Feb. 18 (Bloomberg) -- Germany and France may be forced to contemplate the bailout of entire nations rather than just individual banks as European government budgets buckle under the weight of recession.

German Finance Minister Peer Steinbrueck became the first senior policy maker to broach the topic earlier this week, saying some of the 16 euro nations are “getting into difficulties” and may need help. He went further today, saying Germany would show its “ability to act.” French officials are also concerned about market tensions as the cost of insuring Irish, Greek and Spanish debt against default rises to records and bond spreads widen.

The nightmare for Angela Merkel and Nicolas Sarkozy is that widening deficits will prompt investors to shun the debt of some countries, sparking a region-wide crisis. While few investors are yet forecasting any defaults, the mere risk of it may prompt the bloc’s two richest economies to ignore the European Central Bank and announce their willingness to come to the rescue.

“When push comes to shove Germany, France, the larger players will bail out those smaller peripheral players,” said Alex Allen, chief investment officer of Eddington Capital Management. “You can’t let one part of the system fail because it leads to failure of the whole system.”

Allen’s betting that the risk at least one nation will leave the bloc is higher than the market currently expects.

Swelling Deficits

European deficits have ballooned as governments from Berlin to Dublin committed more than 1.2 trillion euros ($1.5 trillion) to save their banking systems from collapse. The European Commission urged countries to bring their deficits back in line today as EU Monetary Affairs Commissioner Joaquin Almunia said the best way Greece and Ireland could deal with market pressure was by strengthening their finances.

The European Union’s executive arm forecasts a deficit of 11 percent in Ireland, 6.2 percent in Spain and 4.6 percent in Portugal this year, compared with an average gap for the euro region of less than 1 percent in 2007.

European officials have already expressed concern that their bond market could potentially face a crisis similar to that unleashed by the collapse of Lehman Brothers Holdings Inc. in September. ECB board member Lorenzo Bini Smaghi said Feb. 12 there’s a “risk that the mistrust that there is today in financial markets” is “transformed into mistrust in states.”

Bond Spreads

“I would be very reluctant to say: ‘O.K., let Ireland or Greece default, the market will sort it out, punish them for their irresponsibility of the past,’” said Thomas Mayer, co-head of global economics at Deutsche Bank AG in London. “They tried it with Lehman and realized that was not a good idea.”

The gap between the interest rates Greece, Portugal and Spain must pay investors to borrow for 10 years and the rate charged to Germany rose yesterday to the widest since before they adopted the euro and credit-default swaps on Ireland hit a record. The differential between Austrian and German yields widened to a record today as concern intensified about Austria’s exposure to eastern European banks.

“Austria is on the hook for so much money that essentially if they don’t get paid by eastern Europe they’ll go bust,” Marc Faber, managing director of Marc Faber Ltd., said in a Bloomberg Television interview. “So the European Union basically has to help Austria one way or the other.”

Greek credit-default swaps, at 270 points on Feb. 16, show a 4.5 percent chance that the country will default in the next 12 months, according to ING Bank NV.

No-Bailout Rule

Eddington Capital’s Allen, who runs a fund of hedge funds, says the market currently “vastly underestimates” the risks and expects credit-default swaps for Greece, Italy, Spain and Portugal to double in the next 12 months.

Any state-funded rescues may nevertheless meet with opposition from the ECB, which has repeatedly said the Maastricht Treaty forbids bailouts.

“The no-bailout rule is an important pillar on which the European Union was founded,” ECB Executive Board member Juergen Stark, who helped draw up the fiscal rules underpinning the euro, said Jan. 15. Today he urged countries with large deficits to take measures to rein them in.

At the same time, the treaty also says that EU nations can grant financial assistance to a member state if a country is “threatened with severe difficulties” caused by “exceptional occurrences beyond its control.”

“The member countries are working hard on a ‘pre-emptive de facto bailout’ to prevent the test of the “no bailout” clause,” said Juergen Michels, an economist at Citigroup Inc. in London.

Single Treasury

Part of the problem policy makers now face stems from the fact the currency union does not have a single treasury and relies on the Stability and Growth Pact, which has been breached in the past, to keep budgets in check. Billionaire investor George Soros said yesterday the region’s economy must confront the problem posed by the lack of a Europe-wide finance ministry.

For now, finance officials say that market concerns are not justified. ECB President Jean-Claude Trichet said in Rome on Feb. 14 he’s confident countries will work toward sustainable public finances.

Greek Finance Minister Ioannis Papathanasiou said three days earlier the extra interest rates on his country’s debt were unjustified. Spain’s Deputy Finance Minister Carlos Ocana categorically ruled out a default on Feb. 16, and the Irish Finance Ministry warned yesterday against drawing conclusions about public finances from the CDS market.

Steinbrueck’s comments nevertheless suggest that views in Berlin are shifting as the financial crisis worsens.

“In reality the other states would have to rescue those running into difficulties,” he said Feb. 16. Steinbrueck said that Ireland was in a “very difficult situation.”

“There will have to be some kind of support package for some of the smaller economies to avoid the tension and speculation about breakup,” said Ken Wattret, senior economist at BNP Paribas SA in London. “The bigger national governments will say this isn’t our problem. But when push comes to shove, they might need to provide some kind of financial support.”

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.net

Last Updated: February 18, 2009 10:14 EST

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