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Let me stake out more precisely the narrow path that would allow Europe to pass through this minefield. The banking system needs to be guaranteed first, and recapitalised later. Governments cannot afford to recapitalise the banks now; it would leave them with insufficient funds to deal with the sovereign-debt problem. It will cost much less to recapitalise the banks after the crisis has abated and both government bonds and bank shares have returned to more normal levels.
Governments can, however, provide a credible guarantee, given their power to tax. A new, legally binding agreement – not a change to the Lisbon Treaty (which would encounter too many hurdles), but a new agreement – will be needed for the eurozone to mobilise that power, and such an accord will take time to negotiate and ratify. But, in the meantime, governments can call upon the European Central Bank, which the eurozone Member States already fully guarantee on a pro rata basis.
In exchange for a guarantee, the eurozone’s major banks would have to agree to abide by the ECB’s instructions. This is a radical step, but a necessary one under the circumstances. Acting at the behest of the Member States, the ECB has sufficient powers of persuasion: it could close its discount window to the banks, and the governments could seize institutions that refuse to cooperate.
The ECB would then instruct the banks to maintain their credit lines and loan portfolios while strictly monitoring the risks they take for their own account. This would remove one of the two main driving forces of the current market turmoil.
The ECB could deal with the other driving force, the lack of financing for sovereign debt, by lowering its discount rate, encouraging distressed governments to issue treasury bills, and encouraging the banks to subscribe (an idea I owe to Tommaso Padoa-Schioppa). The T-bills could be sold to the ECB at any time, making them tantamount to cash; but, as long as they yield more than deposits with the ECB, the banks would find it advantageous to hold them. Governments could meet their financing needs within agreed limits at very low cost during this emergency period, and the ECB would not violate Article 123 of the Lisbon Treaty.
These measures would be sufficient to calm markets and bring the acute phase of the crisis to an end. Recapitalisation of the banks should wait until then; only the holes created by restructuring the Greek debt would have to be filled immediately. In conformity with Germany’s demand, the additional capital would come first from the market and then from individual governments – and from the European Financial Stability Facility only as a last resort, thereby preserving the EFSF’s firepower.
A new agreement for the eurozone, negotiated in a calmer atmosphere, should not only codify the practices established during the emergency, but also lay the groundwork for an economic-growth strategy. During the emergency period, fiscal retrenchment and austerity are unavoidable; but, in the longer term, the debt burden will become unsustainable without growth – and so will the European Union itself.