There is considerable nonsense written about the European debt crisis. Greece must balance its books, whether they remain inside the Euro or not. There are major benefits and costs to both remaining inside the euro and to exiting. There is no silver bullet that will solve their problems easily. More broadly, banks need to be recapitalized all across Europe. This has not been done as yet, perhaps for political reasons, which only compounds the economic problems and allows them to fester. It seems like the Europeans are working towards solutions, but painfully slowly. So the potential for a worsening of the crisis remains, even if most of the ingredients for a solution are quite obvious. I will focus on the core issues as follows:

Does Greece need to leave the Euro?
Does Greece really matter and shouldn’t we care more about Spain and Italy?
Will the public in Greece and elsewhere in Europe accept so much austerity?
How bad are the banks and how can they be saved?
How bad are the sovereigns and how can they be saved?

Does Greece need to leave the Euro?
Greece does not need to leave the euro, but there are consequences to leaving versus remaining inside. Leaving the euro will not balance Greece’s budget, which is absolutely necessary, since Greece is unable to borrow in the public markets. Who would take the risk of lending to them? Even if Greece resurrects the drachma, it is highly doubtful its citizens would suddenly become inclined to pay their tax bills. So if Greece exits the euro, the deficit will remain. The government will then be forced to print as many drachmas as needed to fill the gap between tax revenues and budget spending. The drachma’s value would fall sharply if Greece replaces euros with drachmas, because Greek citizens will want to own the stronger, safer currency, but the implied decline will be very strongly reinforced by the inflation consequences of printing drachmas to fund the budget deficit. So a Greek exit from the euro implies a severe recession, a surge in inflation, a weak currency and an inevitable requirement to balance the budget anyway. Why is leaving considered by some a good idea?

The primary benefit of leaving the euro is that a fallen drachma would eventually improve Greece’s competitiveness and attract business. It is hard to guess how much the Greek drachma would need to decline to accomplish this. Market forces would drive down the drachma to make up for the high cost of labor and doing business in Greece. But Greece exports very little today and much of its foreign exchange earnings come from tourism. A really savage decline in its currency value would entice tourists to flock to Greece to enjoy cheap vacations if the country settles down peacefully and, over time, business might move some operations there to hire cheap, plentiful labor that is located close to European markets. But tourists might first stay away if they are worried about strikes and riots. Moving business to Greece would take time. Unemployment and inflation would rise sharply at first and might remain high for quite a while. All foreign goods would immediately become sharply more expensive to Greeks, reflecting the fall in the value of the drachma, so living standards in Greece would also fall precipitously. And inflation would remain high for as long as the government funded itself by printing money. The only way for the government to rein in inflation would be to bring its budget closer to balance, so austerity will still occur. If mismanaged, inflation could worsen into hyperinflation, as has occurred in some basket case African countries or Germany in the 1920s. Eventually, a Greek government would be forced to balance its budget, even under a radical government. So, why bother leaving the euro?

Nor is there a clear case to be made for Europe to kick Greece out of the euro. If the Europeans stop lending money to Greece, there is absolutely no reason to kick them out. Greece may default and remain within the Eurozone. What’s been lost would still be lost, but if no more money is thrown in vain into Greece, there’s zero incremental harm to Europe if the Greeks choose to continue using euros as their currency. By analogy, if a U.S. state, say California, were to default, there would be no need for California to drop out of the U.S. or stop using the dollar.

Staying inside the euro does not preclude a Greek default and does not avoid the austere policies that have already caused the public to revolt politically. Since Greece can no longer borrow from the market, it is already under tremendous pressure to implement fiscal austerity. There is a blame game being played that tries to obscure this truth. Austerity is being blamed on foreigners. (Hint: that’s a euphemism for Germans.) But this is a sham and gamesmanship to shift blame. As already noted above, Greece must still balance its budget even if it has its own currency, quits the euro and repudiates its existing debts. Repudiating its debt may make it easier for Greece to balance its budget, since the debt service costs will go to zero, but it will also force an immediate budget balance since no one will lend any money to Greece under such circumstances.

The benefits of staying within the euro are first and foremost the inflation stability that will help Greece cope with its policy problems. The lower level of inflation that Greece shares with Europe also helps keep Greek interest rates down. By staying within the system, Greece would also get some funding support from the rest of Europe that would help it buy time to implement the necessary budget changes. It would be rather painful for budget balance to occur suddenly, as would occur if Greece goes back to the drachma. On a political level, Greece also avoids becoming an outcast in Europe and in capital markets. That matters to a proud people.

The downside of remaining within the euro is that the adjustment process will still be quite painful, although this pain cannot be avoided by dropping out. The government must balance its budget and, without a currency to absorb the blow, living standards within Greece will fall further until Greece prices become cheap relative to Europe. That will be painful and slow, so the Greek recession could last a few years. Greece can soften this blow by staying within the system and obtaining whatever support Europe will provide. All of this suggests there is no way for Greece to avoid the painful retrenchment that will occur as it is forced to reduce its budget imbalance, whether it stays within the euro or exits.

The decision to leave or stay is also a political decision, not just a question of economics. Europe would prefer to avoid evicting Greece and undermine the euro experiment. Europe also wishes to remain on the path of political integration. Similarly, Greeks do not want to be seen as being a pariah within Europe or in the credit markets. The latest survey indicates that about 85% of Greeks want to remain within the euro. The political argument for Greece to exit the euro is that all of the budget restraint comes from elsewhere in Europe and such restraint would be unnecessary if only Greece had its own currency back. This is a blatant falsehood. Thus, there is no political argument for Greece to exit the euro unless it wishes to divorce itself from Europe. This would be a major shift in its political position, albeit with very significant economic consequences.

Does Greece really matter and shouldn’t we care more about Spain and Italy?
Greece represents only about 2% of European GDP, and the private sector has already taken a 70% loss on Greece’s bonds. Governmental agencies, such as the IMF or ECB, have taken no write down at all and hold much of the remaining debt. Another Greek default would affect governments more than the private sector, so any impact would be fairly muted. The primary concern is that a Greek default might promote fear of failures elsewhere in Europe, notably Spain and Italy, and this contagion might undermine European markets. So, Spain and Italy’s finances matter far more today than Greece’s budget problems.

Spain is, arguably, the weakest of the large countries of Europe and its problems stem from a building boom that has caused huge bank loan losses and it is already suffering from a 25% unemployment rate. The loan losses must be absorbed, its banks must be recapitalized, and it needs growth to promote hiring and improve government finances. These are not easy problems, but they are also not insurmountable. The housing market will need years to absorb the overbuilding, but there is no reason growth cannot resume in the rest of the economy.

In my judgment, the banks require attention first because there is no solution without the solvency of the banks, which makes the very limited action taken so far highly disappointing. Spain recently took 45% ownership of Bankia, which accounts for about 10% of Spain’s bank deposits, but there is still a capital shortage that must be filled to make Bankia viable. Spain is now putting 19 billion euros into Bankia, while one outside estimate suggested that 25 billion euros would do the job with Bankia. So, enough may have been done to deal with Bankia. (Bankia was formed from amalgamating very troubled smaller banks, so it is a large fraction of the overall problem and auditors are now reviewing Bankia’s books.) But, it is also necessary to review the books of the larger Spanish banks and to force them to rebuild their own capital bases. To provide some context, the Institute for International Finance estimates that 75 billion euros would recapitalize all of Spain’s banks.

Capital injections into Spain’s banks can be done either in a shareholder friendly or unfriendly way, by having the government invest in preferred shares alongside shareholders or by wiping them out. The cost of issuing debt by Spain may be high at the moment, but relieving the stress of the banking system would lower risk premiums and interest rates going forward. Or, Spain could get funding from the European Stability Mechanism, ESM, or IMF. In time, the government can be repaid after the situation has stabilized and the banks are able to raise capital from the public markets, as occurred here following TARP injections. If wiping out shareholders is politically too difficult, then the government could invest side by side with existing shareholders. But some sort of sizable capital infusion is necessary and it must be done for all of the large Spanish banks that require capital to resolve the market’s concerns.

A second step to shore up the banks may be to insure Spanish bank deposits (and other European bank deposits) to calm credit markets. This was also done in the U.S. with great effect. The Treasury guaranteed all money funds and bank deposits up to $250,000 per account. Doing so in Europe, either by the ECB or some pan-European agency or promise, would halt any run on banks in Europe. (Greece may be excluded from this program on the basis that political parties seeking to run the government may not stand behind its sovereign debt nor be able to recapitalize its banks.) Such action may be unnecessary, but it would be helpful and send a strong positive message. Apparently, something of this sort is now under consideration.

Critically, Spain needs pro-growth policies, not just austerity. Normally, the government might just initiate some new spending or building program to stimulate growth. But this option is unavailable when budget deficits are being reduced and borrowing has become expensive. So, the government must implement new policies to promote spending by the private sector, by relaxing restrictive rules that unleashes private investment. Politically, this may be quite difficult, since some restructuring of the restrictive employment rules and assorted other aspects of the nanny state may be required. Europeans like their social safety nets, even though these inhibit hiring and growth. Germany did this some years ago to positive effect. France is even more unlikely to implement such rules changes after having just elected a Socialist government. However, Spain has just elected a conservative, Rajoy, as Prime Minister. It would be helpful for him to act now, even if the benefits may take some time before they become apparent.

Indeed, all the countries of Europe need to promote growth, and to the extent possible, without increased government spending. Monetary policy has room to reduce interest rates and to implement quantitative easing, if needed. We expect the ECB under Mario Draghi to reduce rates, likely sooner rather than later. Similarly, other Europeans should be pressing their own banks to rebuild capital to enhance market confidence in their financial institutions. The prescriptions suggested for Spain also apply to much of the rest of Europe.

On an entirely different tack, it has been suggested, notably by the new French government, that loans to banks or sovereigns should be made by a new pan-European borrowing agency, something new other than the IMF or the ECB, instead of individual countries. In fact, this is a very political request that seeks to shift the debt burden from individual countries that actually created these financing needs, to some pan-European entity. Since there is no tax authority at the pan-European level, it is unclear how such debt would be serviced or who would really be responsible for it. Such an entity could be created, if the Europeans can work out the details, but that would take plenty of time. Such an approach is actually similar to the recapitalization I suggest for Spain, simply accomplished at the pan-Europe level, instead of country by country. The most obvious benefit of creating such an entity is that it would have the backing of all the members of the Eurozone and all these nations would be able to exert pressure on individual countries to improve their finances.

Will the public in Greece and elsewhere in Europe accept so much austerity?
Voters are already telling government officials they do not have the appetite to accept the austerity programs without a far better explanation for why these are needed. Incumbents have been tossed from office almost everywhere, ranging from a conservative, Sarkozy in France, to a socialist, Zapatero in Spain. Some officials have been reluctant to deliver the bad news before the votes are held. Other politicians tell voters what they wish to hear. Or, the citizens do not understand or care. Electing anarchists, as may occur in Greece, will only worsen the problems, however. Taking such an irresponsible tack will produce policies that will inflict even greater damage on the Greek economy. Perhaps Greece will show the rest of Europe the way, by showing them what should not be done. Nonetheless, some austerity is necessary and it will continue, regardless of the way in which the current crisis is addressed.

Austerity is necessary, because budgets deficits cannot be sustained when the governments can no longer borrow in the market. It is just a simple matter of math. But this does not mean the retrenchment must occur in one gulp. Budget deficits will also decline if there is some growth. So, policies to promote growth need to be part of the solution. More accommodative monetary policy accompanied by meaningful regulation to promote development in the more restrictive economies of Europe would be helpful. So, we expect the ECB to lower rates again, probably soon.

Even so, if socialists or anarchists will not accept some retrenchment in the broad safety net or in the government’s generous retirement and other policies, the markets will make them and the public will be forced to pay. The anarchists expect the rest of Europe to continue lending them money, if they halt the budget retrenchment promised by the previous government. That’s a very risky position. Why would Europe lend them more when they are unwilling to reduce their deficit spending and wish to maintain their irresponsible fiscal policies? If the anarchists gain control in Greece, the governments of Europe will leave Greece to sort out its own finances and redirect their financial support to Spain and Italy to insure they are not enveloped by the maelstrom in Greece. That seems like a far better and safer use of their money. The latest polls suggests that Greeks, after flirting with the anarchists in the last election, are now moving back towards the center.

Government retrenchment is coming in the more profligate economies of Europe, whether their governments support such policies or not. If the pan-European lending to Greece’s government ceases, Greece will run out of cash and budget balance will be imposed by simple mathematics. You can’t spend what you don’t have and can’t borrow. This part of the equation really isn’t complicated. More austerity is coming to Greece, either voluntarily or involuntarily. So it makes more sense to do this with the support of the rest of Europe.

How bad are the banks and how can they be saved?
The budget problems of the governments of Europe are exacerbated by the solvency problems of the banks. Unlike American or British banks, which raised capital after the credit crisis of 2008, continental European banks failed to do so. No one believes they have properly recognized market losses in their loan portfolios. Government mandated stress tests have been unconvincing, particularly since the banks have yet to raise the capital implied by those tests. So, there are good reasons for investors to doubt that European banks are healthy, which is a major problem, since so much of European credit is channeled through the banking system. European bank finances can be improved, but strong action must be taken.

This concern over the banks is greatest in Greece of course, where there is significant risk that bank deposits, denominated in euros, could be converted into drachmas by law if Greece fails to address its problems. Greek citizens have been withdrawing funds from Greek banks and moving them into bank accounts in other European countries to preserve their holdings against an involuntary conversion. This run against Greek banks began roughly three years ago, but the pace has picked up from a trickle to an unsustainable gusher. Could this also happen in Spain or Italy? It isn’t likely, but it isn’t impossible. To reassure the public, some form of guarantee from the ECB or some new agency would be desirable, at least for a pre-stated period of time. This is exactly how the U.S. Treasury acted in 2008, by guaranteeing the deposits of bank accounts up to $250,000 by the FDIC, by guaranteeing money market mutual funds, and even by guaranteeing the bonds issued by banks with any maturity up to three years. Those actions stabilized the banking system here and halted any prospect of a run against the banks.

The other part of the program must be to force the banks to raise capital. The LTRO program provided the banks with liquidity, but not with additional capital. The U.S. Treasury stuffed capital into American banks in 2008 by forcing them to issue preferred shares to the government under fairly reasonable terms, a 5% coupon plus some warrants, under the TARP program. This was done only after numerous missteps and only after the British figured out how to do this sensibly. Europe needs something like this now. In fact, European banks are supposed to raise capital by June 30, yet few have done so, presumably because the cost of capital is very high and dilutive to shareholders. So, the government needs to provide the first sizable slug of capital, so the market understands the risks have been reduced. The U.S. TARP program proved to be highly profitable for the Treasury, since it was repaid in full, plus interest, plus it got bought out of its warrants at a premium. The Europeans could do something similar now.

The Spanish government has already stepped in and taken 45% ownership in Bankia, a large bank assembled from many smaller institutions that had made many now defaulted real estate loans. Investors need to be confident that the losses from bad real estate losses at those firms are adequately backed by capital. The sooner this is accomplished, the sooner markets will become less concerned with Spain. By the same token, Spain’s reluctance to address the capital questions surrounding its banks worry investors and suggest the problems may be far larger than feared and might be unmanageable. So, it is hard to understand why the Spanish government allows these fears to gestate.

Similar issues concern banks across Europe. The largest banks of France and Germany are without a doubt too big to fail, especially since these firms are treated as national champions and protected by their governments. Even so, these governments have yet to guarantee bank liabilities nor forced the banks to raise capital. This is almost irresponsible, since the banks cannot easily raise capital right now and the economies of Europe will struggle, at best, without a capital replenishment. At some point, we expect European governments to help banks raise capital, but Europe will suffer until such steps are taken.

The latest European stress tests suggested that 115 billion euros need to be raised by Europe’s largest banks, which they are “required” to do by June 30. This is seems like a surprisingly small sum, although the banks may need government assistance to do so.

How bad are the sovereigns and how can they be saved?
The unwillingness of the governments to put capital into their banks reinforces the concern in the market that the sovereign governments are themselves in really bad fiscal shape. Everyone knows Greece is a financial basket case. The concern is whether Spain and Italy could weaken as much. However, the market votes quite visibly on the sovereigns every day, by virtue of the rates on their publicly traded bonds. And government policy with respect to taxes, spending programs, and such is highly visible. We know that Spain and Italy have retrenched meaningfully, while Greece has been unable to implement much improvement in its budget projections.

Europe needs to demonstrate to the markets that the problems of the sovereigns are manageable, not just the budget deficits, but that growth will resume. Germany’s single-minded focus on budget retrenchment, with little consideration given to promoting economic growth, will have to give way to a more balanced approach. But, again, it is important for the governments of Europe to provide unambiguous support for governments that are working to bring down their deficits, so they can distinguish themselves clearly from Greece. No one should want to be associated with Greece’s behavior. (Not even the Greeks should be happy to be associated with Greek government policy, except they are reaping what they sowed.) So, the rest of Europe must demonstrate they are doing the right thing. Specifically, what does that require?

First, it is important for the European governments to force a recapitalization of their banks, so investors know the financial system is being protected and banks can lend to finance economic growth. Deposit guarantees may be part of this approach to the banks. A stronger banking system is a prerequisite for economic recovery and for budget improvement at the government level. Europe’s financial problems suggest it is better to do more than risk doing less, even though to this point, they have tended to do the least possible. Shoring up the banks would also reduce the perceived risks of the governments, potentially also lowering their borrowing costs.

Second, policy should be as expansion oriented in every way possible that does not worsen their budget deficits. Specifically, these include interest rate reductions by the ECB and quantitative credit availability to any European bank that meet the Basle III capital requirements. Cheap funding to healthier banks insures that creditworthy borrowers in the private sector can get plentiful financing to fund growth.

Third, while European governments are reluctant to weaken any of the regulations that limit the flexibility of firms to fire workers, start new businesses, and respond flexibly to market conditions, deregulation would unleash private investment. Europe’s socialist tendencies get in the way of this, of course. But the Europeans should look at Germany and try to understand how its deregulation efforts some years ago helped Germany grow even as others in Europe stagnated.

Fourth, the governments of the Eurozone need to state unambiguously that they all stand together to help fund any member state that maintains a longer-term commitment to improving their fiscal finances. This could be in the form of some sort of pan-European lending agency. It could be through use of the ECB. But a firm commitment would help governments fund themselves at reasonable cost and raise capital to recapitalize their banks.

We expect much of the above to be implemented. Hopefully, it will happen to prevent a financial crisis and not in response to one. It is the timing that remains highly uncertain.