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What makes this process particularly frightening is that weaker sovereigns are unable to cope on their own, while the eurozone has nobody in charge. The eurozone may lack the capacity to address the crisis.
The underlying danger is laid out in the latest global financial stability report from the IMF. This is surveillance at its best: clear, compelling, courageous. So what is the message? It is contained in two sentences: “Nearly half of the €6,500 billion stock of government debt issued by euro area governments is showing signs of heightened credit risk”; and, “As a result, banks that have substantial amounts of more risky and volatile sovereign debt have faced considerable strains in markets.”
In the course of October, the eurozone should (with luck) have ratified the modified European Financial Stability Fund, worth €440 billion. The EFSF would then be able to inject capital into banks and purchase bonds of distressed governments on the open market. But this fund is far too small. The eurozone needs a much bigger bazooka. But if action needs to be immediate, as it does, the only entity able to supply the needed funds is the central bank.
Would this work? My answer to this question has seven parts. First, if agreement were reached on action on the necessary scale, it should halt the panic. Second, it may be impossible to obtain such consent, particularly if funding relied heavily on the ECB, at least in the short run.
Third, once banks and sovereigns become heavily dependent on official finance, they may find it quite hard to return to the market. Fourth, such actions cannot solve the deeper difficulty that currently uncompetitive countries will need a sizeable inflow of external funds for a very long time, little of which is likely to come from the now fearful private sector.
Fifth, it is likely that after such a rescue, the imprudent will just go back to their bad old ways, making further rescues necessary. Sixth, internal transfers can be halted only if there is adjustment inside the eurozone, including by the surplus countries, of which there is little sign. Thus the eurozone risks turning into an illegitimate transfer union. Finally, there is a danger that an ambitious programme would degrade the standing of the soundest eurozone sovereigns, though a collapse might do almost as much damage to their ratings.
No good choices remain. The risks involved in the proposed actions are big. But the alternative of financial collapses and sovereign debt crises that ricochet across the globe is vastly worse.
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