David Cameron, the UK prime minister, has called on eurozone leaders to adopt a “big bazooka” approach to their woes. Barack Obama, US president, spoke to Nicolas Sarkozy, president of France, after the latter’s weekend meeting with Angela Merkel, Germany’s chancellor, to press for action. Herman Van Rompuy, the European Council president, has promised that leaders of the European Union would meet on October 23 to “finalise our comprehensive strategy”. That would allow the Europeans to present a plan for restoring confidence to the summit of the Group of 20 leading economies in November.

So should we feel confident that the crisis will soon be over? No.

At least, nobody now sees the eurozone crisis as a little local difficulty. It has become the epicentre of an aftershock of the global financial crisis that could prove even more destructive than the initial earthquake. Potentially, it is a triple shock: a financial crisis; a crisis of sovereigns, including Italy, the world’s third largest sovereign debtor; and a crisis of the European project with unknowable political consequences. It is no wonder people are frightened. They ought to be.

A straw in the wind of the rising anxiety is that credit default swaps on the eurozone’s most creditworthy large sovereigns, France and Germany, have begun to rise (see chart). Astonishingly, Germany’s spread is a fraction higher than the UK’s. This must reflect concern that bailing out weaker eurozone members might become an excessive burden. My standing view is that Germany will do whatever it can to keep the eurozone functioning, provided it does not threaten its own solvency. As Hans-Werner Sinn of the CESifo institute in Munich notes, this threat seems to be closer.*

Against this fearsome background, what should (and can) the eurozone do? The most important part of the answer, as I argued last week, is that it must deal with the immediate crisis in ways that also help resolve the longer-term challenges.

The broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following: divide countries in difficulties into the insolvent and the illiquid; restructure the debts of the former and provide unlimited, but temporary, support for the latter; and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011.

Achieving this package will stretch the eurozone’s inter-governmental decision-making to (and quite possibly beyond) breaking point. The French government, for example, remains unwilling to accept that its banks need more capital. Above everything, the eurozone does not have a central bank willing to ensure liquidity in the market for sovereign domestic currency debt at all times. This is partly because doing so conflicts with Bundesbank ideology. But it is also because it would provide a blank cheque to irresponsible members, ultimately bringing down the euro, just as the rouble zone collapsed in the 1990s.

My concern is deeper: these ideas, albeit now necessary, deal with the symptoms of what has gone wrong, not the underlying causes.

As I have long argued, at bottom this is far more a balance of payments crisis rooted in financial sector misbehaviour and cumulative divergence in competitiveness, than a fiscal crisis. The architects of the eurozone thought that balance of payments crises were impossible in a currency union. They were wrong. In the absence of automatic cross-border financing, an unfinanceable external deficit will emerge as a domestic credit crisis. Then, even currency risk will return if the union is among largely sovereign states.

It is not the case that the countries in difficulties had irresponsible fiscal policy before the crisis. Greece did. Arguably, Italy did, given its huge debt overhang. But Ireland and Spain had fiscal surpluses and negligible net public debt: Ireland’s net public debt was 12 per cent of gross domestic product in 2006, while Spain’s was 31 per cent, far below France’s 60 per cent and Germany’s 53 per cent. Even Portugal’s net debt was 59 per cent of GDP.

What the vulnerable countries shared was reliance on foreign lending, to finance either private or government deficits (see chart). When the external finance dried up, economies contracted. Where the private sector had done the borrowing (as in Ireland and Spain), the bursting of the asset bubble caused a huge surge in fiscal deficits. When the public sector had done the borrowing (as in Greece), the fiscal deficit rose still further.

Wolf charts

What could and, in the original design of the eurozone, should have happened was no financing, a huge depression, falling nominal wages, mass defaults and, after years of devastation, recovery. This would have been adjustment without financing. What did happen was financing with quite limited true adjustment, through ECB funding of dubiously solvent banks and via lending from other governments and the International Monetary Fund, for Greece, Ireland and Portugal.

Of the crisis-affected member countries Ireland has had a uniquely successful adjustment, with a huge depreciation of unit labour costs and a massive adjustment in the external balance. But, in general, as Prof Sinn notes, there has been a mixture of financing with recession. The huge challenge is to make managing the crisis compatible with adjustment.

Critics such as Prof Sinn focus on the risk that excessive financing will undermine, if not destroy, incentives to adjust. Yet there is an opposing risk, that forcing adjustment on the weak will fail, because of a lack of offsetting adjustment in the strong. That would not be a huge problem if those forced to adjust are small. It is a vast problem if they are large. The risk is of a downward spiral as austerity is exported and re-exported.

No doubt, a way must be found to deal with the immediate crisis that does not allow another panic. But that would not be a solution if it merely led to indefinite financing of fundamentally uncompetitive economies. At the same time, one-sided and unduly hasty adjustment would exacerbate the downturns in the eurozone and world economies. What is needed is financing and adjustment. Unless and until that difficult combination is achieved, we are delivering first aid not a cure.

* How to Rescue the Euro, October 3 2011, www.voxeu.org

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