After months of denial, the European policy elite finally begins to understand that something is seriously wrong in the eurozone.
But the prevailing definition of the problem is still too narrow -- the consensus in France and, even more, in Germany is that "this is a Greek problem". Even the most negative still think that Portugal and Spain can easily escape serious damage.
If you want to call for a "rescheduling" of Greece's debts -- a position that is becoming increasingly popular among leading north European intellectuals -- that is fine. But you also need to recognize that the policy elite (central banks and ministries of finance) are completely unprepared to handle the consequences, which would be immediate and devastating for other weaker eurozone countries.
You simply cannot do a low-cost or small unilateral restructuring of government debt in this kind of situation; the market will at once take that as a signal that Portugal, Spain, Italy and perhaps even Ireland will face difficulties (in fact, this is exactly what spreads in the 2-year European government bond market are saying today). The French may smile upon such outcomes with a feeling of superiority, but they might also consider not throwing bricks in glass houses.
It is fine -- even appropriate - to emphasize that big European banks have aided and abetted the irresponsible behavior of eurozone authorities. The profound stupidity of these banks-as-organizations is beyond belief, and it is deeply puzzling quite why leading figures in the US Senate would see them as a model for anything other than what we need to euthanize as soon as possible in the global financial system.
But do not fall into the trap of thinking just because "megabanks are bad" (undoubtedly true) that you can whack them with losses and not face the consequences - these people are powerful for a reason; they hold a knife to our throats. For all his hubris, missteps, and over-reliance on Goldman group think, Hank Paulson had a point in September 2008: If the choice is chaotic global collapse or unsavory financial rescue, which are you going to choose?
The Europeans will do nothing this week or for the foreseeable future. They have not planned for these events, they never gamed this scenario, and their decision-making structures are incapable of updating quickly enough. The incompetence at the level of top European institutions is profound and complete; do not let anyone fool you otherwise.
What we need is a new approach, at the G20 level; this can definitely include debt restructuring, but it has to be done in a systematic fashion (and even then there will be a considerable degree of total mess). Such a change in framework for dealing with these issues will not get broad support until after further chaos in Europe, but it now needs to be put into place.
The Europeans will not lift a constructive finger. The leading emerging markets are too busy battening down the hatches (and accumulating ever more massive chests of reserves). And the White House still seems determined to sleep through this crisis. Expect nothing.
Cross-posted from the Baseline Scenario