The Eurozone crisis has been a battle over who will ultimately be liable for the billions worth of actual and potential losses on sovereign debt held by European financial institutions. With neither the issuance of collectively backed Eurobonds nor the use of the European Central Bank (ECB) as lender of last resort initially available as options, the European Union, the ECB and the International Monetary Fund decided to protect bank bondholders at all costs, choosing instead to impose losses on taxpayers, even at the risk of stretching governments’ solvency to the breaking point. But because voters’ tolerance for bank bailouts had already worn thin following the initial financial crisis, governments in the EU core countries began implementing what amounts to a covert bank bailout, lending huge sums to the periphery — Greece, Ireland and Portugal — so that they could in turn repay their debts to German, French and UK banks in full.
However, the refusal to countenance a Greek default over the last year is now dragging the Eurozone toward even greater crisis. Already, Greece has proven unable to meet the austerity measures laid out by the EU, the ECB and the IMF as conditions for loans. In fact, imposing austerity on Ireland, Portugal and Greece cannot, on its own, solve the Eurozone’s problems, which are not merely the result of profligate borrowing by the peripheral nations, but also reflect earlier profligate lending by the core nations. And because the current bailout proposals are operationally unsustainable, they will lead to a broader contagion.
The best solution economically would be a restructuring of peripheral debt and a recapitalization of the German, French and UK banks that predominantly hold it. The primary obstacle standing in the way is the potential political fallout from such an action.
However, a well thought-out restructuring that allows peripheral economies to reduce their debt to sustainable levels, accompanied by measures to avoid further contagion, is economically necessary now. Otherwise, we are likely to see a successive elimination of countries from the Eurozone, driving instability in the money markets due to speculation as to who comes next and when.
The outstanding debts held by German, UK and French banks that have gambled in the peripheral states can only be repaid by three sources: the ECB through monetizing the debt, the bondholders — i.e., the banks — through a restructure and write-off, and EU taxpayers, whether in the peripheral countries that borrowed the money or the core countries that lent it.
Until now, the Eurozone has ruled out the first two options. As a result, citizens of the peripheral economies have been forced to repay the debts, using money borrowed from core countries under strict and painful conditions of austerity. Not surprisingly, the citizens of peripheral economies such as Greece are now directing their anger at EU and Eurozone policymakers. If the EU forces the citizens of the core countries, such as Germany and France, to bail out their own banks openly, they, too, will question the benefits of EU and Eurozone membership. Both outcomes would threaten the viability the EU and Eurozone projects.
The optimal solution, then, for the Eurozone crisis is to reduce the sovereign debt of Ireland, Greece and Portugal by imposing the losses on private investors — namely, a debt restructuring. At the same time, core economies such as Germany, France and UK would announce measures to support their banks as necessary, standing ready to subscribe capital or guarantee bank deposits and borrowing in order to prevent losses on sovereign bond holdings from setting off a European banking crisis. In such a scenario, the ECB, which is itself heavily exposed to the peripheral economies, may also require recapitalization and financial support.
The Eurozone prescription of austerity without adequately restructuring debt has failed in Greece, and it will fail elsewhere as well. An orderly process toward a real private-sector burden-sharing plan is the best option to prevent further contagion, which would threaten the economic stability of peripheral and core countries alike