The Future of the Euro Area

by Simon Johnson, Peterson Institute for International Economics

August 1, 2012

Summary
  1. Successive plans to restore confidence in the euro area have failed. The market cost of borrowing is at unsustainable levels for euro banks and a significant number of governments.
  2. Two major problems loom over the euro area. First, the introduction of sovereign credit risk has made nations and subsequently banks effectively insolvent unless they receive large-scale bailouts. Second, the ensuing credit crunch has exacerbated difficulties in the real economy, causing Europe's periphery to plunge into recession. This has increased the financing needs of troubled nations well into the future.
  3. With governments reaching their presumed debt limits, the European Central Bank (ECB) is now treading a dangerous path. It feels compelled to provide adequate "liquidity" to avert systemic financial collapse, yet must presumably limit its activities in order to prevent a loss of confidence in the euro—i.e., a change in market and political sentiment that could lead to a rapid breakup of the euro area.
  4. Five measures are needed to enable the euro area to survive: (1) an immediate program to deal with excessive sovereign debt, (2) far more aggressive plans to reduce budget deficits and make peripheral nations "hypercompetitive" in the near future, (3) supportive monetary policy from the ECB, (4) the introduction of mechanisms that credibly achieve medium-term fiscal sustainability, and institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.
  5. Europe's leaders have mainly focused on a potential long-term fiscal agreement, and the ECB under Mario Draghi is setting a more relaxed credit policy; however, the other elements are essentially ignored.

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