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The Achilles' heel of the Eurozone

The European Union's latest fix for Greece's solvency problem is weak and lacks meaningful structural change. The problem cries out for a bold solution that encompasses the whole Eurozone.

November 02, 2011|By Dimitri B. Papadimitriou

The Greek drama is heightening by the day. Last week, Europe's leaders came up with a $180-billion rescue package for its most troubled member, Greece. Like previous efforts, the plan combines bailout funds with demands for continued austerity in an attempt to isolate Greece and leave the rest of Europe economically intact. This week, in response, a call by Greece's prime minister for a national referendum on the proposal surprised the world.

The referendum may accelerate the inevitable fall of the Greek government. And it only emphasizes that a belief in the latest deal as a "Euro success story" — that it solves Greece's problems and prevents a larger Eurozone crisis — is pure fantasy. Whatever the referendum results turn out to be, we are still heading toward the unraveling of an economically united Europe, a union that, despite its many downsides, is in the best interests of the continent's countries — rich and poor — and the global economy.

That the European Union finally recognizes the need to push forward on Greece's solvency problem is a positive development, even though the latest fix basically amounts to providing it with some new breathing room. Greece's payments on its debt principal will be postponed, and interest rates will be lowered. This might, in 2013, begin to bring its deficit under control. The price, though, will include a very high unemployment rate. And, most significantly, the underlying problem of an economy without growth has not been addressed.

Greece lacks both an industrial base and the widespread availability of technology. It simply can't be productive enough to compete with neighbors such as Germany, France or the Netherlands. It's in deep recession and doesn't have the resources to grow out of it, even with an easing of its still-enormous debt level.

Most of the austerity measures and reforms in place — and calls to continue or increase them — won't work. Raising taxes in a society distinguished by flagrant tax evasion has only boosted the shadow economy. Wage and pension cuts are further reducing tax receipts. Worse, these measures are depressing both demand and retail sales, resulting in more unemployment and civil disturbances.

A quarantine of the disaster isn't possible. Europe's banks and nations are too closely entwined. Financial institutions in the Eurozone have made large loans to Greece's government and private sector, as well as to other distressed European nations.

The core European banks hold hundreds of billions of euros in debt issued by Greece, Portugal, Ireland, Italy and Spain, all struggling nations. Banks within these nations hold tens of billions more. Add in losses at the European Central Bank, where incoming President Mario Draghi is providing only lukewarm support for an active role by the bank. Greece still could collapse, provoking a rush to the exits that would trigger bank insolvencies across the continent.

The effects extend beyond Europe. The U.S. and Japan would not be immune from the turmoil. And at least two-thirds of lending to emerging markets originates in European banks. If European institutions start calling back these loans, markets around the globe will be destabilized.

The initiative last week orders Europe's banks to recapitalize to prevent this scenario. Are there sufficient private investors to do so? Or will financial institutions need support from their governments, creating a new layer of financial demands on Europe's population? There's also a provision to increase the resources of the Eurozone's emergency fund, the European Financial Stability Facility. But how? Thus far, only vague ideas have been offered. The tricky decisions — to say the least — of who will pick up which tab remain to be worked out.

In response to the package, the bond market has not changed its tune. The new 50% "haircut" to private sector investors in Greece hasn't altered the conviction of traders that the troubles in Athens will inevitably be contagious. Pricing of Spanish, Italian and even French bonds reflect this pessimistic outlook.

Europe's politicians are aware of what the markets have long known: Patches are destined to fail. But the urge to pass the hot potato without instituting meaningful structural change is, evidently, irresistible. So instead of muscular reforms, we see the same unsuccessful rescue packages supersized. Sunny optimism and mutual back-patting continue, paired with pep talks from the rescue fund controllers at the International Monetary Fund and the World Bank.

The latest steps don't end the Greek crisis. A Eurozone-wide problem requires a Eurozone-wide solution. The European Central Bank should be creating something along the lines of the U.S. TARP program, buying bonds to calm the volatility until a bold, permanent solution is crafted. Greece and the rest of Europe would ultimately survive the disintegration of the Eurozone and the death of the euro. But the end of a unified Europe would leave the entire world poorer.

Dimitri B. Papadimitriou is president of the Levy Economics Institute of Bard College ( and executive vice president of Bard.

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