Eurozone governments in last-chance saloon to save the single currency
All of the metaphors have been used -- from edge-of-a-cliff, meltdowns and hanging threads -- but the real terror confronting the eurozone is that its banks, out of fear that other banks' solvency is threatened by default on sovereign debt, could stop lending to one another.
This would bring the credit system to a halt and the ensuing liquidity crisis would, if left unresolved, result in insolvency and default. European economies could languish in deep recession for a decade or more and this is how a euro crisis would play out -- in sets of insolvency, uncertainty and illiquidity.
So what exactly happened to the eurozone officials over the past 10 days?
First, finance ministers admitted there may need to be a default on sovereign debt. They did not specify for which country or in what form. Instead, they tried to duck out for their summer holidays and said the details would be announced in September. Markets were left to wonder where the axe would fall.
Not surprisingly, the markets and the credit-rating agencies caught the departing ministers by the collar and said this was not good enough. Irish debt was junked and the markets signalled a new low in their confidence in the ability of the eurozone to handle the crisis by raising interest rates on Italian and Spanish debt. This heightened the possibility that the crisis could spiral beyond the financial capacity to manage it. In response, eurozone officials simply condemned the markets and the credit agencies.
Meanwhile, the ECB continued to fiddle with inflation on the banks of the River Main, insisting that it really does not have any role to play in resolving the wider crisis. It has helped to manage the crisis thus far but threatens to pull the plug on Greek banks if there is even a whiff of default on Greek debt. This withdrawal of liquidity could catapult the crisis beyond control, but, while making such threats, Jean-Claude Trichet insists that the euro is a stable currency.
Stress tests on banks suggested they might need €3bn in new capital, but market analysts said this was not credible and the need might be as high as €80bn. Nervous markets are unlikely to want to recapitalise banks to this extent, especially when they still do not see a solution to the crisis, and this makes them even more nervous.
So eurozone leaders reluctantly agreed "to discuss the financial stability of the euro-area as a whole and the future financing of the Greek programme". We are warned in advance, however, that today's three-hour summit will not produce a final solution to the problem.
So where does that leave us?
Governments made significant progress in their understanding of the euro crisis in recent weeks and finally admitted that it was a common problem -- requiring a shared solution -- and not a set of isolated events. The euro group committed "to enhancing the flexibility and the scope" of its response and to lengthening the maturities of loans and lowering interest rates.
This new approach gave expression to what Ajai Chopra of the IMF nicely termed "a European solution to a European problem".
But new approaches need to be fully elaborated, anticipate market reaction and be quickly implemented for maximum effect. Otherwise, markets can panic and block implementation. They will immediately ask the big questions unless all of the answers are spelled out in advance -- and will sell Spanish debt if they do not know how the new plan will save it.
And a lot of questions need to be answered.
The IMF says that the Greek programme is "on a knife-edge" and admits that it would probably walk away from the whole deal if the global financial repercussions would not be so catastrophic. A bigger effort, including debt restructuring, is required and the summit may give a general indication of how this could be achieved.
But, debt restructuring -- or private sector involvement (PSI) -- will rattle the markets and this needs to be anticipated and provided for.
The IMF warns that "given the impact PSI could have on Greece's credit rating, it is imperative for euro-area member states to put in place mechanisms to guarantee liquidity support to Greece's banking system while a PSI operation is undertaken". Moreover, it is "absolutely essential for the sustainability of the program that the ECB stands ready to provide liquidity support if needed".
And this is where the concern now lies: the crisis has already jumped another notch or two beyond the delayed understanding of the eurozone governments. The problem is no longer confined to finding a solution to the debt crisis -- a solution that should have been spelled out a year ago -- but now includes reaching agreement on how to deal with the financial fallout from any plan and putting the necessary structures in place.
This is what the IMF calls a "comprehensive approach".
Today's summit may present a last chance for eurozone leaders to forestall a blizzard in European credit markets and they will not get away with an incomplete response. The summer is still a long, long way off.
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.