It is too much to expect that Europe’s leaders will solve all its problems by close of play next Monday. But we can reasonably hope for agreement on solving one of the three interlocking crises – the banking crisis – and providing plans to start to deal with the other two, currency and debt, that look credible.
Europe has three crises at present: banks that have inadequate capital and sovereign exposures; governments that are heavily indebted and in some cases have little or no chance of repaying that debt; and countries that are so uncompetitive that they are close to or in negative growth territory. These problems are interlocked: solving the competitiveness problems by internal devaluation reduces growth (except in Ireland where exports are more than 100% of GDP) which in turn reduces tax receipts and makes the debt problems worse; devaluing reduces capital adequacy in creditor banks in non-devalued countries; debt write-offs reduce the capital adequacy of banks and worsen the banking crises.
The first task is to shore up the banks. This requires two sets of actions – one at national level and one at EU level. At national level, provision needs to be made to bail out and probably nationalise bust banks. At EU level funding needs to be made available to bail out the bust banks so that they can continue to trade. An agreed plan for this is needed by Monday otherwise we will start to see other banks go the same way as Dexia until the national authorities decide they cannot afford to bail them out at which point there will be a general banking collapse as deposits are withdrawn.
When a system for shoring up the banks is in place, the countries that have major debt problems will have to sort them out.
If this means writing off debt this will have to happen and the funding to support the banks will have to allow for this. Any forecasts of ability to repay need to take account of realistic growth forecasts. Greece, Portugal and Italy probably cannot repay on plausible growth forecasts, Spain and Ireland probably can. Just to quantify this: the stress tests showed that EU banks were likely to be €20.4 billion short of the likely Basel III capital adequacy requirement of 7% Tier 1 capital assuming no sovereign debt writeoffs by 2012. A 50% Greek debt writeoff moves this to €39.8 billion short. Further 50% writeoffs for Italy and Portugal (which would be an extreme assumption, particularly for Italy) would move this to €115.8 billion. But what these calculations do not take account of is knockon effects – typically these multiply the effect by a factor of 3 to 6 times. Funding for the banks needs to be able to take account of these knockon effects, so should allow for up to say €500 billion. Clearly there is no good reason why the solvent economies should pay for the insolvent economies without some guarantee that future solvency is assured by a new treaty setting out fiscal limits. So this will need to be part of the bargain.
There is no appetite to deal with Europe’s currency crisis at present amongst Europe’s leaders. I would prefer the issue to be addressed sooner rather than later, because I do not believe that the European populations can withstand the austerity necessary to make the required adjustments through cutting deficits and achieving internal devaluations. But my view is unlikely to prevail in the short term although the currency issue will have to be addressed eventually and if the leaders fail to address the problem the markets will do it for them and possibly not in the ways that they would prefer.
Sorting this will require German leadership. The problems are exacerbated by the French pretending they are part of the solution – they are not, in fact France is part of the problem. The problems are also being exacerbated by the French and Germans trying to impose taxes on Britain through their foreign exchange transaction tax proposal. This is an extreme form of diversion therapy and if pushed too far would probably cause the UK to leave the EU. The disruption caused by this would certainly break the euro.
I don’t think this is enough to claim a £250,000 prize (helpfully denominated in sterling). But if the European leaders follow our advice they may be making a start to sort out their problems.