Edited by Thorsten Beck - Vox

Resolving the current European mess
Charles Wyplosz
Graduate Institute, Geneva and CEPR
A series of policy mistakes have put Europe on the wrong path. This chapter says that
the current plan to enlarge the EFSF and recapitalise banks through markets will fail.
The twin crises linking sovereign debts and banking turmoil need to be addressed
simultaneously for Europe to avoid economic disaster.
Invariably, policy mistakes make a bad situation worse. The May 2010 rescue package
was officially designed to prevent contagion within the Eurozone, but the crisis has
been spreading ever since, as evidenced by the interest spreads over German ten-year
bond rates (Figure 1). Unofficially, a number of governments were concerned about
exposure of their banks to Greek and other potential crisis-countries’ bonds. Banks
are now in crisis, a striking blow to the July stress tests that were officially intended to
reassure the world and unofficially designed to deliver reassuring results. This is not
just denial; it is an attempted cover-up.
The debate is now whether it is more urgent to solve the sovereign debt crisis or the
banking crisis. The obvious answer is that these two crises are deeply entangled and
that both crises must be solved simultaneously. Debt defaults will impose punishing
costs on banks, while bank failures will require costly bailouts that will push more
countries onto the hit list. Spain, Italy, Belgium, and France are on the brink. Quite
possibly, Germany might join the fray if some of its large banks fail. This should dispel
any hope that Germany will bankroll governments and banks. German taxpayers are
revolting against more bailouts, but they may not realise that they cannot even afford to
be the white knight of Europe. From this, a number of conclusions follow.
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