Euro zone has to bank on its financial muscle

Europe's sovereign debt crisis has infected the heart of the single currency bloc and a grim road beckons but, given a concerted effort, the end is not yet nigh.

The euro zone now faces a classic currency crisis. AP Photo

With the crisis at the euro zone's periphery having mutated into a crisis at its core, the prescriptions for recovery must change.

Fortunately, it is not too late, but an effective response must be immediate, overwhelming and free of the ideological rivalries that have enfeebled the euro zone since the common currency was launched. The European Central Bank (ECB) is the only institution that can generate such a response.

The euro zone now faces a classic currency crisis. Inevitably, this crisis - manifested, under a fixed exchange-rate system, through bond spreads - threatens to take down debtors indiscriminately, be they governments, banks, or households.

In attempting to save governments through fiscal austerity, banks are threatened with balance-sheet losses and a sudden collapse in confidence, while households suffer much higher unemployment. Attempts to shore up the banks through "stress tests" that lack credible recapitalisation facilities and resolution mechanisms have undermined confidence in sovereign debt. In the end, it appears to be taxpayers who are hurt most by attempts to fight a debt crisis with more debt.

At the extremes, the euro zone's debt problems can be solved through bailouts or default. By promising bailouts in return for fiscal austerity, governments have inevitably been pushed toward the prospect of socialising an unbearable amount of private debt. As the negative feedback loop between banks and sovereigns grows, confidence in an increasing number of governments' debt has steadily been eroded.

The lack of a fiscal-transfer mechanism within the euro zone, born of member states' unwillingness to cede control of their own fiscal policies to a central authority, has always been the euro's Achilles' heel. Fixing the current governance structure and creating a fiscal-transfer mechanism are yesterday's lost opportunities and tomorrow's necessity.

That means, first and foremost, the ECB, like other central banks since 2008, will need to look beyond the "hard money" ideology upon which it was founded. To be sure, the answer is not to print endless amounts of money or to relieve politicians of their responsibility to fix a broken system. But nor can the ECB sit by and allow the crisis to reach full force.

The strongest signal a central bank can send during a financial crisis is to ease monetary policy aggressively. Standard monetary policy together with bad structural policies are to blame for the euro zone's growth disparities. Lost competitiveness in the periphery was, in part, an equilibrating movement caused directly by the economic-adjustment process under a common monetary policy. Accordingly, interest rates should be used more actively to cushion the adjustment, given bailouts are unaffordable and default is undesirable. A de facto ECB guarantee to back all euro zone government debt will be more controversial. But there is no alternative. The European Financial Stability Facility (EFSF) is an appropriate vehicle to fight peripheral fires, but it is far too small - and cannot be scaled up quickly enough - to fight a systemic blaze. Leveraging the EFSF's resources should be considered, but any such move will be constrained by the need to preserve the vehicle's "AAA" rating with sufficient sovereign guarantees.

Moreover, deployment of EFSF resources remains hobbled by political bickering (such as the fight over Greek loan collateral).

Effective insurance is normally the least likely to be used. The ECB is the only euro-zone institution that has the capacity, through its power of seigniorage and profit and loss sharing to all member central banks, to provide Eurobond-like support. It could "guarantee" all euro-zone debt, either formally or with the force of will (effectively promising to purchase any and all government debt). Bringing down sovereign borrowing costs would partly, if not entirely, restore governments' ability to fund bank recapitalisation where needed.

In theory, it is immaterial whether the ECB eventually buys all euro sovereign debt through its securities markets programme or guarantees all debt pre-emptively. But the former would tend to reinforce the negative feedback loop between banks and sovereigns, while the latter would likely avoid socialising a rising volume of private debt as the feedback loop is attenuated.

Under such a system of ECB guarantees, there would still be an important role for traditional stabilisation programmes, such as those now in place for Ireland, Portugal, and Greece - particularly while countries still run primary deficits. Sovereign defaults could be better facilitated.

The ECB has rightly resisted assuming responsibility for debt problems that are ultimately fiscal in nature. Nonetheless, with the crisis now systemic, it must take up the fiscal-transfer baton that euro-zone leaders have so unceremoniously fumbled.

Of course, losses would be borne by euro-zone taxpayers, but they would be mitigated as banks avoid sharp deleveraging and asset fire sales.

The euro zone would be safe, at least temporarily.

Gene Frieda is a strategist for Moore Europe Capital Management.

* Project Syndicate