by Simon Tilford

Time is running out to prevent the eurozone crisis from imperilling Europe's banking system and with it the integrity of the currency union. It is beholden on policy-makers to minimise the economic (and hence political costs) to the EU. Three things need to happen: the debts of Greece, Ireland and Portugal need to be restructured as soon as possible; the European Commission and the European Central Bank (ECB) need to do everything to make sure that the adjustments facing the other struggling euro economies are realistic; and there needs to be policy co-ordination between the member-states aimed at ensuring balanced economic growth across the currency union. This requires leadership and an honest and better informed debate about the causes of the crisis. Both are in short supply.

The adjustments facing Greece, Ireland or Portugal were always a tall order. Now that borrowing costs have ballooned, those adjustments are impossible. Under no plausible economic growth forecasts will these economies be able to pay back their debts. However, eurozone policy-makers continue to treat the crisis as one of liquidity rather than solvency, providing indebted member-states with loans (at punitive interest rates) but doing nothing to improve their chances of being able to service them. This is the worst of all possible worlds. Investors have taken fright and pushed up the borrowing costs of countries whose debts might otherwise have proved manageable. Far from limiting creditor losses, they risk spiralling out of control. Piling up more debt when solvency (not liquidity) is the issue is self-defeating.

The bail-out of Ireland simply increases that country's already unsustainable levels of debt, while insulating investors. The ECB and the Commission opposed restructuring the debts of the Irish banking sector. Instead, they have argued for ever more implausible degrees of fiscal austerity in return for extending costly loans. Unsurprisingly, the Irish government's borrowing costs remain prohibitively high. A bail-out of Portugal will be similarly ineffective. It will benefit lucky investors, but do nothing to improve Portugal's prospects. The loss of confidence in the eurozone and resulting surge in borrowing costs threatens to draw Spain into the insolvent camp, ultimately requiring a Spanish debt restructuring. This would be catastrophic for Europe's banks and would impose huge fiscal costs.

Of course, restructuring the debts of Greece, Ireland and Portugal will be costly for creditors. But if debt positions are unsustainable the problem needs to be addressed sooner rather than later. Banks based in eurozone members such as France and Germany, as well as in non-eurozone countries such as the UK and US, would suffer big losses on their investments in the defaulting countries. The ECB would also book losses. This would be messy and governments would have to bite the bullet and recapitalise their banks. But it would ultimately prove less damaging to economies such as Ireland, Greece and Portugal, and the currency union as a whole, than persisting on a course that promises an even bigger restructuring (and bigger losses) down the line.

The second part of the strategy would be to ensure that the adjustment process facing Spain and other hard-hit economies is a manageable one. The ECB could help by launching an aggressive programme of government bond purchases. Monies from the European Financial Stability Fund (EFSF) could also be used to tide the countries over until they regain access to the financial markets on affordable terms. But these countries' fiscal programmes will also have to be consistent with a return to decent economic growth. Crucially, cuts in spending on education and infrastructure must be kept to a minimum, as these would further reduce growth potential. Reforms of pension and healthcare systems would go a long way to address investors' concerns about the long-term sustainability of countries' fiscal positions. 

The third part of the strategy – rebalancing economic growth in the eurozone – will be the hardest to execute, but is essential if future crises are to be avoided. Governments need to support the Commission's drive to foster closer economic integration and to co-ordinate their policies to ensure that they are compatible with balanced economic growth across the eurozone. Huge current account balances are not consistent with a stable currency union, because one way or another they require massive (and hence politically and economically destabilising) transfers between the participating economies. However, even if trade imbalances are reduced, there will have to be greater fiscal supra-nationalism. This could take the form of a common E-bond, some minimal fiscal union, or ideally a combination of the two. Without some element of fiscal supra-nationalism, the adjustment costs facing countries that cede trade competitiveness within the eurozone will simply be too high.

However unpalatable these measures are to eurozone governments, the European Commission and the ECB, they can all be done if governments can summon the political will. Governments have to explain to their voters why debt relief for Greece, Ireland and Portugal and the resulting injection of public funds into banks is necessary in order to head off far greater costs down the line. They have to summon the political courage to make the case for greater economic integration. A fiscal union can also be fashioned in such a way that limits moral hazard. But all of this requires leadership, not least from Germany. The fact that the alternative – a series of ever larger and ineffective bail-outs, culminating in far bigger defaults and a systemic banking sector crash – is much worse, ought to focus minds. After all, under that scenario the political glue holding the union together could dissolve altogether.

Simon Tilford is chief economist at the Centre for European Reform.