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Not Even Close...

Posted: 12/21/11 10:36 AM ET

There is only one relevant question with respect to last week's summit in Europe on saving the euro: Is it enough to halt or reverse the run on the European banking system?
 
Not even close.
 
Last week's attempt at fiscal union looked eerily familiar to rules already in place in the original Maastricht treaty that led to the euro. While last week's rules did have more enforcement bite, measured against the scale of the ongoing crisis, and against the failures of the past, the summit represented just baby steps.
 
And if these steps are sufficient to solve the fiscal and banking problems of countries like Greece, Portugal, Spain and Italy, then all we can say is: Te salut Merkozy.
 
Instead, both short-term measures and more wide-scale long-term structural changes are necessary to make the euro-zone area stable.
 
The immediate challenge is to halt a banking crisis that could surpass that of 2008. The only way to do this is to write-down substantial amounts of debt and hope the banking system survives, or to issue a large amount of eurobonds, which would represent a Franco-German fiscal transfer to the weaker countries.
 
To get within range of the targets idealized in last week's agreement will require removing 1.5 to 2 trillion euros of debt from the system. And, contrary to the view of many market participants, this is not the European Central Bank's (ECB) battle to fight.
 
Unless they succeed, euro-area policymakers will not have a chance to repair the faulty design.
 
To fix the euro in the long run, one must understand why it got into such a pickle in the first place. Prior to the launch of the euro, the architects of the European monetary union knew that many countries hoping to join the currency area had to impose monetary and fiscal discipline to make themselves fit for the enterprise. 
 
Inflation stability was hard-wired by the ECB; unfortunately, the fiscal discipline was not. The results of this decade-long experiment of monetary union should have come as no surprise.
 
With a strong currency and inefficient labor markets, many of the periphery countries were not competitive, and the only way to maintain their standard of living within the euro was to break the principles underlying the Maastricht Treaty and live beyond their means. The lack of credibility of the treaty's no-bailout provisions due to their being no mechanism for exiting the Euro engendered severe moral hazard. A credible long-term solution must address this.
 
Over the long term, governments must commit to credible non-discretionary rules of fiscal and financial behavior. Last week's agreement is just a start. Only those countries with economies sufficiently flexible to prosper under such rules should expect to take part. As a result, it is increasingly doubtful that the euro area will survive in its current form.
 
It is useful to look at the monetary union of the U.S. The states retain many sovereign powers that result in considerable fiscal discretion. They establish their own tax systems and spending rules. While many states are legally bound to balance their budgets, they need not fund future obligations and are not subject to the U.S. Bankruptcy Code.
 
So how do U.S. states guard against default and preserve their borrowing privileges?
 
In spite of their well-advertised budgetary problems, most states have access to capital markets at favorable rates. A key reason is that, in most cases, debt service for general obligation bonds holds constitutional priority over other expenditures. This means that the "sovereign" debt must be paid out of revenues before meeting other obligations. When fiscal problems nevertheless arise (as, for example in California), they need not threaten the banking system or the stability of the U.S. monetary union as a whole. Indeed, the principle that states can default was established in the United States in the 1840s.
 
But even such fiscal arrangements probably would prove insufficient to ensure a stable euro area. The reason is that they would not preserve the safety of the "financial commons." If the banks of one nation in Europe take on excessive risks, their interconnectedness pollutes the banks of other nations in a potentially systemic way. In addition, governments will be tempted to violate fiscal rules to rescue a fragile financial system (as in Ireland) or a "national champion" (such as Dexia). These considerations favor a financial race to the bottom, in which the implicit subsidies for bad banks impose cross-border costs.
 
Over the long run, then, euro members will need to share both the oversight and the backstopping of large cross-border financial intermediaries. There can be no national champions that threaten fiscal stability or systemic disruption. A European version of the U.S.'s FDIC with corresponding risk premiums and prompt corrective action seems like a good place to begin.
 
These are just the basic necessary ingredients for viability or the euro. Issues like competitiveness of labor markets and fiscal federalism are also important, but the clock is ticking, and there is still such a long way to go.