As European leaders meet this week, they continue to twiddle their fingers as the risk of an enormous global financial crisis caused by Europe’s crisis increases. The Eurozone faces critical jssues borne of their inability to properly construct a functional economic union, and the problems they have created will require aggressive and bold solutions. European citizens and their leaders face no choice but to ensure an orderly default for Greece, effectively guarantee the debts of all other Eurozone countries, and recapitalize European banks; the alternative is almost certain to be economic chaos and recession.
Europeans have constructed their economic union in a few stages. First, the Europeans had an integrated market, a wise idea that broke down trade and immigration barriers and increased economic activity by allowing the free movement of goods and peoples. This market strengthened over time and led to a society that maintained distinct cultures and governments but shared economic markets and a set of admirable fundamental rights. They should have stopped there.
Instead, many of the EU member states went ahead and created a currency union. The flaw in their plan was that fiscal and monetary policy must go hand in hand; it is impossible to run a properly functioning monetary union without also having integrated fiscal policy. We can see the ramifications of the Europeans’ decision right now: Countries like Greece, Italy and Spain would traditionally use substantial inflation to devalue their debts, but instead they are subject to a tight monetary policy that better suits the stronger European economies such as Germany and Austria.
If Europeans don’t find a way to manage an orderly default for Greece, protect other at-risk Eurozone economies, and recapitalize European banks, they could start a global economic crisis that would make the 2008 financial crisis look like a warm-up act. Taken as a single entity, the EU is the world’s largest economy. A chaotic default by Greece, or even worse, defaults by Spain or Italy, could send the European economy into a tailspin, and it would bring the rest of the global economy down with it.
Europeans must immediately arrange an orderly debt restructuring (partial default) for Greece. This will entail reducing Greece’s debt burden to a manageable level by forcing bondholders to take substantial haircuts, or debt-for-equity swaps, on their holdings of Greek debt. Greece is almost certain to default at this point, and the only question is whether it will do so in a chaotic or orderly fashion. It is essential it is done in a methodological manner to minimize the effects on other European economies as well as the larger global economy.
Forcing bondholders to take substantial haircuts on Greek debt will understandably result in major losses for banks. European member states and the European Central Bank must together commit to support the banks through a combination of recapitalization measures and unlimited lending facilities. Member states seem to have agreed to a preliminary set of recapitalization measures, but any that don’t include unlimited lending facilities won’t go far enough to ensure trust in the European financial system. It is never pleasant to bailout large banks, but given the large sovereign debt holdings of most European banks, the alternative could be a string of disastrous bank failures.
Finally, European member states must ensure that none of the other Eurozone economies default. This requires a commitment to “open-ended financing” from the ECB to every other European economy. The ECB must commit to buying all bonds of European countries for the foreseeable future as well as engaging in more expansionary monetary policy. A strong commitment to financing will remove investor concern that these countries won’t be able to pay off their debts, while a more expansionary monetary policy will devalue the nominal debts and make it easier for countries to pay them off.
Instead of committing to this right now, the Eurozone is convinced that a leveraged fund, the European Financial Stability Fund, should be put together to buy European bonds. Yet its hard to believe that a complex, leveraged, and limited vehicle for bond purchases subject to electoral approval by every single Eurozone member state will really be more effective than an ECB that can just print the Euros necessary to finance the debt of member states. It is puzzling that European leaders and Mario Draghi, the chair of the ECB, are not committing to debt purchases of all at-risk EU sovereign debt.
Europeans have not committed to the bold measures that are needed to prevent disaster because, to quote Matthew Yglesias ’03, they are uncomfortable with being fully “on the hook” for problems arising in any European member state. By joining the currency union, however, Europeans committed themselves to integrated fiscal and economic governance. They now have no choice to continue on this path if they want to avoid a string of defaults, bank failures, and crises that would leave Europe and the rest of the global economy in tatters.
Ravi N. Mulani ’12, a Crimson editorial writer, is an applied mathematics concentrator in Winthrop House.