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Blog: Why Euro Crisis will Continue to Unnerve the Markets

Dan Steinbock|Research Dir., International Business, India China and America Institute
Wednesday, 26 Oct 2011 | 11:28 AM ET
CNBC.com

As markets have been rebounding on euro hopes, the eurozone leaders have been debating a plan that should satisfy the financial markets.

The hope is futile.

A comprehensive plan does not exist.

The eurozone crisis will get worse before it will get better.

Why the best scenario is unsustainable

In order to satisfy the markets, the eurozone leaders should achieve three objectives.

  • First, the liquidity facility should be expanded from the current EUR 440 billion ($610 billion) to EUR 1-2 trillion ($1.4-$2.8 trillion).
  • Second, the Greek debt reductions should be increased from the current 21% to 60-75% (current consensus is close to 50%).
  • Third, the “systemically critical” euro banks would have to be recapitalized by EUR 100-110 billion ($140-$155 billion).

The first goal is difficult because the political and popular support of the current euro leaders is rapidly eroding. In Italy, the center-right coalition almost collapsed over EU demands for serious economic reforms – until Premier Silvio Berlusconi reached a deal with his allies on emergency growth measures.

Even in Germany, Chancellor Angela Merkel's conservatives bowed to pressure for a full vote in parliament over controversial plans to boost the euro rescue fund – despite the unknown number of rebels in her ranks.

French President Nicolas Sarkozy shuns measures that would penalize investors and thus could contribute to banks’ rating downgrades, which, in turn, would endanger France’s triple-A rating.

Moody’s has already warned that France's credit rating could be downgraded in the next three months if the nation's budget is stretched further by bank bailouts to help other debt-heavy eurozone countries.

Greece’s bailout in 2010-2020: EUR 500 bn ($700 bn)

Even if there are few alternatives available to bank recapitalization, eurozone cities have already been swept by demonstrations and, in some cases, violent riots, aimed against the financial sector.

Besides, the Greek dilemma will remain. In May 2010, the eurozone supported Greece with EUR 110 billion ($150 billion); now Athens hopes to complete another bailout round of EUR 109 billion.

But additionally, Greece will need at least another EUR 250 billion ($350 billion) in the next 10 years – and it is not the only near-insolvent euro economy.

Unfortunately, an inadequate liquidity cushion, a difficult bank recapitalization, and a complex debt restructuring are not the eurozone’s only problems.

Why the crisis will linger

Until recently, most euro economies have engaged in severe front-load austerity measures and promises of long-term fiscal support. That has spawned violent riots from Athens to London. Instead, the euro economies need short-term fiscal support to support nascent recovery, and credible, long-term back-load austerity to sustain growth.

Along with misguided fiscal policy, many euro economies have suffered from ill-advised monetary policy.

Not so long ago, ECB chief Jean-Claude Trichet sought to hike the interest rates, which was precisely the wrong thing to do. Appropriate monetary easing remains vital, especially to provide credit easing for small and medium-size enterprises which are critical to employment. As Trichet retires on November 1, all eyes will be on his successor, Mario Draghi, currently chief of Italy’s central bank.

During the great recession, many national central banks in the eurozone embraced billions of euros of toxic debt. For all practical purposes, these central banks are no longer autonomous, but subject to the ECB system. As a result, ECB’s toxic assets must still be defused.

Finally, all euro leaders agree that the region’s problems cannot be overcome without appropriate growth. And yet, adequate structural reforms have not been implemented since the 1980s, when Brussels began to address the issue of growth and competitiveness.

The euro summit is a defining moment in the postwar European history. It is a historical moment that can be seized – or squandered.

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).

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