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With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama over bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change of direction but if not, the world can no longer afford the deference that the International Monetary Fund and non-European G20 officials have shown European policymakers in the past 15 months.

Three realities must be recognised if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish not a policy. US policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed that because time had passed since the Bear Stearns’ bail-out, the market had learnt lessons and so was prepared. In fact, the main lessons learnt were on how best to find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

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Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations’ burdens Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies, but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates are likely to become insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland, and is in danger of happening in Italy and Spain.

In short, the approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative. Assertions that the most indebted countries can service their debts in full at current interest rates only undermine the credibility of policymakers when they go on to assert that the fundamentals are relatively sound in Spain and Italy. Further lending at premium interest rates only increases the scale of the necessary restructuring. It is reasonable to argue that the recognition of debt unsustainability in Greece has been excessively deferred. It is not reasonable to argue that Greek reprofiling or restructuring alone will address a general crisis of confidence.

A fundamental shift of tack is required, towards an approach focused on avoiding systemic risk, restarting growth and restoring arithmetic credibility rather than simply staving off disaster. The twin realities that Greece, Italy and Ireland need debt relief and that the creditors have only limited capacity to take immediate losses, mean that all approaches require increased efforts from the European centre. Fortunately, the likely consequence of doing more upfront is a lower cost in the long run. The details are less relevant than having an appropriate approach overall, aligned with EU political realities. But some elements are crucial to any viable strategy.

European authorities must restate their commitment to solidarity as embodied in a common currency and recognise that the failure of any European economy is unacceptable. If they can find the political will, the technicalities of a policy response are not that difficult. But it should include these further commitments.

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First, for programme countries, interest rates on debt to the official sector should be reduced to a European borrowing rate, defined as the rate at which common European entitities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated, so there is no reason to charge a needless risk premium that puts the whole enterprise at risk.

Second, countries whose borrowing rate exceeds some threshold – perhaps 200 basis points over the lowest national borrowing rate in the euro system – should be exempted from contributing to bail-out funds. The last thing the marginal need is to be pulled down by the weak.

Third, there must be a clear commitment that, whatever else happens, no big financial institution in any country will be allowed to fail. The most serious financial breakdowns – in Indonesia in 1997, Russia in 1998, and the US in 2008 – came when authorities allowed doubt over the basic functioning of the financial system. This responsibility should rest with the ECB, with the requisite political support.

Fourth, countries judged to be pursuing sound policies will be permitted to buy EU guarantees on new debt issuances at a reasonable price, payable on a deferred basis.

These measures would do much to contain the storm. They would lower payments for debtor nations, protect states at risk from participation in rescue efforts or from shortfalls in market confidence, and ensure the ECB could continue backstopping the stability of European banks.

This leaves the question of what is to be done with sovereign private debt. Creditors gain nothing from breakdown. Some will want to sell out of their exposures at prices marginally above their current market value. Others, who are still regarding sovereign European debts as worth par, should be given appropriate, reduced interest rate longer maturity options. Debt repurchases are a possibility if the private sector accepts sufficiently large present-value debt reductions. But any approach should be judged on the sustainability of programme country debt repayments.

Much of this will seem unrealistic given the terms of Europe’s debate. It seemed highly unrealistic even 10 days ago that Italy’s solvency would come into substantial doubt. The alternative to forthright action today is much more expensive action – to much less benefit – in the not too distant future. The next few weeks may be the most important in the history of the EU.

The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton

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In the dim and distant past, before September 2007, banking supervisors typically believed that the less said about a bank in trouble, the better. “Least said, soonest mended” was the motto of prudential regulators on both sides of the Atlantic. Any public hint that a bank might not be meeting regulatory capital standards created the risk of a bank run. Far better to work privately with management in an attempt to resolve the problems, leaving outsiders in the dark until a deal was done. That “deal” might be closure, but in an orderly manner, usually involving a managed and ostensibly “friendly” takeover. The UK’s secondary banking crisis in the 1970s was handled on these principles, and few people knew much about it until it was over.

How different it is today. “Least said, soonest mended” has been replaced by “let it all hang out” on the sign over the regulator’s door. Under the living will regime, some think the sign now reads “abandon hope all ye who enter here”.

Of course we all understand this change of approach. In retrospect we can see that banks had been allowed to operate with too little capital to withstand a sharp market correction. Too little attention had been paid to the quality and duration of their funding, or to the movements in their loan-to-deposit ratios. Capital requirements imperfectly captured the risks of different asset classes and the correlations between those risks. And there was simply too little capital in the trading books.

So regulators are rightly much tougher. Anyone on the board of a bank (I chair the risk committee of Morgan Stanley) knows they now impose far tougher internal stress tests, and the dialogue between companies and their supervisors is radically improved. Previously boards had to rely almost exclusively on what management told them. Now they have direct access to another triangulation point. And that dialogue results in changes to capital and liquidity levels – or should do.

So what is the value of public exercises such as the European-wide stress tests published by the European Banking Authority on Friday?

European regulators are copying what was perceived to have succeeded in the US in the early aftermath of the crisis, when confidence in the banking system as a whole had collapsed. The exercise, conducted after quite a large recapitalisation exercise involving the federal government, was broadly reassuring, though bank failures in the middle and lower tiers of the US banking sector have continued.

The European exercise is far more complex, not least because the respective responsibilities of the EBA and national supervisors are still far from clear. It is also widely recognised that the first iteration of the exercise was weakly specified. Some banks that passed with flying colours were effectively bankrupt shortly after. Moreover, it is hard for supervisors to require banks to plan against a break-up of the eurozone, the outcome the markets most fear.

So the latest exercise is almost bound to raise more questions than it answers. The headline results indicate that nine banks failed, with 16 close to the line. But what Europe needs is not a league table of the good, the less good and the capitally challenged; but a plan, country by country and bank by bank, to fortify the banking sector. If there are one or more sovereign defaults, as now seems likely, that may require member states to provide new capital for banks that suffer significant write-downs. Overall, a Greek “selective default” is manageable, but some banks will be embarrassed. As governments have encouraged them to keep their Greek bonds, it is not unreasonable that they should look in that direction for assistance.

We will not soon return to a supervisory regime in which, as a former Bank of England governor liked to say, the regulator’s actions were “clouded in decent obscurity”, although some in the City look back on those times with nostalgia. But the stress test exercise, which may generate more heat than light, should not distract from the painstaking work needed to restore the challenged parts of the European banking sector to health.

That will require individual capital plans worked through by supervisors and management, and almost certainly some injections by governments if the eurozone crisis continues to deepen. The EBA can draw attention to the problem areas, but it cannot solve them. But drawing attention to them makes them more urgent, a point that governments need to understand.

The writer is a former chairman of the UK Financial Services Authority

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