The governor of the Bank of England said on Wednesday that the euro zone is “tearing itself apart without any obvious solution" as he admitted that the UK central bank, the Financial Services Authority (FSA) and the government have been discussing contingency plans to deal with the prospect of a Greek exit from the euro or a collapse in the euro zone “for some time.”
Mervyn King refused to go into detail on the plans for fear of “fanning the flames,” as he put it during a press conference, but he added that the UK is being buffeted by a storm already and warned UK banks to shore themselves up by keeping profits.
"What is so depressing about it [the euro zone crisis] is that this is a re-run of the debates in 2007/2008 - these are not liquidity problems, they are solvency problems," he said.
"The imbalances between countries in the euro area have created creditors and debtors and at some point the credit losses will need to be recognised and absorbed and shared around and until that is done then there will not be a resolution. That is why just kicking the can down the road is not an answer."
King said the ECB had acted heroically in buying time, but that the current crisis in Europe was “two and half years in the making."
He added that: "Germany and the Netherlands have yet to face up to rebalancing their own economies”.
"The interesting economic question is not whether the euro will survive but the imbalances in competitiveness in Europe, which need to be addressed," he said. At some point credit losses will have to be accepted as well, the UK central bank governor added.
“What is needed is a credible path spelled out by the euro area as to how they will achieve that,” he said.
The Bank governor also suggested that British banks should not pay staff or shareholders cash bonuses or dividends but should instead pay bonuses in the form of equities, adding: "Keep the cash in the bank... It means you are not running down the capital of the bank and keep the money that might have been paid out to shareholders in the bank - the shareholders have a claim on it, they haven't lost the money in any sense - to give the bank just that bit more of protection when the storm comes."
King's comments during the release of the BoE's latest quaterly inflation and economic outlook report are the strongest he has every made in relation to the euro zone crisis. They also revealed the governor's frustration with the lack of political solution to the euro zone crisis.
"The economy will continue to face strong headwinds over the forecast period. Underlying concerns about balance sheets, especially in the financial sector with its exposure to the euro area, mean that the path of recovery is likely to be slow and uncertain,” King added.
The Bank governor said the Monetary Policy Committee (MPC), which determines the baseline interest rate for the UK, was focused on the big picture.
"That bigger picture is of a gradual recovery in output and of subdued domestic cost pressures, meaning that inflation is likely to fall back as external influences fade," he added.
King said the outlook for UK economic output remains weak in the immediate future, while the prospect of inflation remaining above the central bank’s 2 percent target remains high.