“Governments and central banks have to take out the catastrophic risk from markets,” US Secretary of Treasury Timothy Geithner said recently on the sidelines of a meeting of euro zone finance ministers in Wroclaw, Poland.
The euro crisis is now at a dangerous turn.
While it is difficult to forecast the future of the zone, it is possible to list the conditions that are required for the sustained solvency of Greece and the euro zone overall.
Focusing on any one aspect of the list will not suffice; each and all challenges must be overcome.
· Short-term fiscal support, back-load austerity
Until recently, most euro economies have engaged in severe front-load austerity measures and promises of long-term fiscal support. Instead, the euro economies should engage in short-term fiscal support, in order to support nascent recovery, and credible, long-term back-load austerity, in order to sustain growth.
· Monetary easing
After three years of effective global crisis, the traditional instruments of monetary policy have been exhausted. The simple reality is that the European Central Bank (ECB), along with the Fed and Japan’s central bank, are now stepping in the footprints of Japan. Not so long ago, ECB chief Jean-Claude Trichet sought to hike the rates, which was precisely the wrong thing to do. In contrast, appropriate monetary easing remains vital, especially to provide credit easing for small and medium-size enterprises which are vital to employment.
· Restructure sovereign debt
For almost two years, the euro zone leaders in Brussels and the ECB refused to talk about the restructuring of Greek debt and the euro bonds. Moreover, the recent decision to permit a restructuring of Greek debt with a modest haircut for private creditors is inadequate. What Greece needs is probably a 40%-50%net present value debt reduction. An orderly, managed restructuring is unavoidable. Neither can Portugal or Ireland escape substantial haircuts.
· Provision of effective liquidity
In the euro zone, liquidity support is vital for many euro nations. Even the proposed changes to the stability facility (EFSF) will not be enough, as Geithner suggested in Wroclaw. The current EUR 440 billion will not deter runs on Italy or Spain. On the other hand, even if the EFSF were to be doubled or tripled, that will not save the “too big to fail” major economies in the euro zone. Still, the strengthening of the EFSF resources are a first step to the creation of the euro bonds, which can fortify the euro markets – but only in the long term.
· Recapitalizing banks and cleaning ECB
Despite two rounds of not-so-stressful stress tests, banks remain vulnerable in the euro zone, as indicated by Moody's downgrading of Société Générale (SocGen) and Crédit Agricole, two of France's largest banks, due to their exposure to Greek sovereign debt. The EZ/IMF projections of the euro banks’ capital needs ignore the massive losses that these banks would accrue from debt restructurings. Furthermore, since the onset of the global crisis, the ECB has embraced trillions of dollars of questionable debt. These toxic debts must still be defused.
· Support productivity and competitiveness via structural reforms
Even if the G-7 nations can overcome their debt challenges, they cannot maintain their level of development without sustained growth. In the pre-crisis era, productivity growth eroded in most euro zone nations. In order to sustain their competitive strengths, these nations need to engage in pro-growth policies, strengthen their competitiveness and fortify their innovation capacity.
The common denominator of all these points is the impending political decision that all euro economies, particularly the current debtors, can no longer avoid. They must decide whether the euro zone will comprise a few deeply integrated economies, or many loosely integrated economies. This political decision will determine their approach to the outlined economic challenges.
Dan Steinbock is research director of international business at India China and America Institute (USA), visiting fellow at Shanghai Institutes for International Studies (China) and in the EU-Center (Singapore).