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After months of living in fantasy land, everything is back on the table

Despite Ireland's junk status, the big problems are now in the core of the eurozone. The eurozone is finally headed back to Earth, having drifted in a fantasy world for the past 18 months, but the re-entry phase will be dangerous. A safe landing from the new approach could at long last put the recovery programmes for crisis countries on solid ground -- because debt reduction is promised -- but the process of allocating losses to debt holders will rattle financial markets.

Ironically, some countries on the periphery -- including Ireland -- have an escape pod at their disposal to avoid any short-term melt down; one that is not available to most countries in the core.

On Monday evening, finance ministers "recognised the need for a broader and more forward-looking policy response" to the crisis in the eurozone.

Until now, the approach was to concentrate losses in the countries where they were incurred -- to prevent the crisis from spreading -- and to limit assistance to the affected countries to relatively short-term loans at high interest rates. Now, an abrupt turnabout could offer assistance that is more practical and on realistic terms.

First, the ministers committed themselves "to enhancing the flexibility and the scope" of the European Financial Stability Facility (EFSF) to include the possibility of using new loans to buy back old debt on the secondary markets.

This would allow countries to take advantage of their own weakness: if old debt is trading at a discount on the market -- due to fears that it might not be repaid -- the proceeds from new and EFSF-guaranteed debt can buy up additional old debt and simply retire it. If old Greek debt trades at 50 cent in the euro, €100bn in new debt could be used to buy out €200bn in old debt.

Second, the euro group agreed "to lengthening the maturities of the loans and lowering the interest rates, including through a collateral arrangement where appropriate". This suggests that the silly argument about interest rates is over. Instead, our European partners could accept a meaningful share in the risk of getting to a recovery and their assistance will be affordable.

This new-found magnanimity was born of a heightened fear that Italy and Spain might need a bailout. Italian budget problems contributed to this, but the market pressure truly resulted from a growing realisation that current funding is simply not big enough to help these large countries. In order to be credible, the funds needed to be massively augmented or used more efficiently -- and the latter option was chosen.

As a result, sovereign bondholders will have to accept some losses.

EFSF loans would be used to limit those losses, and to limit the financial fallout from them, rather than to try to recoup them all. This represents a significant change in position for Germany in particular, and ministers did not even rule out the possibility of a selective (or limited) default, as strongly opposed by the ECB. Everything is back on the table and that is why Ireland was downgraded.

The devil is hiding in the detail, of course, and it is still not clear where the losses will fall or whether they can be sustained. This could lead to confusion and panic. Moreover, the EU has finally soldered the link between sovereign debt on the periphery and bank fragility in the core on the eve of a second round of stress tests -- to be released tomorrow -- intended to identify vulnerable European banks.

National fall-back plans are in place to support the banks but the exercise could, nonetheless, have a significantly destabilising effect on markets.

Moreover, we could be in line for further downgrades -- for banks as well as for Italy and Spain -- and more EU fumbling cannot be ruled out. Therefore, it is not realistic to delay concrete proposals relating to the new approach until September, as initially planned. The markets will need far more detail before they calm down.

In the meantime, Ireland should not panic. There are means available to protect the economy from a euro-wide financial crisis.

A last line of defence would place a temporary freeze on foreign credits and deposits in Irish banks. Then, because domestic assets (at €380bn in the covered banks) exceed domestic liabilities (of €354bn), the banks could re-open for domestic purposes while the storm passed over.

In addition, Irish austerity measures have already secured a current account surplus -- so that our exports can fund our imports during any financial hiatus -- and the government deficit has been reduced to a level where its deposits in the Irish banks could fund the budget for a year or more.

Ironically, in the creditor countries, this option is not available because the domestic assets of their banks are far smaller than their domestic liabilities -- their assets are mostly held abroad.

This fall-back position should not be construed as a proposal for anything short of an emergency situation and would break all sorts of EU undertakings. But it is comforting to know that the hatches could be closed, if necessary, while the core of the eurozone dealt with its problem banks.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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