Breaking up the eurozone just isn’t an option

IN the two weeks ending last Friday, global equity markets experienced their worst performance in several months.

Given how traumatic markets have been recently, that is saying something. In contrast this week saw a much stronger market performance, although a lot of incredible volatility was seen from hour to hour.

The market reaction to Tuesday night’s meeting of EU finance ministers was muted to negative. Some statements were made about agreement being reached on boosting the strength of the European Financial Stability Facility and the possibility was raised about the IMF receiving more resources to help out countries who are finding it impossible or very expensive to borrow money on international markets.

While this was a bit vague, it does hold out the prospect that the ECB will turn on the printing press and give the money to the IMF to buy the bonds of countries in difficulty. This indirect method might be enough to circumvent the legislation preventing the ECB from intervening directly. It might also make it easier for the German chancellor to sell the message of what needs to be done to a sceptical public.

On Wednesday, markets were given a further boost when the ECB, the US Federal Reserve, the Bank of England, the Bank of Canada, the Bank of Japan and the Swiss central bank intervened and provided cheap dollars to banks to alleviate the fear dominating market sentiment.

This move will reduce the cost for banks of accessing funds and improve market liquidity and sentiment. At the same time the Bank of China eased liquidity in its banking system to stimulate economic growth.

It is still hard to predict with any certainty how the eurozone crisis will unfold. However, it is very clear that the survival of the project has become high risk and its future is in the balance.

From an economic perspective, the decisions needed are straightforward — in the short term this will necessitate the creation of an EFSF of at least €3 trillion and massive bond purchasing by the ECB based on quantitative easing of money supply, Greek default of at least 50%, and re-capitalisation of affected banks.

This will have to be followed up in the long term with the creation of a euro-bond guaranteed by Europe and greater fiscal discipline imposed from the centre. This would be the creation of fiscal federalism, which should have come in 1999.

It was far from clear how political agreement would be reached from the Germans, who will effectively be bankrolling the solution, or those countries that will be forced to cede political and fiscal sovereignty. In theory, the constitution of the ECB would have to be changed to allow it do what is necessary, and treaty changes would be required.

The events of Tuesday and Wednesday may signify that the political elite in Europe are starting to recognise that the cost of saving the system is likely to be far less than the political and economic chaos if the system were allowed fall apart.

Politically, the process of European Union could be set back 50 years and could fracture the political entity. Could another European war be a possibility?

Breakup would result in economic chaos — banking systems and economies of the weaker countries would be thrown into chaos and core countries would see a damaging appreciation of their currencies.

What happened this week may be a ‘Kosovo moment’. Some years back the US went into Kosovo to sort it out once it lost patience with the prevarication of European political leaders.

It now would appear to be spearheading an effort to solve the eurozone crisis. This must be followed up with very strong measures by eurozone leaders, but a resumption of eurozone growth is crucial. A slashing of ECB interest rates would be a good first step.