The European Crisis

The world's financial markets are currently swaying to and fro on a daily basis in reaction to every twitch and whisper of key Euro leaders with respect to the European fiscal crisis, in the PIGS, but also Italy and even Belgium. What is the issue and solution?

The issue is that Greece is heavily indebted beyond its ability to repay its government bonds. But a default would create ripples throughout Europe, especially among European banks that hold Greek debt. The write off of Greek debt that would be required would jeopardize their capital ratios. But more broadly, it would create a market perception of likely default by other heavily indebted nations, first Portugal, and then Ireland. These are all small countries on the periphery of Europe, both economically and geographically. But if this perception were to spread (called "contagion") to larger heavily indebted countries, especially Spain and Italy, then the economic disruption, and the threat to the Global banking system, not just European banks, would be far greater.

What should be done? Many commentators casually suggest that this is the end of the EU. I think this is a superficial and foolish analysis. The heart of the EU is the Franco-German alliance, and neither of these countries is going to abandon the EU very easily. Why? Because it is in their respective economic and financial interest for the EU to survive. There is a deep psychological thread in the German psyche dating back to its creation in 1870 of being isolated in Europe between enemies (Russia and France). The EU has created the longest period of peace in Europe for centuries. As a result, the Germans will work to preserve the EU unless it becomes prohibitively expensive for them. Of course, the French want to be in the EU because it strengthens their trade relations with the member states, and protects them from more competitive markets in Asia, and even the US. Add in the historic trading partners of each, The Netherlands, Belgium and Luxembourg, and this core of Europe accounts for over 50% of EU GDP.

Similarly, this core group is going to fight to retain the Euro which has brought great economic and financial advantages to them as exporting countries with heavy manufacturing bases. The Euro has become one of the leading currencies in the world and a counterweight to the US$. This was impossible when each country had a separate currency. Again, France and Germany, see the Euro as very much in their respective interests, for slightly different reasons, but will fight for its survival.

What is the solution to the Crisis? There are three problems that have to be addressed, and they are interlinked.
1. Ring fence Greece so that a default is either impossible, or the Euro banks are protected via a Euro-TARP with respect to capital ratios. This has to be definite and certain. If Greece defaults, then simultaneously, the EU will have to announce step 2 to halt any further deterioration in credit in the Eurozone. Currently there is too much uncertainty about the likelihood of a default and the likelihood of a ECB rescue plan. These risks have to be taken off the table.
2. Some method of funding the other crises in Europe, including Portugal, and Ireland. The chance of default of these countries MUST BE RULED OUT ONCE AND FOR ALL. The message to the financial markets must be: IT STOPS HERE. For example, all financing after a Greek default could be made through Eurobonds and not national bonds.
3. Some method of controlling future deficits within the EU. For instance, a council of finance ministers that monitors sovereign budgets and uses its persuasive power to insure that future deficits are within a range of reason.