How to Contain the European Debt Crisis

by Francesco Giavazzi and Anil K Kashyap

Bloomberg
July 20, 2011

With Italy now paying the same rates as Spain to finance its debt, the European crisis has reached a critical stage.

To prevent the possible demise of the single currency, the European Union now must come up with a credible plan to address the future of the euro area. Only a proposal that takes into account the following four painful realities would be credible and stand a chance of persuading markets to resume financing on a sustainable basis.

First, the EU must acknowledge that some countries won’t repay their debts and that default is inevitable. The first in line surely is Greece, but that default in isolation would be easily managed because the money involved is modest. But once Greece defaults other countries will be tempted to follow in its footsteps. Even a rescue of Greece, Ireland and Portugal is affordable, but there could be no realistic way of preventing Spain from taking the same course.

Second, Europe’s banks are at risk because they own substantial amounts of government debt. As defaults approach, the banking systems across the continent could be subject to an epic run, as depositors and institutions pull out of banks to avoid losses. The European financial system is bank-centered: A run would cripple credit flows, plunging the euro zone into recession and creating a global financial crisis.

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