the high interest rates it will have to pay. In Washington, President Barack Obama huddled with European Union officials, but the White House insisted Europe alone was responsible for fixing its debt problems. Obama said failing to resolve the debt crisis could damage the U.S. economy, which has grown slowly since the end of the recession in June 2009 and still has 9 percent unemployment. "If Europe is contracting, or if Europe is having difficulties, then it's much more difficult for us to create good here jobs at home," Obama said at an annual meeting between U.S. and EU officials. Despite signs of possible progress on the debt crisis Monday, the euro has appeared to be in increasing danger the past few weeks. Experts said the currency could fall apart within days without drastic action, with consequences rivaling those of the 2008 financial crisis. "Everyone knows that if the eurozone crashes the consequences would be very dramatic and in the race after that there would no winners, just losers," said Finland's finance minister, Jutta Urpilainen. For countries that decided to leave the euro group and return to their own sovereign currency, the conversion would be wrenching. If Germany broke away, for example, its national currency could rise in value quickly because the German economy is stronger than the European economy as a whole. But a stronger German mark would damage the German economy because Germany depends heavily on exports, and it would cost more for everyone else to buy German goods. As for weaker countries that decided to leave, depositors would probably yank money out of their banks, fearing a plummeting currency. Savers in Greece would not want their euros replaced with, say, feeble drachmas. If countries tried to repay their old euro debts with their own currencies, they'd be considered in default and would struggle to sell bonds in global financial markets. Corporations would face the same squeeze. Overall, economists at UBS estimate, a weak country that left the eurozone would see its economy shrink by 50 percent. Currency chaos and defaults by governments and companies would weaken European banks and also cause them to stop lending to each other. Because banks are connected globally, a credit freeze in Europe would spread. As it did in 2008, a credit freeze would cause stock markets to sell off worldwide, and another deep recession would probably follow. Wolfgang Munchau, a columnist for the influential Financial Times newspaper, wrote Monday that the common currency "has 10 days at most" to avoid collapse. He called for decisions on a fiscal union and the creation of a powerful common treasury. Unlike the United States, which has centralized institutions in Washington for raising taxes and spending money, the euro nations have 17 independent treasuries with little oversight from Brussels, the headquarters of the EU. That would change under the fiscal union proposal being aired ahead of another summit of EU leaders that begins Dec. 9. Ten nations in the EU do not use the euro currency, most notably Britain. While not explicitly backing a fiscal union, Germany and France have promised to propose measures that will make the 17 euro countries operate under strict and enforceable rules, so that no single country can wreak continent-wide damage. Already, the Organization for Economic Cooperation and Development, an international group devoted to economic progress, warned that the global economy would be rocky in coming months. In its six-month report Monday, it said the continued failure by EU leaders to stem the debt crisis "could massively escalate economic disruption" and end in "highly devastating outcomes." The latest turmoil came last week, after Germany tried to auction $8 billion worth of its national bonds and could persuade investors to buy only $5.2 billion. It was a sign that even mighty Germany was not immune from the debt crisis. Investors around the world will watch the Italian bond auction Tuesday. If it receives a similarly poor reception, more European countries will be in danger of being locked out of the international bond market. Exactly how a fiscal union would take shape in Europe is an open question. Schaeuble, the German financial minister, said the proposal would require passage only by the 17 countries that use the euro currency. The other 10 countries in the EU, such as Britain, Poland and Sweden, could adopt it if they wanted to. But analysts said such a move would take a long time to come to fruition. "We do seem to be moving slowly towards more of a fiscal union but at a pace that may result in all the components being put in place after a complete meltdown of the financial system," said Gary Jenkins, an economist with Evolution Securities. Many think the ECB is the only institution capable of calming frayed market nerves. But Merkel, the German chancellor, has continually dismissed the prospect of a bigger role for the ECB.

Chance of 2012 U.S. recession tops 50 percent: Fed paper

(Reuters) - The European debt crisis is raising the odds of a U.S. recession, with economic contraction more likely than not by early 2012, according to research from the San Francisco Federal Reserve Bank.

While it is difficult to gauge the odds precisely, an analysis of leading U.S. economic indicators suggests a rising chance of a recession through the end of the year and into early next year, researchers at the regional Fed bank wrote on Monday. The risk of recession recedes after the second half of 2012, they found.

New governments in Greece and Italy, with fresh promises to tackle fiscal problems have in recent days, allayed investor concerns about a near-term sovereign debt default in the euro zone, but Europe's debt crisis is far from resolved. The region is facing its worst hour since World War II, German Chancellor Angela Merkel said on Monday.

Although domestic threats to economic growth in the United States are limited, a shock from abroad could derail a fragile recovery.

The weak U.S. economy is more than usually vulnerable to turbulence beyond its borders, as the unexpectedly severe U.S. effects from Japan's devastating earthquake in March demonstrates, the researchers said.

"A European sovereign debt default may well sink the United States back into recession," wrote Travis Berge, Early Elias and Oscar Jorda in the latest San Francisco Fed Economic Letter. "However, if we navigate the storm through the second half of 2012, it appears that danger will recede rapidly in 2013.

The assessment of recession risk is more dire than that of many private economists. A November 4 Reuters poll of primary dealers shows Wall Street economists see a 30 percent chance of a U.S. recession next year, down from 35.5 percent a month earlier.

Last week the Federal Reserve's influential vice chairwoman Janet Yellen warned on the threat from Europe, saying governments there need to take forceful steps to contain the crisis or risk substantial damage to the United States.

Before taking her post at the Fed Board in Washington, Yellen headed the San Francisco Fed.

Her successor, John Williams, is due to give a major policy speech on Tuesday.

(Reporting by Ann Saphir; Editing by Padraic Cassidy)
.