The major battle in the fight for the survival of the euro will be fought on Spanish soil. Greece, Ireland and soon Portugal should be regarded as skirmishes. But Spain is different, in terms of scale and solvency.

If the strategy implemented by European Union policy makers is appropriate, the markets will shift their attention to other risks, such as inflation, after the decisive event has taken place in Spain. If the EU plan is seen as inadequate, the euro-debt drama will roll out of control and the financial risks will be so great to cause a perfect global systemic storm.

The financial markets are neither pro- nor anti-euro. Yet, once they have evidence of a major inconsistency, they will press on until it is solved. In the case of the euro, the inconsistency is between its nature ― a currency without a state ― and its governance, impaired by a triple and self-defeating “No”: No fiscal union, no bailout, no sanctions.

Private investors will refrain from buying Spanish government bonds until they are convinced that the euro is sustainable, even if Spain is fundamentally solvent in the euro area. The reason is simple: If the euro were to break up, the new peseta would fall and the Spanish government would have to renegotiate with creditors.

Liquidity backstops, such as the loans to Greece, Ireland and soon Portugal, have only avoided serial failures in the European banking system, including in the U.K. But they can’t dissipate doubts about the long-term solvency of countries, such as Greece, and they didn’t address the governance issue.

The way to end the crisis is to convince investors that the euro is sustainable by changing its governance. The Oct. 29 decision by EU leaders to create a permanent debt-crisis mechanism by 2013 was a watershed event in this regard. For the first time, the region’s politicians acknowledged that sovereign defaults are possible and must be dealt with in an orderly way.

To be fair, investors have remained skeptical. First, 2013 is very far away. Second, the future crisis-resolution system is still vague. Third, and more importantly, investors will continue to doubt the political commitment of the strongest members of the euro club, starting with Germany, until supranational euro-bonds are issued on behalf of member countries. The difficulty is that these bonds may initiate a “stealth fiscal union,” as former European Central Bank Chief Economist Otmar Issing recently warned against. This would trigger a popular rejection of the euro.

The “E-bonds” solution, advocated by Italian Finance Minister Giulio Tremonti and Luxembourg Prime Minister Jean-Claude Juncker, doesn’t pass the Issing test, since good- and poor-quality issuers would be merged. One remedy would be to issue bonds collateralized by taxes actually levied in each participant country. This would by no means imply a fiscal union because each member state would get an amount of funding equal to the collateral it would pledge. But its “fiscal devolution” dimension still makes it politically unpalatable at this stage.

Even though policy makers are moving much faster than expected toward a comprehensive governance overhaul, the speed at which the markets may choke the refinancing of governments of large countries, such as Spain or Italy, may overwhelm the timeframe of political negotiations.

This is why a “shock-and-awe” strategy is indispensable to governance. Policy makers are considering such an approach before the Feb. 11 economic summit of EU leaders in Brussels. A combined loan of 500 billion euros ($672 billion) to Portugal and Spain would probably cover their government-financing needs until the end of 2012, a reasonable deadline for the completion of the euro-governance overhaul, as well as providing them with a contingency facility to recapitalize banks in difficulty.

This is the essence of the time-honored principle laid out by English writer Walter Bagehot in the 19th century for the lender of last resort: “Lend freely at a high rate on good collateral.”

Coordinated loans may fail to convince investors if the ECB doesn’t show a strong hand and express its commitment to safeguarding the euro during the Spanish battle. If the ECB is convinced that Spain is solvent, then the bank shouldn’t be concerned by a possible deterioration in its balance sheet caused by purchases of Spanish bonds at a price lower than fundamentals would warrant. In the end, taxpayers would even pocket a profit, since the ECB would book a capital gain on the sale of its Spanish bonds a few years later.

Since the Bagehot-inspired “shock-and-awe” strategy is both rational and feasible, it is likely to be implemented, given the economic and political stakes in the Spanish case. Tinkering and delaying decisions would just lead to an intractable situation. For European policy makers, taking a calculated risk to restore the stability of the euro is a much more sensible option than praying that nothing will happen.

By Eric Chaney

Eric Chaney is the chief economist of Axa Group in Paris. The opinions expressed are his own. ― Ed.

(Bloomberg)