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The world’s inability to shake off the economic downturn and contagion in Italy has changed the nature of the eurozone crisis. What was once a debt problem of small peripheral countries is now threatening the euro’s existence. Europe’s leaders did not see this coming. They failed to recapitalise their banking system sufficiently. And when they designed the European financial stability facility, they created a mechanism suitable only for small countries. Their strategy has come unstuck.
At the autumn meetings of the International Monetary Fund and the World Bank, eurozone policymakers came under an unprecedented degree of pressure to act. Will they?
On a purely technical level, the eurozone crisis can still be solved. A eurozone bond, flanked by a minimally sufficient fiscal union, would do it. Alternatively, the European Central Bank could extend its bond purchases programme to the same effect. Both steps would require fiscal and financial reform.
A more modest but effective proposal would be to strengthen the EFSF. Economists Thomas Mayer and Daniel Gros have proposed that it should attain a banking licence so that it can draw funds from the ECB. Others have proposed that the EFSF could issue discounted bills. I have also heard a proposal to turn it into an insurance company.
The proposals have in common that the EFSF would be leveraged, so that it can operate beyond its notional ceiling of €440bn.
The technicalities are complicated, on financial, legal and political levels. The real problem, however, is not technical but political. Until recently, Angela Merkel reiterated day-in day-out that there shall be no eurozone bond. The German constitutional court gave a ruling that further reduces her political freedom of manoeuvre.
The debate has focused entirely on what cannot be done rather than what can – no eurozone bond, no monetisation, no bail-out, no break-up, no this, no that. As the world is discussing the next crisis resolution steps, the European authorities are still struggling with the implementation of the ratification of the rather minor changes to the EFSF agreed by the European Council on July 21, or the perverse debate about Finland’s request for collateral. European policy has been constantly lagging behind.
This will continue. On Thursday, the Bundestag will vote on the EFSF. In October, it will vote on the next loan tranche for Greece. In the new year, it will vote on the European stability mechanism, the successor to the EFSF. By then it may have to vote on a third Greek programme, as the second, not yet ratified, programme is already way out of date. There may be second programmes for Portugal and Ireland as well. Each, of course, will require a separate vote in the Bundestag.
Berlin, however, is not the only source of uncertainty. Parliamentary majorities are melting in Helsinki, The Hague, Bratislava – and Athens. Do we really believe the Greek government can implement one austerity plan after another with a majority of five seats?
So even if Europe’s leaders were to come together tomorrow and agree on all the necessary steps to end the crisis, they would not have solved it until they could demonstrate that they enjoyed full political support. That is unlikely to be the case for a while yet. To achieve this outcome, Ms Merkel will have to do a lot more than reiterate that the failure of the euro would mean the failure of Europe. She will need to put her political future on the line.
In the meantime, a domestic credit crunch and the prolonged global economic slowdown are about to throw the eurozone back into recession. To break out of this vicious cycle, the ECB will have to cut interest rates, and return to a policy of unlimited long-term funding. Governments must quickly start to recapitalise the banking system. The European Union has wasted two precious years with dishonest stress tests that have shaken the credibility of the European Banking Authority, the European Commission, national central banks and national bank regulators. If you factor in the economic slowdown, Europe’s banks could be undercapitalised to the tune of €500bn.
Beyond the very short term, the eurozone will need to provide a common backstop to the banking system, not just for cross-border banks but for all systemically important financial institutions. Such a system would encompass supervision, resolution regimes and deposit insurance. Expect the political opposition to be at least as strong as it is to eurobonds: it is through the Landesbanken and cajas that German and Spanish politicians exercise power.
Rescuing the eurozone requires an action plan of a scale hard to fathom. In the coming weeks, Europe’s political leaders will have to decide what to do about Greece, recapitalise the banking sector, fix the EFSF, all in a way that ties in with a clearly laid-out strategy for the future of the eurozone. A short-term fix may impress the markets for a few days. It is not going to end the crisis.
Based on previous performance, it is hard to imagine that the European Council will rise to the occasion. If it does, it is even harder to believe that they can get the support back home.
I have never seen Europe’s policymakers as scared as I saw them in Washington last week.