The Solution to the European Problem?

“The bare minimum the eurozone needs to cope with its crisis is an effective mechanism for writing down the debts of evidently insolvent private and sovereign borrowers, such as Greece; funds large enough to manage the illiquid bonds markets of potentially solvent governments; and ways to make the financial system credibly solvent immediately.”

This is the prognosis of Mr. Martin Wolf, the economics editor of the Financial Times, in today’s edition of the paper.

“Yet, alas, the eurozone requires more still: it needs a credible path of adjustment, at whose end we see weaker economies restored to health.”

The word is getting out…the European banks are going to have to take bigger write downs of their holdings of sovereign debt than ever imagined.

Can the eurozone governments cover the hole in the balance sheets of these banks?

The United States stock market seems to think that they can. This is the reason given for the rapid recovery of stock prices in the market yesterday.

But, let’s look more closely at what Mr. Wolf is saying. In the first condition, he writes about how the amount of the write down will be determined along with how the write down will be administered. This is a daunting task in, and of, itself.

Note further, however, that he is including ‘private’ debt along with the debt of sovereign borrowers. The need to write down the ‘private’ debt is something new, something that has not gotten a lot of attention in the press in all the noise relating to the sovereign debt issue.

The second point Mr. Wolf makes is about contagion. How is any write down of the debt of the peripheral nations going to be kept to just the peripheral nations bonds, themselves? The concern is that once write downs take place in bonds of the fiscally weaker nations that some spread is bound to occur to the nations that are in a stronger position, fiscally.

Then, Mr. Wolf addresses the issue of credibility. Given all the “messing around” for the better part of almost three years, how can financial markets come to believe that solvency has been restored to the impacted nations? If anything has increased over the past three years or so, it is the lack of trust in the eurozone governments when it comes to how the politicians carry out their responsibilities. There is little or no trust in the people heading up most of the governments in Europe. Can this “trust” be regained…and in time?

The add-on to this analysis is that the eurozone countries also need an immediate return to a robust economic recovery.

The happy conclusion to the analysis: “If such a path is not found, the eurozone, as it is now, will fracture. The question is not if, but when. The challenge is simply as big as that.”

Two comments on this analysis: first, I am glad to see that some people are finally seeing the problem as one of solvency and not one of liquidity. It has taken a long time for the analysis to get to this point. Now, it is time for the policy makers to accept this fact.

Second, Mr. Wolf pretty well lays out the dislocation that is going to have to take place in order to restructure and restore the eurozone to some sense of order and balance.

“How, then, did the eurozone fall into its plight? The easy credit conditions and low interest rates of the first decade (of the European Union) delivered property bubbles and explosions of private borrowing in Ireland and Spain, incontinent public borrowing in Greece, declines in external competitiveness in Greece, Italy and Spain and huge external deficits in Greece, Portugal and Spain.”

The European condition is the result of credit inflation! Quite an admission for a dyed-in-the-wool Keynesian!

The point is, however, that a long period of excesses must be matched by a painful and uncomfortable period of restructuring.

In conclusion, however, one cannot ignore the social situation in Europe. The “social contract” of the post-World War II era appears, to many, to be broken, and there is protesting and rioting in the streets.

Strong economic growth and low levels of unemployment, something that seems more and more unlikely to happen in the near future, of course, can resolve this situation. Writing a new “social contract”, as history shows us, is not an easy thing to do.

Are there any lessons here for others?

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