Investors betting against the euro-area surviving its debtcrisis in one piece may be overlooking one thing: the will ofpoliticians to hold it together.

German Chancellor Angela Merkel is intensifying her defense ofthe currency. French President Nicolas Sarkozy says there's noalternative to channeling aid to Greece without risking the kind ofcataclysm set off by the 2008 collapse of Lehman Brothers HoldingsInc. Greek Premier George Papandreou this week proposed 6.6 billioneuros ($8.7 billion) of fresh austerity measures in a recessionheaded into a fourth year.

The euro is “a political project,” said Erik Nielsen, globalchief economist at UniCredit Group in London. “The market may nothave believed them, but leaders have repeatedly said they will dowhatever it takes to keep it together.”

Keeping the 17-nation region together means politics will haveto remain the glue, challenging the argument of investors includingPacific Investment Management Co. Chief Executive Officer MohamedEl-Erian. He says the euro area may need to shrink to survive. Thatconcern is highlighted by the swelling gap between the 10-yearinterest rates of Germany and Italy.

In a sign investors are questioning the longevity of the euro,the spread between German and Italian benchmark bonds reachedalmost 400 basis points, having held below 50 basis points for mostof the last decade. Four in 10 respondents to the quarterlyBloomberg Global Poll said last month they expect a nation to leavethe euro within a year and a further 32 percent said a member wouldexit in two to five years.

'Big Italy'
“Many global investors see Greeceas a precedent for big Italy,” said Holger Schmieding, chiefeconomist at Joh. Berenberg Gossler & Co. in London. “The testof whether European defenses are strong enough to prevent contagionfrom Greece to Italy could be made soon.”

It may come in the weeks before a Nov. 3-4 summit of Group of 20leaders in Cannes, France, which international finance chiefs seeas the deadline for European governments to devise fixes forturmoil.

That meeting “is likely to be a major point of inflection, whichwill either resurrect life or leave us in deep hibernation throughthe winter,” said Jim O'Neill, chairman of Goldman Sachs AssetManagement in London.

Economists at Goldman Sachs Group Inc. yesterday revised theiroutlook to show the euro-area economy will expand 0.1 percent nextyear rather than the 1.3 percent previously anticipated withGermany and France suffering mild recessions.

'Too Much to Lose'
Some investors still beton euro-area leaders avoiding the worst case scenario. KathleenGaffney, co-manager of the $19.4 billion Loomis Sayles Bond Fund,says she continues to hold Greek debt and is buying sovereignsecurities from other European countries.

The European Union has “too much to lose” if Greece were to exitthe euro, Gaffney said in a Sept. 28 interview with Lisa Murphy onBloomberg Television's “Fast Forward.”

The euro is also trading above its average since it was bornalmost 12 years ago, another sign that investors see little chanceof a collapse as officials take on the crisis.

“Too much political and ideological capital has been investedinto making the euro project work and bringing the continent ofEurope closer together since the end of World War II to allow it tounravel now,” Thanos Papasavvas, the head of currency management inLondon at Investec Asset Management Ltd., which invests about $95billion, said in a Sept. 20 interview.

Merkel's Shift
Having once held out on aidingGreece, demanded investors play a greater role in bailouts andflatly rejected initiatives such as joint euro-area bonds, Merkelis changing gears to stress governments must hold the euro areatogether.

Deeper integration “is the only way forward for Europe,” shesaid Sept 9. On Aug. 21 she even agreed that sharing debt in theform of joint bonds might be possible in the “distant future.”

Sarkozy and Merkel will meet Oct. 9 to discuss speeding the euroarea's economic integration. Among the options: enacting apermanent rescue fund next July, a year earlier than planned. Thatwould provide a 500 billion-euro war chest and provisions forsharing costs with bondholders for countries with “unsustainable”debt. Governments may also unpick a second Greek rescue agreed inJuly to increase the financial industry's contribution and create asafety net for banks.

There's “no credible alternative” to aiding Greece, Sarkozy saidSept. 30. “The failure of Greece would be the failure of all ofEurope.”

Greek Cuts
Greece itself is trying to countercriticism over its failure to satisfy the terms of an internationalbailout. Papandreou pushed new cuts through his Cabinet this weekand his finance minister, Evangelos Venizelos, rejected making hiscountry a scapegoat for Europe's policy failures.

Other governments are also taking steps to fortify theirfinances. France, Italy and Spain have entered German-style budgetdeficit limits into their constitutions. Italy last monthintroduced a 54 billion-euro package of austerity measures thatincluded cuts in central and regional spending and a higher salestax.

Politicians are likely realizing failure to keep the euro areatogether risks “threatening another Great Depression,” HSBCHoldings Plc economists Stephen King and Janet Henry said in aSept. 30 report. They see the evolution of a “fiscal club” in whichtroubled countries get aid from neighbors, yet are required totemporarily sacrifice their fiscal sovereignty.

'Costs of Failure'
“Ultimately the costsinvolved in fixing the euro's manifest weaknesses are far lowerthan the costs of failure,” said King and Henry.

Politics as much as economics have lain at the heart of the europroject, born in part by the desire to avoid another war by bondingnations together. It is the offspring of an integration which beganin 1951 with the establishment of the European Coal and SteelCommunity.

Former German Chancellor Helmut Kohl told Bild newspaper in 2010that “there's no alternative to Europe, especially in the questionof war and peace.” It was Kohl who helped turn the euro from aneconomic tool into a political one as he pushed for the inclusionof “the greatest possible number of countries” rather than justthose with the strongest economies.

Jacques Delors, a former president of the European Commission,once said “people forget too often about the political objective ofEuropean construction. The argument in favor of the single currencyshould be based on the desire to live together in peace.”

Flouting Rules
Still, as union grew from thesix founders to 27 members today, it never had the political willto enforce its own economic rules and no plan for dealing withcountries, like Greece, that threatened default. No nation was everpunished for violating deficit limits and in 2005, Germany andFrance led the push to water them down.

Some are questioning its ability to stick together. NourielRoubini, chairman of Roubini Global Economics LLC, said in an Oct.2 interview in Dubai that Greece would be better off outside theeuro and that in three to five years, there's a “good probabilitythat the euro zone is smaller than” now. El-Erian, who helps managethe world's biggest bond fund at Newport Beach, California-basedPimco, says there is the potential for a “smaller, much betterintegrated, fiscally strong euro zone.”

El-Erian nevertheless sees hope that European policy makers“finally” understand the severity of their crisis. After four daysof meetings in Washington, El-Erian said in Sept. 27 radiointerview on Bloomberg Surveillance with Tom Keene and Ken Prewittthat “they recognize they have deep problems, and they recognizethey need to do something about it.”

Bloomberg News

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