THE EURO zone crisis has shifted into a qualitatively more serious level as EU leaders prepare to reach agreement on three major issues at their summit in Brussels tomorrow. They are ready to accept Greece must write down its unsustainable debt by up to 50 per cent and possibly more. They must find a way to recapitalise banks exposed to that loss. And they must decide how best to use the European Financial Stability Facility in achieving these tasks. This is a grave responsibility, stimulated by the penetration of the debt and financial crises into the huge Italian economy and now to France by market forces.
Definite and welcome progress has been made in facing up to these issues, which deeply divide euro zone member states and affect their core interests. It has taken months for them to accept that Greece’s debt cannot be afforded. The severe cuts imposed by austerity policies have deflated its economy, with latest estimates of the costs involved soaring towards astonishingly high numbers and a growth recovery completely off the agenda. A 50 per cent default imposes painful costs on the French and German banks which financed Greece’s debt, with French banks most exposed. It is only now being fully accepted that this is so and that these recapitalising costs will be borne ultimately by European taxpayers. Following the prolonged denials that any default was necessary or banks exposed to this again is a positive step, though many of the details required have yet to be determined.
The third major issue facing the summit is how to finance these two momentous tasks. They could go as wrong for Europe as the Lehman’s collapse was for the United States in 2008. Recent weeks have seen a strenuous tug of war between France and Germany over whether the European Central Bank should take on that role. The argument in favour put by France and its supporters says the bank must be the final backstop of the single currency, capable of issuing and guaranteeing the capital needed. The argument against from Germany and its allies (including the bank itself) says this would break its mandate to prevent inflation and compromise its statutory independence. Germany has won that battle of wills, at least for the present. This is not surprising because its economic strength confers decisive power as well as imposing the main cost burden for the whole rescue operation.
The trouble is that the alternatives expected to be adopted instead of relying on the ECB threaten to be sub-optimal in amount and method. The sums required are immense according to the best informed estimates. Up to €2 trillion would be needed to provide ironclad guarantees against financial contagion and to face down market speculation by a determined show of political will. That is much easier done through the ECB than by using the leveraged insurance guarantees and capital markets access schemes now under consideration. Although these do represent clear incremental progress towards tackling the first two major issues they could be too little and too late to deal with their severity. Whatever is agreed tomorrow is unlikely to be final, but it must be a decisive step towards protecting the euro.