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Some tough love for the eurozone leaders

Merkel | Some tough love for the eurozone leaders Morningstar

European sovereign debt solutions are on everybody's lips, with last week's papers filled with everything, including paparazzi reports about how Angela Merkel's breakfast choices could provide an insight into the next move of the world economy. Is an effective final deal not far away or will the whole thing fall apart like soggy Weetabix?

The level of scrutiny surrounding the bail-out plan is not completely unwarranted. The sovereign debt crisis is very real, and it has the potential to bring the global financial system to its knees again. A failure to act to stem the problem will have real consequences for the economy and, therefore, on earnings for companies around the world. So it makes sense that stocks would sell-off if a solution doesn't look close by.

Europe needs to come up with a realistic and flexible plan to mitigate this crisis very soon. Every day that goes by without a solution is just making the problem harder to solve. If investors get too skittish, the rumors and worries about a financial collapse will become a reality.

The substance of the plan is going to be critically important. In order for any proposed solution to work, it needs to acknowledge a few basic facts.

Greece Is Broke

As I've written about before, Greece's liabilities far exceed an amount that the country will ever be able to pay back. Any serious plan must involve a major haircut for current Greek bondholders; they are not going to be paid back 100 cents on the dollar. Any plan that assumes that Greece is solvent, or that the solution is just a matter of providing a short-term liquidity cushion, is delusional.

No amount of austerity measures is going to suddenly produce enough revenue to pay back debtholders. Even after the cuts already made, Greece still has a primary budget deficit. This means that the debt load is actually still growing, not shrinking. And, as the protests in Greece indicate, it's going to be challenging to keep social order and make cuts significantly deeper than those already planned. It's nearly impossible to turn a country on a dime; promises have been made to retirees and current workers that will be hard to walk back on.

By setting clear terms of the default and firmly backing the remaining debt, the European community may be able to build a wall around Greece, stop the contagion from spreading, and keep the common currency together.

Banks Need More Capital

My colleague Erin Davis looked earlier this week at the capital positions of the major European banks. She found that on some measures the banks look adequately capitalized, but that upon closer inspection many of the large European banks are in less-than-ideal positions. Even with a "polite" default of Greek debt, the banks are going to need support to stay upright. If the crisis is allowed to threaten banks and spurs bank runs, the problem could become even more intractable.

Now, of course, bailing out banks and helping boost capital levels won't be a tremendously popular decision, but without strong banks it will be almost impossible to solve the debt problem and keep the crisis from spilling over into every sector of the economy.

It Is Going to be Fantastically Expensive

This is not going to be a cheap project. Greece will likely still need aid even after a default, banks will need more capital, and other European nations may need an insurance fund to stabilize their bond markets. None of this comes cheap. It will almost certainly overwhelm the 440 million euros already allocated for the European Financial Stability Facility. Now, I don't know exactly how much higher the final tally will go, but the core European countries need to accept that they are going to need to foot a very expensive bill if they want to save the periphery. The rumor this week that the fund would expand to 2 trillion euros is a step in the right direction on that front.

Long-Term Thinking Is Needed

Rebooting the bail-out is also a good time to begin to address some of the structural problems that got us into this mess in the first place.

The underlying cause of much of the trouble is that every nation in the eurozone set its own fiscal policy while monetary policy is administered by a central authority. This made it very hard to create a monetary policy that was acceptable for all of the economies. Low rates may have been perfect for Germany, but they spelled ruin for Greece. In order to keep these imbalances from re-emerging, the EU is going to need to take a more aggressive role in policing how much each of the member states is spending. The toothless stability pact that was signed when the euro was introduced will need to be scrapped and replaced with something that has real penalties for running too large of a budget deficit.

On that note, the leaders would also be wise to revisit the concept of Eurobonds. Eurobonds are sovereign debt instruments that have the explicit backing of eurozone members. These bonds are very unpopular politically, but they have the advantage of removing the differential between the credit-worthiness of the strongest members of the zone and the weakest. This shared burden, coupled with tighter fiscal reforms, would keep this issue from ever popping up again.

The Plan Must Be Flexible

This crisis is fluid and likely has a few tricks up its sleeves. Any plan the community puts together will need to have the flexibility to rapidly respond to the changing situation without needing to get the sign-off from every eurozone government. Just like the purpose of TARP changed several times during the financial crisis in the United States, the EFSF will likely need to adapt a few times to stem the crisis for good. I'll be very skeptical of any plan that proposes to be the be-all and end-all and has little scope to deviate from its initial plan.

The next few weeks will be pivotal in determining if Europe has the political will to take the bold steps it needs to. If they can acknowledge their problems, then it's not too late to keep the crisis from escalating further.


This article was written by markets editor Bearemy Glaser and originally published on Morningstar under the title: 5 Hard Truths the Eurozone Deal Must Address.

Tags: Angela Merkel , bail out , bail outs , bailout , Bearemy Glaser , deficit , EFSF , Erin Davies , euro bond , eurobonds , european debt crisis , European Financial Stability Facility , eurozone , Greece bail-out , Greece default , Greek bail-out , liquidity cushion , Morningstar , sovereign debt , TARP , Troubled Asset Relief Program , Weetabix
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