di Guido Tabellini

What has to be done to prevent the Greek crisis from sweeping aside the single currency? This will be the key question in today’s informal meeting of heads of state and government in Brussels. The summit will allow for progress only if it takes note of two aspects of the current economic reality.

First, the ECB’s three-year program of loans to European central banks, while necessary to ease the banks’ liquidity crunch, has been inadequate for restoring confidence. The reason was clear from the beginning. The euro’s crisis is, first of all, a sovereign debt crisis. Pressuring banks into using the ECB’s financing to buy their country’s public debt, as has happened in Italy and Spain, is counterproductive: on one side it increases the banking system’s fragility and on the other it does not resolve the real economy’s credit crunch.

Second, as time passes, rather than improving, the crisis of confidence worsens. Initially, there was hope that time would act as an ally: with more time available, the economies of southern Europe could have implemented the necessary reforms and could have regained credibility. The countries have begun carrying out the reforms (even if they are still insufficient), but at the same time we have witnessed the re-nationalization of the European financial system. This worsens the crisis. As the financial integration of the member countries of the euro zone reverses, the costs of abandoning the single currency decrease. Regardless of the reforms, with every passing day the euro zone increasingly resembles a fixed exchange rate system on the brink of collapse, rather than a system that is held up by a single currency.

Taking note of the existing reality is a necessary step for planning an exit from the crisis. From a technical point of view, we’re don’t lack the required instruments. The essential moves are well-known and have been repeatedly underlined in the European debate.

First off, it is necessary to put a stop to the negative spiral with which the depression aggravates public balances and with which fiscal austerity exacerbates the depression. This means supporting the aggregate demand of the southern European member states so as to exit a classical Keynesian depression caused by a lack of “effective demand.” More than stimulating public investments (in Spain and in Portugal there have been excessive investments in infrastructure), as already stated by previous European agreements, it is necessary to avoid retrieving any externalities from the budget objectives due to the negative economic context and to expedite payments to the public sector to loosen the credit crunch. But the most important role is reliant on monetary policy, which also has to influence future expectations. The ECB should bring the interest rate down to zero, so as to indicate in both words and actions that its long-term monetary policy will be expansive, that inflation is the last of our worries and that, considering the present circumstances, a weaker euro is more than justified.

Secondly, the connection between the sovereign debt crisis and the banking crisis of the southern European countries has to be severed. This calls for action on two fronts. On one side, the effects of the banking crisis should not endanger the public balances of the single countries, as has happened in Ireland and is happening in Spain. Thus, we should step on the gas in recapitalizing banks through the direct use of the European Stability Mechanism and in creating an insurance system on deposits financed through the use of European source and under the direct supervision of European authorities. On the other side, the sovereign debt crisis should not dig into the banks’ balances, as is happening in Spain and Italy. This objective can be reached in the short term only through monetary policy. The ECB has to announce an extensive plan to buy the public debt of the most endangered countries (especially Spain and Italy because, for the time being, Portugal and Ireland do not have to recur to the market to finance themselves). To avoid concentrating the entire credit risk onto the remaining government bonds, the ECB should also clarify that it does not intend to exercise its secured creditor status. The acknowledgement that the countries of the euro zone can make use of a lender of last resort, similar to what happens in extreme cases in other advanced countries, would be of enormous help in restoring confidence in the southern countries.

An independent central bank such as the ECB does not only have the ability, but may have the moral duty, to do what it can to prevent the crisis of confidence from sweeping aside the single currency. It is, however, clear that these actions would entail a redistribution of risks and resources among the single countries, which would go far beyond what was agreed upon at the time of the birth of the euro. They would, however, be accompanied by a new project that would involve an effective political integration, not just an economic one.

It is difficult to discern if Europe is ready for such a delicate step. The majority of skeptics would be correct in pointing out that Europe has already moved too quickly once in the past, when it created the single currency without understanding all the implications of what it was doing. Now it is on the verge of taking a second, bigger leap forward in an even greater rush.

What we can do is say that this step is unavoidable, unless we want to drop the single currency. If we are not willing to face the issue now, we will be forced to do so in a couple of months, when the economic context will have worsened.

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