The EU’s ‘Shock and Awe’ Debt Crisis Package

European Union leaders have yet again come up with a detail-free plan to address the European debt crisis, with the hope being that this one with be massive enough to have the needed "shock and awe" effect to calm markets. Whether or not it will be enough to have more than an immediate impact remains to be seen. How will European banks recapitalize without consolidating their holdings, at a time when bank shares have been falling? Who will actually pony up the money to reinforce the European Financial Stability Facility (EFSF)? How realistic is the Greek austerity budget? And how compatible is the entire package with the dismal long-term prospects for growth? The viability of the plan depends on the as yet uncertain answers to all of those questions.

As for the criticism that Europe could have saved itself a year and a pretty penny by adopting this plan when the initial Greek debt crisis emerged, it is technocratically correct but otherwise unrealistic. It's similar to someone pointing to an airplane in flight and saying, "That's great, but why bother with the takeoff?" To understand why, it's worth noting that the Greek and subsequently European debt crisis has in fact been shorthand for what was all along really three crises. The first was a debt-driven liquidity crisis (and in the case of Greece, an actual solvency crisis). The second was a political crisis. The third was an institutional crisis.*

With regard to Greece's liquidity and solvency, the former required two things, both of which were politically toxic: a brutal austerity budget in Greece and European bailouts. We've seen how difficult the first two have been to implement, even at a gradual pace over the past year. Anything faster could have resulted in revolution and martial law in Greece, and a veto by the German parliament that would have left Italy and Spain entirely unprotected from the contagion. As for Greek solvency, it has long been clear that holders of Greek debt would have to take haircuts, which have now been set at 50 percent. It's worth remembering, however, that the mere suggestion of private participation in restructuring Greek debt a year ago drove markets into a panic. Had it been imposed immediately, it could have set off a capital flight from the eurozone, bank runs and even more catastrophic interest rates on government debt than we've seen so far.

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