Europe’s Triple Threat

PALO ALTO – Europe is suffering from simultaneous sovereign-debt, banking, and currency crises. Severe economic distress and political pressure are buffeting relationships among citizens, sovereign states, and supranational institutions such as the European Central Bank. Calls are rampant for surrendering fiscal sovereignty; for dramatic recapitalization of the financially vulnerable banking system; and/or for Greece and possibly other distressed eurozone members to quit the euro (or for establishing an interim two-tier monetary union).

In this combustible environment, policymakers are desperately using various vehicles – including the ECB, the International Monetary Fund, and the European Financial Stability Facility – in an attempt to stem the financial panic, contagion, and risk of recession. But are officials going about it in the right way?

The sovereign debt, banking, and euro crises are closely connected. Given their large, battered holdings of peripheral eurozone countries’ sovereign debt, many of Europe’s thinly capitalized banks would be insolvent if their assets were marked to market. Their deleveraging inhibits economic recovery. And the large fiscal adjustment necessary for Greece, Ireland, and Portugal, if not Italy and Spain, will be economically and socially disruptive. Default likely would be accompanied by severe economic contraction – Argentina’s GDP fell 15% after it defaulted in 2002.

Despite stress tests, bailout funds, and continual meetings, a permanent workable fix has so far eluded European policymakers. Failure will erect a huge obstacle to European economic growth for years to come, and could threaten the survival of the euro itself. Disagreement among and between heads of state and the ECB over the Bank’s purchases of distressed sovereign debt have only added to the uncertainty.