Hugo Dixon

The break-up of the euro would be a multi-trillion euro catastrophe. An interest subsidy costing around 50 billion euros over seven years could help save it.

The immediate problem is that Spain’s and Italy’s borrowing costs - 6.3 percent and 5.8 percent respectively for 10-year money - have reached a level where investors are losing confidence in the sustainability of the countries’ finances. A vicious spiral - involving capital flight, lack of investment and recession – is under way.

Ideally, this week’s euro summit would come up with a solution. The snag is that most of the popular ideas for cutting these countries’ borrowing costs have been blocked by Germany, the European Central Bank or both.

Take euro bonds, under which euro zone countries would collectively guarantee each others’ debts. They would allow weak countries to borrow more cheaply. But Germany won’t stand behind other countries’ borrowings unless they agree to a tight fiscal and political union which prevents them racking up excess debts in future. Such a loss of sovereignty France, for one, will find hard to swallow.

Or look at pleas for the ECB to buy Italian and Spanish government bonds in the market. That too would cut their borrowing costs – for a while. But when the bond-buying ends, the yields would just jump up again. Private creditors would merely use the opportunity to offload their bonds onto the public sector. The ECB has already spent 220 billion euros buying sovereign debt with no lasting impact, and is reluctant to do more.

Italy’s idea that the euro zone’s bailout funds should buy bonds in the market has the same drawbacks. What’s more, the bailout funds only have 500 billion euros left. If they use their firepower to bail out private creditors, they will not have enough to fund governments. Giving the bailout funds banking licences and allowing them to borrow from the ECB would solve that problem. Unfortunately, both Germany and the ECB are against the idea.

But what about a direct interest subsidy? Core countries - such as Germany and France – could pay into a pool an amount that depended on how much their cost of funding was below the euro zone’s average. Peripheral countries – such as Italy and Spain – would then take a sum out of the pool depending on how much their cost of funding was above the average.

The idea recently surfaced in an article by Ivo Arnold, programme director of the Erasmus School of Economics in Rotterdam. It has also been touted by Pablo Diaz de Rabago, economics professor at the IE Business School in Madrid. But it has not yet had much oxygen.

Under such a scheme, the final cost of funds paid by all countries could be equalised or just narrowed. The key questions are: would it work, would it be politically acceptable and is it legal?

First, look at workability. An interest subsidy would help the peripheral countries in two ways. They would benefit from cash payments from the core. But the yield they pay on their own bonds would also drop as worries about the sustainability of their finances eased.

The yields on core bonds, by contrast, would rise. Investors would be worried that Germany and others were shouldering part of the burden of bailing out their neighbours. What’s more, some of money that has rushed into German bonds in recent years would flood out. But, in a sense, this would just be giving back to the periphery a windfall Berlin has enjoyed as investors have panicked over the possibility of a euro collapse.

My colleague Neil Unmack and I have crunched the numbers. Suppose the yield on Spanish and Italian bonds fell by one percentage point as a result of the scheme, and that the yield on the bonds of core countries rose by 50 basis points.

Also assume that core countries were willing to make up half the remaining difference between their interest rates and those in the periphery. That would limit the scale of the subsidy while maintaining pressure on peripheral countries to reform. In this scenario, Spain’s cost of borrowing for 10 years would drop to 4.4 percent, while Italy’s would drop to 4.1 percent – no longer worrying levels.

Now look at political acceptability. The interest subsidy would start off being cheap. On the above assumptions, the first year cost would be only 1.9 billion euros, about 60 percent provided by Germany. Each year, of course, the cost would mount, as countries added new debt to the scheme. But the cumulative cost over the first seven years would still be a manageable 53 billion euros.

The core wouldn’t have to guarantee the periphery’s debt. And subsidies could be provided one year at a time. So if a country didn’t keep up with its reform programme, it could be kicked off the scheme. What’s more, if markets settled down, the operation could be wound down.

Such limitations mean the scheme would be unlikely to fall foul of the German Constitution or the no bailout clause in the EU treaty. Of course, investors may not be convinced that the safety net is strong enough. So it wouldn’t remove the need for Europe’s leaders to come up with a credible long-term vision as well as continue with their reforms. But interest subsidies are still a reasonably cheap and practical answer to the zone’s most pressing problem.

Some European policymakers are talking about a “banking union” for the euro zone as if it was around the corner. Jose Manuel Barroso, the European Commission president, for example, told the Financial Times last week that such a union – which would involve euro-wide supervision, bailouts and deposit insurance for the banking industry – could be achieved next year.

But this is not remotely likely. Parts of the zone’s banking industry are so rotten that taxpayers elsewhere can’t reasonably be asked to bear the burden of bailing them out. A massive cleanup is required first. The crisis in Greece, Spain and other countries may provide the impetus. But even then, as Germany suggests, banking union should proceed in stages.

The appeal of a euro zone banking union is understandable. Governments and lenders are currently roped together in what has been dubbed the sovereign-bank doom loop. Weak banks – for example those in Spain, Ireland and Cyprus – can drag down their governments when they need a bailout. Equally, weak governments, such as Greece’s, can drag down their banks when those are stuffed with their own sovereigns’ bonds. By shifting responsibility for bailouts to the euro zone as a whole, the loop could be cut. Or, at least, that is the hope.

The snag is that banks and their governments are entangled in a tight incestuous relationship. Some of Spain’s cajas, for example, made dubious loans to their directors, as well as financing politicians’ pet projects. And the ex-chairman of Bankia, which has required the mother of all bailouts, was a former finance minister. Conflicts of interest have also been rife in Ireland, Cyprus and Greece. Even supposedly virtuous Germany has suffered from incompetent Landesbanken, controlled by regional governments, whose boards are filled with political appointees.

Bank boards were often useless or worse. But the national supervisors who should have spotted the problems were not much better. And Europe’s initial attempts at cross-border banking supervision have been pathetic. A European-wide stress test in 2010 didn’t even bother to examine Anglo Irish, a cesspit of bad property loans which virtually bankrupted Dublin. Another test in July 2011 concluded that Spain’s banks were only 1.6 billion euros short of capital. Then another last October bumped the number up to 26 billion euros – but didn’t stress the lenders’ property loans. Finally, last weekend’s bailout came up with a hopefully more realistic figure: up to 100 billion euros.

Governments have given the European Banking Authority (EBA) inadequate authority to overrule national supervisors. Meanwhile, the domestic authorities always have an incentive to downplay the capital needs of their banks. So long as lenders are pronounced solvent, they can get liquidity from the European Central Bank. That way, governments can delay putting in any of their own money to bail out their domestic lenders.

Part of the “doom loop” involves banks stocking up on sovereign debt. That link has grown tighter in Italy and Spain in recent months as foreigners have stopped buying bonds, leaving domestic lenders to step into the breach. They got the money from the ECB. If governments really surrendered control of their banks to a tough supranational agency, it would be harder to engineer such a money-go-round.

Yet another problem is that governments are reluctant to inflict losses on bondholders. In Bankia’s case, there were an estimated 12 billion euros of subordinated debt and 8 billion euros of senior debt – or 20 billion euros in total. These have not suffered losses as part of the bailout. But unless there are haircuts for a bank’s own bondholders, is it reasonable to ask the taxpayers of a foreign country to fork out cash to bail out banks and their depositors?

All this means that for banking union to work effectively, there needs to be effective supervision as well as a system to bail in bondholders. Everyone agrees on this. The real debate is largely one of timing. The peripheral countries want a euro-wide system of bailouts and deposit insurance fast, as an answer to the current crisis. Germany is stressing the need to start with supervision.

Berlin is right that the clean-up has to come first. That may, of course, be accelerated by the crisis. Spain’s banking bailout gives the rest of the euro zone a golden opportunity to insist that its system of crony finance is swept away. The same goes for Cyprus, a haven for recycling dubious money from Russia and elsewhere, if it requires a bailout.

But the euro zone will also need to determine who will supervise banks. The EBA is a busted flush. So it would be best way to empower an institution that has credibility. The obvious candidate is the ECB – an idea Germany’s Angela Merkel backed last week. But even that could be problematic: giving the ECB responsibility for supervision as well as monetary policy would concentrate a huge amount of power in a single body. Even it might struggle to monitor banks over such a vast area.

Then, of course, a system for bailing in bondholders needs to be crafted. Although the European Commission this month proposed a plan, it is not supposed to kick in until 2018. Finally, there is the question of how governments in trouble will finance their debts if they can no longer lean on their banks. Nobody yet has a good answer to this.

The banking union train may be about to leave the station. But it will take years to reach its destination.

Odysseus would recognise the dilemma faced by today’s Greeks as they must choose either the pain of sticking with the euro or the chaos of bringing back the drachma. The Homeric hero had to steer his ship between the six-headed sea monster, Scylla, and the whirlpool, Charybdis. Avoiding both was impossible. Odysseus chose the sea monster, each of whose heads gobbled up a member of his crew. He judged it was not as bad as having the whole ship sucked into the whirlpool.

As Greece heads to the polls on June 17 for the second time in just over a month, none of the options it faces are attractive. The economy has shrunk about 15 percent from its 2008 peak, unemployment stands at 22 percent and further austerity and reform are required as part of the euro zone/IMF bailout. But the lesser of two evils is staying the course.

Some of this misery was inevitable. Greece’s current account and fiscal deficits each reached around 15 percent of GDP in 2008 and 2009, and had to be cut. But successive Greek governments have managed to make the situation worse than it needed to be.

When Odysseus had to pass by the sea monster, he told his crew to row as fast as possible and not stop. That way, each of Scylla’s heads only had time to munch one man.

By contrast, today’s Greeks have dawdled. Confidence in the country and its political class is shot to bits, both at home and abroad. Capital is fleeing, investment has vanished and tax-dodging has become even worse than it was – which is saying a lot. The government isn’t paying its bills, nor are many companies. As a result, Scylla keeps gobbling up more men.

Terrible as things are, the current situation is not hopeless. The budget deficit, before interest payments, declined by 9 percentage points of GDP in 2010-2011. The economy is also getting more competitive: unit labour costs, which shot up vis-a-vis Greece’s euro zone partners in the first decade of the single currency, had by the end of last year recouped half the lost ground. They will have fallen further since the minimum wage was slashed earlier this year.

What is now needed is a strong government. It should embark on three main tasks. First, continue the reform programme, and get serious at last on fighting tax evasion. Second, negotiate with the euro zone/IMF a longer period to eliminate its budget deficit and secure investment to boost short-term growth. Third, negotiate another debt reduction plan.

If such a government were formed, confidence could gradually return and the economy could stop shrinking. The experience of the Baltic countries – Latvia, Lithuania and Estonia – shows such reforms can work. After the credit crunch crisis, GDP in the three countries fell by between 15 and 21 percent but has since partly recovered.

But wouldn’t going back to the drachma be better? Some commentators point to countries like Iceland, which restored its competitiveness by a massive devaluation following the credit crunch and only suffered an 11 percent fall in GDP. Wouldn’t devaluation be a quicker and less painful way for Greece to get back in shape?

The answer is no – for two reasons. First, the dislocation caused by bringing in a new currency would be much more severe than devaluing a currency that already exists. The banks would temporarily run out of cash and there would be multiple legal disputes over who owes what, which could gum up the economy for years.

Second, Greece is receiving an extraordinary amount of cheap money as part of its second bailout plan: 130 billion euros, or 88 percent of GDP. This gives it time to cut its twin deficits. If Athens left the euro, it would be lucky to get a fraction of that cash. The country would then have to balance its books immediately.

An even harsher fiscal squeeze would exacerbate the vicious spiral. The alternative would be to print drachmas to fill the hole in the budget. But such monetary financing would lead to rapidly rising inflation, which would already have been given a boost by the devaluation. Lucas Papademos, the country’s former technocratic prime minister, predicted last week that inflation could reach 30-50 percent in such a scenario.

Meanwhile, Greece is hugely dependent on imports not just for final consumption but also to keep its economy going. It imports oil, medicine, food. If it had to slash imports suddenly, industry would grind to a halt. Even tourism, the mainstay of its economy, which accounts for 16.5 percent of GDP, could suffer if hotels promising a five-star experience delivered a three-star one. GDP might fall another 20 percent, according to Papademos.

Social unrest would worsen, with street battles, attacks on immigrants, vigilante law enforcement and major strikes. That would further deter the tourists. It would also make it harder to put together a sensible government. The field would be open for populists and extremists. This way leads to Charybdis.

To avoid this menace, the electorate will need to give a strong leader the mandate to pursue the current course more vigorously. Unfortunately, neither of the front runners in next Sunday’s election – conservative Antonis Samaras and radical leftist Alexis Tsipras – is a modern-day Odysseus. And neither looks able to secure a decisive win. Unless a third election can produce a better outcome, the drachma will probably return, and the Greeks will get sucked into the whirlpool.

The euro zone crisis is a multi-dimensional game of chicken. There isn’t just a standoff between the zone’s core and its periphery; there is also one between the European Central Bank and the euro zone governments over who should rescue the single currency. In such games somebody usually blinks. But if nobody does, the consequences will be terrible.

The brinkmanship between the governments is over how much help the northerners, led by Germany, should give the southerners. The core is effectively threatening the peripheral countries with bankruptcy if they don’t cut their deficits and reform their economies. The periphery is saying that, if they collapse, so will the entire single currency which has been so beneficial to Germany’s economy. The game is being played out transparently in Greece and covertly in Spain.

But even if the core eventually decides to help the periphery, there is a struggle of whether the aid should come from governments or from the ECB. Politicians would like the central bank to do the heavy lifting to avoid having to confront taxpayers with an explicit bill. But the ECB doesn’t think it is its job to help governments, arguing that such support violates the Maastricht Treaty.

This standoff is making it hard to devise a Plan B to cope with what is now a clear and present danger: an explosion in the euro zone.

Look at the most immediate problem: what to do if the “jog” out of Greek bank accounts accelerates into a run. The ECB’s exposure to Greek banks is about 125 billion euros – through a combination of its normal liquidity operations and emergency liquidity assistance (ELA) provided by Greece’s central bank.

The Bundesbank, Germany’s hard-line central bank, says the eurosystem, the collection of national central banks, shouldn’t increase its risk level in Greece. Instead, it wants governments to guarantee any further liquidity injections. But the politicians don’t want to face that issue, at least until Greek voters have given a clear answer over whether they want to stay in the euro.

The snag is that the June 17 election may not provide a clear answer and that might provoke a bank run. At the moment, there isn’t a plan of how to respond. Would the ECB blink and authorise extra ELA – in which case it would look remarkably silly if Greece then quit the euro and the central bank faced massive extra losses on its exposure? Or would it shut off the tap – in which case cash withdrawals from Greek ATMs would have to be rationed, quite possibly provoking panics elsewhere?

The difficulty coming up with contingency plans goes beyond Greece. What, for example, should be done if bank runs do spread to other countries such as Spain and Italy? Mario Draghi, the ECB’s president, last week gave what might seem like a reassuring comment to the European Parliament, saying: “We have all the means to cope with this as far as solvent banks are concerned”. What he didn’t spell out, though, is how the ECB would react if there were runs on insolvent lenders.

There would probably be brinkmanship. The ECB would argue that it was the governments’ job to recapitalise their banks. The politicians would try to avoid injecting taxpayers’ money into their lenders, not least because the governments don’t have the cash. The ECB would then probably say the governments should borrow money from the European Stability Mechanism (ESM), the euro zone bailout fund.

The politicians might come up with inventive schemes, such as giving their banks IOUs which could then be swapped with their own national central banks for ELA. That fudge was used two years ago to recapitalise Ireland’s banks – and Spain was originally toying with a variation on the theme to shore up Bankia. But the ECB doesn’t like it, not least because ELA is supposed to be only temporary.

On the other hand, if neither side blinked, some banks could collapse – triggering runs even among solid ones.

Yet another weakness in the euro’s defences is what to do if investors refuse to buy Spanish and Italian government debt. Madrid, for one, wants the ECB to step in with massive purchases of its bonds through what is known as the securities markets programme. The central bank, though, thinks it should do this only to a limited extent and that if a government needs cash, the relief should come from the ESM, that is from the other governments.

The snag is that the bailout fund doesn’t have enough money to rescue both Madrid and Rome. That’s why France and other countries have argued that it should be allowed to borrow money from the ECB – back to the central bank again. But Draghi has rejected that idea, saying that it would constitute “monetary financing” – or bailing out governments by printing cash – which is forbidden by the Maastricht Treaty. Others argue that the legal position isn’t so clear.

Either way, another potential standoff is being set up. If Italy lost access to the markets and the ECB didn’t blink, then Rome would have to turn to extreme measures: force its citizens to buy bonds, suspend debt repayments or something else. That would be a pretty hairy moment, which might spell the end of the single currency.

Of course, all hell might not break loose. And, if it does, some clever compromises might be found. But multi-dimensional chicken certainly heightens the risks.

Greece needs to go to the brink. Only then will the people back a government that can pursue the tough programme needed to turn the country around. To get to that point, bailout cash for both the government and the banks probably has to be turned off.

It might be thought that the country is already on the edge of the abyss. This month’s election savaged the two traditional ruling parties which were backing the bailout plan that is keeping the country afloat. Extremists of both right and left gained strength – voters liked their opposition to the plan. But nobody could form a government. Hence, there will be a second election on June 17.

Will this second election express the Greeks’ desire clearly: stick with the programme and stay in the euro; or tear up the plan and bring back the drachma? That is how Greece’s financial backers in the rest of the euro zone, such as Germany, are trying to frame the debate. But the electorate doesn’t yet see the choice as that stark. Roughly three quarters want to stay with the euro but two thirds don’t want the reform-plus-austerity programme.

The next election is unlikely to resolve this inconsistency – or at least that is the conclusion I came to from a trip to Athens last week. The battle for first place is between Alexis Tsipras, the young leader of the radical left SYRIZA party, and the centre-right New Democracy party led by Antonis Samaras.

A victory for Samaras might seem to offer the hope that Greece will stick with the programme and the euro. He has, after all, campaigned for both. However, even if he comes first – which he did in this month’s election – he will not have a parliamentary majority. He will either have to stitch together a majority coalition or govern a minority government. Neither is the recipe for a strong government.

A Samaras government could theoretically deliver a positive shock by moving full-steam ahead on reforms and gaining so much credibility with Greece’s euro zone partners that they give Athens real help in turning around the country. But it is far more likely that he will be timid and the rest of the euro zone will throw Greece only a few crumbs. The economy, which has gone from bad to worse in the last couple of months of electioneering paralysis, would continue its nosedive, Samaras’ popularity would evaporate and after a few months his government would collapse.

A victory by Tsipras in next month’s election might seem even worse. After all, he will probably set Athens on a collision course with the rest of the euro zone. Last week Tsipras likened the relationship between Greece and the euro zone to that between Russia and America in the Cold War, when both had nuclear weapons that could destroy the other but refrained from firing them. Tsipras thinks the rest of the euro zone is scared that Greece’s return to the drachma would cause the entire single currency to unravel and that the bail out of Athens will continue, even without substantial economic reform.

The impact on the euro zone of Greece’s expulsion would undoubtedly be severe. But the other countries are finally preparing contingency plans to mitigate the damage. Germany, for one, will not be blackmailed by threats of mutually assured destruction.

It is conceivable that Tsipras will blink first, if he wins the election and finds he can’t shift the Germans. But this is unlikely. The typical weasel words of a politician won’t be enough to get him out of a tight spot; he would have to perform a complete somersault. It is doubtful the Marxists in his party would let him get away with this and, if they did, he would certainly lose all credibility in the country.

That said, a victory for Tsipras may paradoxically be Greece’s best chance of staying in the euro because it would bring things to a head rapidly. The country is being kept alive by a dual life-support system: the euro zone and IMF are channelling cash to the government, while the European Central Bank is authorising cash transfers to the banks. If the first tap is turned off, the government will not be able to pay salaries and pensions from July. If the second tap is turned off, the banks could run out of cash within days.

Cutting off Greece’s life support could be the trigger for reintroducing the drachma as the people found the cash machines ran dry. But it could also finally force the people to decide whether they were prepared to back reform – provided the euro zone simultaneously rolled out a proper plan to help the country. A key element of that would have to be to take over the Greek banks and guarantee their deposits, putting the country into a form of financial protectorate.

In such a scenario, a Tsipras government would probably collapse. After all, even if he comes first in the next election, he will not have a majority and so would be relying on coalition partners or governing in a minority. Greece would then need a third election, after which it might be able to put together a national unity government – perhaps even led by Lucas Papademos, the technocrat who ran the country for the last six months.

It is a slim chance full of risks, but probably Greece’s best chance of avoiding the drachma.

What should be the long-term vision for the euro zone? The standard answer is fully-fledged fiscal, banking and political union. Many euro zone politicians advocate it. So do those on the outside such as David Cameron, Britain’s prime minister, who last week called on the zone to “make up or break up”.

The crisis has demonstrated that the current system doesn’t work. But a headlong dive into a United States of Europe would be bad politics and bad economics. An alternative, more attractive vision is to maintain the maximum degree of national sovereignty consistent with a single currency. This is possible provided there are liquidity backstops for solvent governments and banks; debt restructuring for insolvent ones; and flexibility for all.

Enthusiasts say greater union won’t just prevent future crises – it will help solve the current one. The key proposals are for governments to guarantee each other’s bonds through so-called euro zone bonds and to be prepared to bail out each other’s banks. In return for the mutual support, each government and all the banks would submit to strong centralised discipline.

But the European people are not remotely ready for such steps. Anti-euro sentiment is on the rise, to judge by strong poll showings by the likes of France’s Marine Le Pen and Italy’s Beppe Grillo. Germany’s insistence last December on a fiscal discipline treaty has stoked that sentiment.

An attempt by the region’s elite to force the pace of integration with even more ambitious plans could easily backfire with voters, particularly in northern Europe. They would fear being required to fund permanent bail outs for feckless southerners. Premature integration might not even help with the current crisis if it backfired with investors. They might start to question the creditworthiness of a Germany if it had to shoulder the entire region’s debts.

In contrast, the principle of “subsidiarity” – the Maastricht treaty’s specification that decisions should be taken at the lowest possible level of government that is competent to handle them – is good politics and good economics. Of course, even advocates of political union such as Wolfgang Schaeuble, Germany’s finance minister, subscribe to this principle. The issue is to define the minimum conditions needed for the sustainability of the single currency. There are probably three.

The first is that insolvent entities – whether they are governments or banks – should have their debts restructured. One of the main reasons states and lenders were allowed to leverage themselves so much in the boom was because there was a widespread view that they couldn’t go bust. The complacency sowed the seeds of the crisis.

Meanwhile, a key mistake in managing the crisis was the failure to restructure Greece’s debts as soon as they became unbearable. If that had been done, private-sector creditors would have taken the hit. Instead, they were largely bailed out – with the result that 74 percent of Athens’ outstanding 274 billion euros in debt is now held by governments and the International Monetary Fund, according to UBS. This means taxpayers will be on the hook when the big fat Greek default occurs.

Of course, if Greek debt had been restructured earlier, banks in the rest of the euro zone would have had big holes in their balance sheets. Some would have needed bailouts from their governments. But that would have been better than the current debilitating long drawn out sovereign-cum-banking crises.

What’s more, in the future, insolvent banks shouldn’t be bailed out either. Their creditors should be required to take losses before taxpayers have to stump up cash. The failure to do so explains why the government of Ireland, previously financially solid, become infected by its lenders’ folly.
The second minimum condition for monetary union to flourish follows the first: there should be liquidity backstops for banks and governments that are solvent.

With banks, the natural liquidity backstop is the European Central Bank. The quid pro quo is that lenders have to be properly capitalised. Time and again throughout the crisis, euro zone governments have ducked this issue. Only this month, France and Germany conspired to dilute the Basel 3 global capital rules as they apply to Europe, while Spain imposed another half-hearted restructuring on its banks. If the euro zone’s leaders want a successful single currency, this nonsense has to stop.

For governments, the natural liquidity backstop is the European Stability Mechanism, the zone’s soon-to-be-created bailout fund. To do its job properly, it will need extra funds – as it isn’t be big enough to help both Spain and Italy. One option could be to allow it to borrow from the ECB.

Again, the quid pro quo would be solvency. Insolvent government would only get access if they restructured their debts. And illiquid but insolvent ones would need credible long-term plans to cut their debts. Italy, with debt over 120 percent of GDP but huge private wealth and state assets, might one day find itself in the latter category. In return for liquidity, it might have to agree a multi-year programme to privatise real estate and to tax wealth.

The final minimum condition for a successful monetary union is much more flexibility, particularly in labour markets. This is the key to restoring competitiveness in southern Europe and enabling the zone to respond to future shocks.

If the euro zone can do these three things – restructure insolvent institutions’ debts, provide liquidity to solvent ones and improve flexibility everywhere – nations will be able to keep both the euro and much of their sovereignty. That’s a preferable vision to either a euro super-state or the chaos of disintegration.

When euro zone policymakers are asked if there is a Plan B to cope with a Greek exit from the single currency, their typical answer goes something like this: “There’s no such plan. If there were, it would leak, investors would panic and the exit scenario would gather unstoppable momentum.”

Maybe there really is no plan. Or maybe policymakers are just doing a good job of keeping their mouths shut. Hopefully, it is the latter because, since Greece’s election, the chances of Athens quitting the euro have shot up. And unless the rest of the euro zone is well prepared, the knock-on effect will be devastating.

The Greeks have lost their stomach for austerity and the rest of the euro zone has lost its patience with Athens’ broken promises. But unless one side blinks, Greece will be out of the single currency and any deposits left in Greek banks will be converted from euros into cut-price drachmas.

People outside Greece may think this is simply a Greek problem. Would it really be much worse than Athens’ debt restructuring earlier this year which passed off with barely a murmur? But the process of bringing back the drachma is likely to involve temporarily shutting banks and imposing capital controls. That would set a frightening precedent.

Politicians and central bankers would, of course, argue that Greece was a not a precedent but a one-off. But why trust them? When Greece was first bailed out in 2010, policymakers said it was a special case. Then Ireland and Portugal required official bailouts while both Spain and Italy have had to be helped by the European Central Bank. If savers in Greece get hammered, depositors and investors in these other weak euro member would want to move their money to somewhere safer. Fears would rise of a complete break-up of the euro zone.

Indeed, there already has been significant capital flight from peripheral economies. The best way of seeing this is by looking at so-called Target 2 imbalances – the amount of money that national central banks in the euro zone owe to the ECB or are owed by it. These imbalances are a rough proxy for capital flight.

Four euro zone central banks – in Germany, the Netherlands, Luxembourg and Finland – have positive balances. At the end of April, the Bundesbank was owed 644 billion euros, according to data collected by Germany’s Ifo Institute. The sum has been rising by an average of 33 billion euros a month since the crisis took a turn for the worse at the end of July last year. Meanwhile, all the peripheral countries have big liabilities. Italy and Spain have the largest with 279 billion euros (as of April) and 276 billion euros (as of March) respectively.

A Greek exit from the euro would, at least temporarily, accelerate capital flight. Measures would need to be taken to counteract it – to protect both depositors and governments in vulnerable countries.

Fortunately, it’s not too difficult to construct a contingency plan. To protect depositors, the ECB would have to make clear that a limitless supply of liquidity with very few strings attached was available for banks across the euro zone. This would avoid the possibility that savers would find they couldn’t get money out of their accounts. After a while, calm might return.

To protect governments, the ECB would also need to wade into action. Although it cannot lend to states directly, it can buy their bonds on the secondary market. Indeed, it has already done so. It would, though, need to be prepared to buy bonds in limitless quantities. Otherwise, investors might just run anyway and take the ECB’s money while it lasted.

Although the ECB would have to play the main role in preventing a panic, the euro zone’s so-called firewall should play a subsidiary role. The region will soon have two main bailout funds – the existing European Financial Stability Facility and the European Stability Mechanism. These could be deployed in two ways.

First, they could provide a backstop to national deposit guarantee funds. That way, an Italian saver would know that, if Rome’s own guarantee scheme ran out of money, there were funds in another kitty to fill the hole. Second, the bailout funds could lend cash directly to governments that were no longer able to issue bonds in the markets.

However, the bailout funds are not large enough to stem a panic on their own. They only have 740 billion euros available. Even with help from the International Monetary Fund, they would not be able to douse the flames.

Although it is fairly easy to think of a plan B, that doesn’t mean it would be easy to get political agreement for it from Germany and the other creditor countries. One concern would be that the ECB would be taking huge financial risks by buying government bonds and lending to banks. Another is that such rescues, which would amount to a big step towards fiscal union, would take the pressure off the peripheral governments and their banks to reform themselves and improve their solvency.

On the other hand, failure to act as a lender of last resort in a Greek-exit panic could trigger a domino effect of bankruptcies – of banks and governments – throughout the periphery. The euro couldn’t survive that.

Germany may soon need to decide between going all-in to save the single currency or witnessing its destruction.

It has become fashionable to talk about the need for a euro zone “growth compact” as weariness mounts over a diet of nothing but austerity. France’s new president Francois Hollande has popularised the idea. Even Mario Draghi has backed it. That gives the concept credibility as the European Central Bank president was one of the main supporters of the austerity-heavy “fiscal compact”, which requires governments to balance their budgets rapidly. Olli Rehn, the European Commission’s top economic official, has joined the bandwagon too: at the weekend, he advocated a pact to boost investment, while hinting that there may be scope to ease up a bit on the austerity.

But all this chit-chat won’t lead to much unless politicians are prepared take unpleasant decisions on reforming labour, welfare and banking – measures which would boost growth in the long run. That has to be the quid pro quo for loosening the current fiscal squeeze or further easing monetary policy – measures that would help in the shorter term. 

Without such a grand bargain, any growth compact is likely to amount to little more than extra funds for investment. Rehn mentioned the main ideas at the weekend: using EU budget funds to guarantee lending to smaller firms; encouraging countries with fiscal surpluses to increase public investment; and boosting the capital of the European Investment Bank. While these measures are worthy, they are not of the scale needed to change the course of one of the biggest economic crises in recent history. 

The main guts of a growth compact ought to be somewhat looser fiscal and monetary policy married to deep structural reform. 

Look first at fiscal policy. It is great that policymakers such as Rehn seem to understand the dangers of an austerity spiral – where excessive budget squeezes crush the economy which in turn makes it harder to balance budgets and so requires further austerity. He says Europe’s fiscal rules are “not stupid”. 

 But even if Germany, Europe’s paymaster, can be persuaded to go along with a laxer interpretation of the rules, there is a limit to what will pass muster with the bond markets. While investors aren’t enamoured with growth-crushing austerity, they won’t finance profligacy either. Credible long-term plans to rein in deficits and restore competitiveness are needed. With those in place bond investors would be happy if the European Commission allowed governments another year or so to balance budgets. 

 The need for substantial change is not limited to countries already in crisis. In France, industry is increasingly uncompetitive and the government spends 57 percent of GDP. Tackling that ought to be the government’s priority, though it got little mention during the election campaign. Even Germany would benefit from reforming its weak services industries. Meanwhile, across Europe there needs to be a determined drive to deepen the region’s single market. 

 To gain the full benefits of monetary policy, there also needs to be a quid pro quo with the politicians. It’s important not to misinterpret Draghi’s new fondness for the word “growth”. The ECB is still keen on fiscal rectitude and is not signalling looser monetary policy. When Draghi talks about a growth compact, what he has in mind is structural reform – something that will not bear fruit for some time. Indeed, Draghi talks about the need for a 10-year vision. 

 While the central bank has engaged in exceptional measures to prevent the system collapsing – buying government bonds and spraying cheap money at the banking system – it has done so with a heavy heart. It rightly fears that such monetary rescues reduce the pressure on both governments and banks to reform themselves. Germany’s Bundesbank is even calling for the ECB to prepare to exit from these exceptional measures. While it won’t get its way – Draghi has made clear he thinks it’s too early to do this – talk of an exit is already making the money markets and the banks nervous. And that is undermining some of the benefits of the current loose policy. 

 For the ECB to be happy to pursue further monetary laxity, it will need to be convinced that governments are going to use the time they are being given wisely. A priority is to recapitalise zombie banks. So long as lenders have weak balance sheets, they will find it hard to fund themselves in the markets and will therefore lack the confidence to finance growth. 

 The key short-term imperatives are in Spain and Greece. But weak balance sheets are not confined to these two countries. Other governments have shown themselves unwilling to impose higher capital requirements on their lenders. Last week, for example, both Germany and France argued for changes in the way the new Basel 3 capital rules are applied to Europe so that their banks won’t need to raise so much capital. If politicians could bring themselves to grasp the nettle on banking, lenders would find it easier to fund themselves in the markets and the ECB would be less grudging about providing emergency assistance if it was still needed. 

 The ideal growth compact would match reform of banks, labour and welfare with less short-term austerity and accommodative monetary policy – and throw in some extra money for investment. Given the difficult political choices required, such a deal won’t be easy to pull off. But the tectonic plates are shifting across Europe. Now is the time to push for it.

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

A further difficulty concerns whether such a banking union should stretch across the euro zone or the entire European Union, which includes the United Kingdom, home to the region’s largest financial centre. Britain would argue that it shouldn’t be roped into a system that is designed to shore up the single currency it is not a part of. On the other hand, if the euro countries went ahead on their own, the single market in financial services would fragment.

Quite apart from the politics, a banking union wouldn’t actually solve all the problems. In particular, it would do nothing to stop banks owning too much government debt. Indeed, in the last few months, Spanish and Italian lenders have bought even more of this debt – using cheap money from the European Central Bank. This has helped finance their governments through a rough patch but at the cost of tying the banks’ fate even more closely to that of their countries. Over time, governments ought to be weaned off reliance on their local banks. But, realistically, this isn’t going to happen fast.

Does this mean that a European banking union is a totally dead idea? Not quite. It may be possible to cherry-pick bits of it. The most important part would be to create a Europe-wide “resolution” regime. The basic idea is that such a regime would allow insolvent banks to go bust in a controlled fashion. If shareholders haven’t put in enough capital, bondholders have to be “bailed in”. Only if bondholders also haven’t put in enough capital do deposit guarantee schemes – and possibly taxpayers – have to be activated to make sure savers are repaid. With such a framework, governments such as Ireland’s wouldn’t in future be infected by their lenders’ problems.

At present, many European countries lack such a resolution regime and those that do exist don’t collaborate effectively with one another. What’s more, until recently the European Central Bank has been hostile to the idea that bank bondholders should suffer any losses. It prevented Dublin from bailing in bondholders, fearing that this would trigger contagion.

The mood, though, is changing. The European Commission is planning to publish plans for an EU-wide resolution regime in June. Even the ECB has started lending its support to such a scheme. The devil, of course, will be in the detail. But there finally seems to be momentum behind this proposal.

A second idea that could be cherry-picked is to reinforce Europe’s deposit guarantee schemes. At the moment, every country has its own. The problem is that depositors in weak countries, especially Greece, don’t have confidence that their national schemes have enough money to pay out. So savers have been taking their cash abroad.

It is too much to expect that Germany, Europe’s paymaster, would agree to a euro-wide deposit insurance scheme. But what about some sort of reinsurance scheme? Nicolas Veron from the Bruegel think tank argues that the European Stability Mechanism, the euro zone’s soon-to-be-created bailout fund, could provide national schemes with a backstop.

Europe is not ready for banking union any more than it is ready for political union. But such ideas show there are practical ways of limiting the unhealthy nexus between lenders and their governments. Europe should grasp them.

We’re going to be really tough on the euro zone. If they want more bailouts from the International Monetary Fund, they are going to have to submit to strict conditionality. That was the message delivered by the rest of the world when it agreed at the weekend to participate in a fundraising exercise that will boost the IMF’s resources by at least $430 billion.

But the meaning of the message isn’t quite what it seems. The IMF is actually in some ways calling for less rather than more short-term austerity in the euro zone. So if the Europeans submit to IMF discipline, it will ironically mean less of a hair shirt.

It is easy to see why the rest of the world is unhappy with the special treatment the euro zone receives from the IMF. The managing director, currently Christine Lagarde, has always been a European. Vast resources, way beyond what are normally available in IMF programmes, have been channelled to Greece, Ireland and Portugal.

What’s more, the rest for the world – from developed countries such as America, Britain and Canada to emerging nations such as Brazil – feel that, despite being pretty rich, the euro zone has not done enough to sort out its own problems. Hence, the agreement to beef up the IMF resources only after a long wrangle – and only after scaling back the original request from $600 billion as well as insisting on strict conditionality before the money is ever disbursed.

At the same time, the IMF has three recommendations, as outlined in last week’s World Economic Outlook, which are somewhat at variance with current euro zone policy. First, it wants the region not to overdo short-term fiscal austerity while placing more emphasis on longer-term structural measures to improve budgets. Second, it wants the European Central Bank to continue very accommodative monetary policies. Finally, it wants the euro zone authorities to be prepared to inject capital directly into troubled banks and to accompany that with stronger European-wide supervision of lenders. All these ideas would help reduce the pressure of the current euro zone recession and so ease the crisis.

Will the IMF, though, get its way? Well, certainly not immediately. The euro zone doesn’t have to listen to it unless another country – say Spain or Italy – needs a bailout. Even then, only the country requiring cash would technically have to pay heed to the IMF. The rest of the euro zone, led by Germany, could argue that the IMF has no business interfering with the monetary policy or banking supervision of the entire 17-member euro zone when only a few peripheral nations are receiving help.

What’s more, the bulk of the money from any future bailouts would continue to come from other euro zone countries rather than the IMF. These other countries would argue that they should have a big say, even on fiscal policy, because they will be bankrolling most of any deficit shortfall.

But even if the IMF can’t get its way immediately, the debate is shifting slowly in its favour. The euro zone may not like interference in monetary policy. But the ECB has shown itself willing to spray 1 trillion euros in long-term loans at the region’s banks in the heat of the crisis in recent months. Some of the central bank’s members, with the notable exception of Germany’s Bundesbank, are saying it is too early to plan for an end to such policies.

Or take fiscal policy. Euro zone leaders may have agreed the so-called fiscal compact which will require them to balance their budgets and cut their debts. But no sooner had the deal been signed than Spain varied its fiscal targets. Italy has followed up by saying it won’t react to a deeper than expected recession by pushing through more cuts – a policy that would just lead to further recession.

Now the Dutch government, previously the high priest of austerity, has found it cannot push through its own budget cuts. Meanwhile, Francois Hollande has promised to push for a more growth-orientated policy if he wins the French election. The austerity consensus is fraying.

Finally, consider banking policy. The intertwining of lenders and their states is unhealthy. Banks which get into trouble need to be bailed out. That makes their governments less creditworthy which, in turn, further infects banks which loaded up on their bonds. That occurred in Ireland and could be repeated in Spain.

The IMF’s proposal is to sever this incestuous relationship by getting the euro zone to put money directly into troubled banks rather than by lending to governments which, in turn, would inject capital into the banks. Such a policy would be matched by euro zone-wide supervision of banks.

The idea is rational. That, of course, doesn’t mean that it will be adopted. But with an expanded warchest, the IMF has greater ability to be heard on this and other issues – especially if it keeps reminding the euro zone that the rest of the world has insisted that strings are attached before any more countries are given bailouts.