Hugo Dixon

Greece needs to go to the brink. Only then will the people back a government that can pursue the tough programme needed to turn the country around. To get to that point, bailout cash for both the government and the banks probably has to be turned off.

It might be thought that the country is already on the edge of the abyss. This month’s election savaged the two traditional ruling parties which were backing the bailout plan that is keeping the country afloat. Extremists of both right and left gained strength – voters liked their opposition to the plan. But nobody could form a government. Hence, there will be a second election on June 17.

Will this second election express the Greeks’ desire clearly: stick with the programme and stay in the euro; or tear up the plan and bring back the drachma? That is how Greece’s financial backers in the rest of the euro zone, such as Germany, are trying to frame the debate. But the electorate doesn’t yet see the choice as that stark. Roughly three quarters want to stay with the euro but two thirds don’t want the reform-plus-austerity programme.

The next election is unlikely to resolve this inconsistency – or at least that is the conclusion I came to from a trip to Athens last week. The battle for first place is between Alexis Tsipras, the young leader of the radical left SYRIZA party, and the centre-right New Democracy party led by Antonis Samaras.

A victory for Samaras might seem to offer the hope that Greece will stick with the programme and the euro. He has, after all, campaigned for both. However, even if he comes first – which he did in this month’s election – he will not have a parliamentary majority. He will either have to stitch together a majority coalition or govern a minority government. Neither is the recipe for a strong government.

A Samaras government could theoretically deliver a positive shock by moving full-steam ahead on reforms and gaining so much credibility with Greece’s euro zone partners that they give Athens real help in turning around the country. But it is far more likely that he will be timid and the rest of the euro zone will throw Greece only a few crumbs. The economy, which has gone from bad to worse in the last couple of months of electioneering paralysis, would continue its nosedive, Samaras’ popularity would evaporate and after a few months his government would collapse.

A victory by Tsipras in next month’s election might seem even worse. After all, he will probably set Athens on a collision course with the rest of the euro zone. Last week Tsipras likened the relationship between Greece and the euro zone to that between Russia and America in the Cold War, when both had nuclear weapons that could destroy the other but refrained from firing them. Tsipras thinks the rest of the euro zone is scared that Greece’s return to the drachma would cause the entire single currency to unravel and that the bail out of Athens will continue, even without substantial economic reform.

The impact on the euro zone of Greece’s expulsion would undoubtedly be severe. But the other countries are finally preparing contingency plans to mitigate the damage. Germany, for one, will not be blackmailed by threats of mutually assured destruction.

It is conceivable that Tsipras will blink first, if he wins the election and finds he can’t shift the Germans. But this is unlikely. The typical weasel words of a politician won’t be enough to get him out of a tight spot; he would have to perform a complete somersault. It is doubtful the Marxists in his party would let him get away with this and, if they did, he would certainly lose all credibility in the country.

That said, a victory for Tsipras may paradoxically be Greece’s best chance of staying in the euro because it would bring things to a head rapidly. The country is being kept alive by a dual life-support system: the euro zone and IMF are channelling cash to the government, while the European Central Bank is authorising cash transfers to the banks. If the first tap is turned off, the government will not be able to pay salaries and pensions from July. If the second tap is turned off, the banks could run out of cash within days.

Cutting off Greece’s life support could be the trigger for reintroducing the drachma as the people found the cash machines ran dry. But it could also finally force the people to decide whether they were prepared to back reform – provided the euro zone simultaneously rolled out a proper plan to help the country. A key element of that would have to be to take over the Greek banks and guarantee their deposits, putting the country into a form of financial protectorate.

In such a scenario, a Tsipras government would probably collapse. After all, even if he comes first in the next election, he will not have a majority and so would be relying on coalition partners or governing in a minority. Greece would then need a third election, after which it might be able to put together a national unity government – perhaps even led by Lucas Papademos, the technocrat who ran the country for the last six months.

It is a slim chance full of risks, but probably Greece’s best chance of avoiding the drachma.

What should be the long-term vision for the euro zone? The standard answer is fully-fledged fiscal, banking and political union. Many euro zone politicians advocate it. So do those on the outside such as David Cameron, Britain’s prime minister, who last week called on the zone to “make up or break up”.

The crisis has demonstrated that the current system doesn’t work. But a headlong dive into a United States of Europe would be bad politics and bad economics. An alternative, more attractive vision is to maintain the maximum degree of national sovereignty consistent with a single currency. This is possible provided there are liquidity backstops for solvent governments and banks; debt restructuring for insolvent ones; and flexibility for all.

Enthusiasts say greater union won’t just prevent future crises – it will help solve the current one. The key proposals are for governments to guarantee each other’s bonds through so-called euro zone bonds and to be prepared to bail out each other’s banks. In return for the mutual support, each government and all the banks would submit to strong centralised discipline.

But the European people are not remotely ready for such steps. Anti-euro sentiment is on the rise, to judge by strong poll showings by the likes of France’s Marine Le Pen and Italy’s Beppe Grillo. Germany’s insistence last December on a fiscal discipline treaty has stoked that sentiment.

An attempt by the region’s elite to force the pace of integration with even more ambitious plans could easily backfire with voters, particularly in northern Europe. They would fear being required to fund permanent bail outs for feckless southerners. Premature integration might not even help with the current crisis if it backfired with investors. They might start to question the creditworthiness of a Germany if it had to shoulder the entire region’s debts.

In contrast, the principle of “subsidiarity” – the Maastricht treaty’s specification that decisions should be taken at the lowest possible level of government that is competent to handle them – is good politics and good economics. Of course, even advocates of political union such as Wolfgang Schaeuble, Germany’s finance minister, subscribe to this principle. The issue is to define the minimum conditions needed for the sustainability of the single currency. There are probably three.

The first is that insolvent entities – whether they are governments or banks – should have their debts restructured. One of the main reasons states and lenders were allowed to leverage themselves so much in the boom was because there was a widespread view that they couldn’t go bust. The complacency sowed the seeds of the crisis.

Meanwhile, a key mistake in managing the crisis was the failure to restructure Greece’s debts as soon as they became unbearable. If that had been done, private-sector creditors would have taken the hit. Instead, they were largely bailed out – with the result that 74 percent of Athens’ outstanding 274 billion euros in debt is now held by governments and the International Monetary Fund, according to UBS. This means taxpayers will be on the hook when the big fat Greek default occurs.

Of course, if Greek debt had been restructured earlier, banks in the rest of the euro zone would have had big holes in their balance sheets. Some would have needed bailouts from their governments. But that would have been better than the current debilitating long drawn out sovereign-cum-banking crises.

What’s more, in the future, insolvent banks shouldn’t be bailed out either. Their creditors should be required to take losses before taxpayers have to stump up cash. The failure to do so explains why the government of Ireland, previously financially solid, become infected by its lenders’ folly.
The second minimum condition for monetary union to flourish follows the first: there should be liquidity backstops for banks and governments that are solvent.

With banks, the natural liquidity backstop is the European Central Bank. The quid pro quo is that lenders have to be properly capitalised. Time and again throughout the crisis, euro zone governments have ducked this issue. Only this month, France and Germany conspired to dilute the Basel 3 global capital rules as they apply to Europe, while Spain imposed another half-hearted restructuring on its banks. If the euro zone’s leaders want a successful single currency, this nonsense has to stop.

For governments, the natural liquidity backstop is the European Stability Mechanism, the zone’s soon-to-be-created bailout fund. To do its job properly, it will need extra funds – as it isn’t be big enough to help both Spain and Italy. One option could be to allow it to borrow from the ECB.

Again, the quid pro quo would be solvency. Insolvent government would only get access if they restructured their debts. And illiquid but insolvent ones would need credible long-term plans to cut their debts. Italy, with debt over 120 percent of GDP but huge private wealth and state assets, might one day find itself in the latter category. In return for liquidity, it might have to agree a multi-year programme to privatise real estate and to tax wealth.

The final minimum condition for a successful monetary union is much more flexibility, particularly in labour markets. This is the key to restoring competitiveness in southern Europe and enabling the zone to respond to future shocks.

If the euro zone can do these three things – restructure insolvent institutions’ debts, provide liquidity to solvent ones and improve flexibility everywhere – nations will be able to keep both the euro and much of their sovereignty. That’s a preferable vision to either a euro super-state or the chaos of disintegration.

When euro zone policymakers are asked if there is a Plan B to cope with a Greek exit from the single currency, their typical answer goes something like this: “There’s no such plan. If there were, it would leak, investors would panic and the exit scenario would gather unstoppable momentum.”

Maybe there really is no plan. Or maybe policymakers are just doing a good job of keeping their mouths shut. Hopefully, it is the latter because, since Greece’s election, the chances of Athens quitting the euro have shot up. And unless the rest of the euro zone is well prepared, the knock-on effect will be devastating.

The Greeks have lost their stomach for austerity and the rest of the euro zone has lost its patience with Athens’ broken promises. But unless one side blinks, Greece will be out of the single currency and any deposits left in Greek banks will be converted from euros into cut-price drachmas.

People outside Greece may think this is simply a Greek problem. Would it really be much worse than Athens’ debt restructuring earlier this year which passed off with barely a murmur? But the process of bringing back the drachma is likely to involve temporarily shutting banks and imposing capital controls. That would set a frightening precedent.

Politicians and central bankers would, of course, argue that Greece was a not a precedent but a one-off. But why trust them? When Greece was first bailed out in 2010, policymakers said it was a special case. Then Ireland and Portugal required official bailouts while both Spain and Italy have had to be helped by the European Central Bank. If savers in Greece get hammered, depositors and investors in these other weak euro member would want to move their money to somewhere safer. Fears would rise of a complete break-up of the euro zone.

Indeed, there already has been significant capital flight from peripheral economies. The best way of seeing this is by looking at so-called Target 2 imbalances – the amount of money that national central banks in the euro zone owe to the ECB or are owed by it. These imbalances are a rough proxy for capital flight.

Four euro zone central banks – in Germany, the Netherlands, Luxembourg and Finland – have positive balances. At the end of April, the Bundesbank was owed 644 billion euros, according to data collected by Germany’s Ifo Institute. The sum has been rising by an average of 33 billion euros a month since the crisis took a turn for the worse at the end of July last year. Meanwhile, all the peripheral countries have big liabilities. Italy and Spain have the largest with 279 billion euros (as of April) and 276 billion euros (as of March) respectively.

A Greek exit from the euro would, at least temporarily, accelerate capital flight. Measures would need to be taken to counteract it – to protect both depositors and governments in vulnerable countries.

Fortunately, it’s not too difficult to construct a contingency plan. To protect depositors, the ECB would have to make clear that a limitless supply of liquidity with very few strings attached was available for banks across the euro zone. This would avoid the possibility that savers would find they couldn’t get money out of their accounts. After a while, calm might return.

To protect governments, the ECB would also need to wade into action. Although it cannot lend to states directly, it can buy their bonds on the secondary market. Indeed, it has already done so. It would, though, need to be prepared to buy bonds in limitless quantities. Otherwise, investors might just run anyway and take the ECB’s money while it lasted.

Although the ECB would have to play the main role in preventing a panic, the euro zone’s so-called firewall should play a subsidiary role. The region will soon have two main bailout funds – the existing European Financial Stability Facility and the European Stability Mechanism. These could be deployed in two ways.

First, they could provide a backstop to national deposit guarantee funds. That way, an Italian saver would know that, if Rome’s own guarantee scheme ran out of money, there were funds in another kitty to fill the hole. Second, the bailout funds could lend cash directly to governments that were no longer able to issue bonds in the markets.

However, the bailout funds are not large enough to stem a panic on their own. They only have 740 billion euros available. Even with help from the International Monetary Fund, they would not be able to douse the flames.

Although it is fairly easy to think of a plan B, that doesn’t mean it would be easy to get political agreement for it from Germany and the other creditor countries. One concern would be that the ECB would be taking huge financial risks by buying government bonds and lending to banks. Another is that such rescues, which would amount to a big step towards fiscal union, would take the pressure off the peripheral governments and their banks to reform themselves and improve their solvency.

On the other hand, failure to act as a lender of last resort in a Greek-exit panic could trigger a domino effect of bankruptcies – of banks and governments – throughout the periphery. The euro couldn’t survive that.

Germany may soon need to decide between going all-in to save the single currency or witnessing its destruction.

It has become fashionable to talk about the need for a euro zone “growth compact” as weariness mounts over a diet of nothing but austerity. France’s new president Francois Hollande has popularised the idea. Even Mario Draghi has backed it. That gives the concept credibility as the European Central Bank president was one of the main supporters of the austerity-heavy “fiscal compact”, which requires governments to balance their budgets rapidly. Olli Rehn, the European Commission’s top economic official, has joined the bandwagon too: at the weekend, he advocated a pact to boost investment, while hinting that there may be scope to ease up a bit on the austerity.

But all this chit-chat won’t lead to much unless politicians are prepared take unpleasant decisions on reforming labour, welfare and banking – measures which would boost growth in the long run. That has to be the quid pro quo for loosening the current fiscal squeeze or further easing monetary policy – measures that would help in the shorter term. 

Without such a grand bargain, any growth compact is likely to amount to little more than extra funds for investment. Rehn mentioned the main ideas at the weekend: using EU budget funds to guarantee lending to smaller firms; encouraging countries with fiscal surpluses to increase public investment; and boosting the capital of the European Investment Bank. While these measures are worthy, they are not of the scale needed to change the course of one of the biggest economic crises in recent history. 

The main guts of a growth compact ought to be somewhat looser fiscal and monetary policy married to deep structural reform. 

Look first at fiscal policy. It is great that policymakers such as Rehn seem to understand the dangers of an austerity spiral – where excessive budget squeezes crush the economy which in turn makes it harder to balance budgets and so requires further austerity. He says Europe’s fiscal rules are “not stupid”. 

 But even if Germany, Europe’s paymaster, can be persuaded to go along with a laxer interpretation of the rules, there is a limit to what will pass muster with the bond markets. While investors aren’t enamoured with growth-crushing austerity, they won’t finance profligacy either. Credible long-term plans to rein in deficits and restore competitiveness are needed. With those in place bond investors would be happy if the European Commission allowed governments another year or so to balance budgets. 

 The need for substantial change is not limited to countries already in crisis. In France, industry is increasingly uncompetitive and the government spends 57 percent of GDP. Tackling that ought to be the government’s priority, though it got little mention during the election campaign. Even Germany would benefit from reforming its weak services industries. Meanwhile, across Europe there needs to be a determined drive to deepen the region’s single market. 

 To gain the full benefits of monetary policy, there also needs to be a quid pro quo with the politicians. It’s important not to misinterpret Draghi’s new fondness for the word “growth”. The ECB is still keen on fiscal rectitude and is not signalling looser monetary policy. When Draghi talks about a growth compact, what he has in mind is structural reform – something that will not bear fruit for some time. Indeed, Draghi talks about the need for a 10-year vision. 

 While the central bank has engaged in exceptional measures to prevent the system collapsing – buying government bonds and spraying cheap money at the banking system – it has done so with a heavy heart. It rightly fears that such monetary rescues reduce the pressure on both governments and banks to reform themselves. Germany’s Bundesbank is even calling for the ECB to prepare to exit from these exceptional measures. While it won’t get its way – Draghi has made clear he thinks it’s too early to do this – talk of an exit is already making the money markets and the banks nervous. And that is undermining some of the benefits of the current loose policy. 

 For the ECB to be happy to pursue further monetary laxity, it will need to be convinced that governments are going to use the time they are being given wisely. A priority is to recapitalise zombie banks. So long as lenders have weak balance sheets, they will find it hard to fund themselves in the markets and will therefore lack the confidence to finance growth. 

 The key short-term imperatives are in Spain and Greece. But weak balance sheets are not confined to these two countries. Other governments have shown themselves unwilling to impose higher capital requirements on their lenders. Last week, for example, both Germany and France argued for changes in the way the new Basel 3 capital rules are applied to Europe so that their banks won’t need to raise so much capital. If politicians could bring themselves to grasp the nettle on banking, lenders would find it easier to fund themselves in the markets and the ECB would be less grudging about providing emergency assistance if it was still needed. 

 The ideal growth compact would match reform of banks, labour and welfare with less short-term austerity and accommodative monetary policy – and throw in some extra money for investment. Given the difficult political choices required, such a deal won’t be easy to pull off. But the tectonic plates are shifting across Europe. Now is the time to push for it.

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

A further difficulty concerns whether such a banking union should stretch across the euro zone or the entire European Union, which includes the United Kingdom, home to the region’s largest financial centre. Britain would argue that it shouldn’t be roped into a system that is designed to shore up the single currency it is not a part of. On the other hand, if the euro countries went ahead on their own, the single market in financial services would fragment.

Quite apart from the politics, a banking union wouldn’t actually solve all the problems. In particular, it would do nothing to stop banks owning too much government debt. Indeed, in the last few months, Spanish and Italian lenders have bought even more of this debt – using cheap money from the European Central Bank. This has helped finance their governments through a rough patch but at the cost of tying the banks’ fate even more closely to that of their countries. Over time, governments ought to be weaned off reliance on their local banks. But, realistically, this isn’t going to happen fast.

Does this mean that a European banking union is a totally dead idea? Not quite. It may be possible to cherry-pick bits of it. The most important part would be to create a Europe-wide “resolution” regime. The basic idea is that such a regime would allow insolvent banks to go bust in a controlled fashion. If shareholders haven’t put in enough capital, bondholders have to be “bailed in”. Only if bondholders also haven’t put in enough capital do deposit guarantee schemes – and possibly taxpayers – have to be activated to make sure savers are repaid. With such a framework, governments such as Ireland’s wouldn’t in future be infected by their lenders’ problems.

At present, many European countries lack such a resolution regime and those that do exist don’t collaborate effectively with one another. What’s more, until recently the European Central Bank has been hostile to the idea that bank bondholders should suffer any losses. It prevented Dublin from bailing in bondholders, fearing that this would trigger contagion.

The mood, though, is changing. The European Commission is planning to publish plans for an EU-wide resolution regime in June. Even the ECB has started lending its support to such a scheme. The devil, of course, will be in the detail. But there finally seems to be momentum behind this proposal.

A second idea that could be cherry-picked is to reinforce Europe’s deposit guarantee schemes. At the moment, every country has its own. The problem is that depositors in weak countries, especially Greece, don’t have confidence that their national schemes have enough money to pay out. So savers have been taking their cash abroad.

It is too much to expect that Germany, Europe’s paymaster, would agree to a euro-wide deposit insurance scheme. But what about some sort of reinsurance scheme? Nicolas Veron from the Bruegel think tank argues that the European Stability Mechanism, the euro zone’s soon-to-be-created bailout fund, could provide national schemes with a backstop.

Europe is not ready for banking union any more than it is ready for political union. But such ideas show there are practical ways of limiting the unhealthy nexus between lenders and their governments. Europe should grasp them.

We’re going to be really tough on the euro zone. If they want more bailouts from the International Monetary Fund, they are going to have to submit to strict conditionality. That was the message delivered by the rest of the world when it agreed at the weekend to participate in a fundraising exercise that will boost the IMF’s resources by at least $430 billion.

But the meaning of the message isn’t quite what it seems. The IMF is actually in some ways calling for less rather than more short-term austerity in the euro zone. So if the Europeans submit to IMF discipline, it will ironically mean less of a hair shirt.

It is easy to see why the rest of the world is unhappy with the special treatment the euro zone receives from the IMF. The managing director, currently Christine Lagarde, has always been a European. Vast resources, way beyond what are normally available in IMF programmes, have been channelled to Greece, Ireland and Portugal.

What’s more, the rest for the world – from developed countries such as America, Britain and Canada to emerging nations such as Brazil – feel that, despite being pretty rich, the euro zone has not done enough to sort out its own problems. Hence, the agreement to beef up the IMF resources only after a long wrangle – and only after scaling back the original request from $600 billion as well as insisting on strict conditionality before the money is ever disbursed.

At the same time, the IMF has three recommendations, as outlined in last week’s World Economic Outlook, which are somewhat at variance with current euro zone policy. First, it wants the region not to overdo short-term fiscal austerity while placing more emphasis on longer-term structural measures to improve budgets. Second, it wants the European Central Bank to continue very accommodative monetary policies. Finally, it wants the euro zone authorities to be prepared to inject capital directly into troubled banks and to accompany that with stronger European-wide supervision of lenders. All these ideas would help reduce the pressure of the current euro zone recession and so ease the crisis.

Will the IMF, though, get its way? Well, certainly not immediately. The euro zone doesn’t have to listen to it unless another country – say Spain or Italy – needs a bailout. Even then, only the country requiring cash would technically have to pay heed to the IMF. The rest of the euro zone, led by Germany, could argue that the IMF has no business interfering with the monetary policy or banking supervision of the entire 17-member euro zone when only a few peripheral nations are receiving help.

What’s more, the bulk of the money from any future bailouts would continue to come from other euro zone countries rather than the IMF. These other countries would argue that they should have a big say, even on fiscal policy, because they will be bankrolling most of any deficit shortfall.

But even if the IMF can’t get its way immediately, the debate is shifting slowly in its favour. The euro zone may not like interference in monetary policy. But the ECB has shown itself willing to spray 1 trillion euros in long-term loans at the region’s banks in the heat of the crisis in recent months. Some of the central bank’s members, with the notable exception of Germany’s Bundesbank, are saying it is too early to plan for an end to such policies.

Or take fiscal policy. Euro zone leaders may have agreed the so-called fiscal compact which will require them to balance their budgets and cut their debts. But no sooner had the deal been signed than Spain varied its fiscal targets. Italy has followed up by saying it won’t react to a deeper than expected recession by pushing through more cuts – a policy that would just lead to further recession.

Now the Dutch government, previously the high priest of austerity, has found it cannot push through its own budget cuts. Meanwhile, Francois Hollande has promised to push for a more growth-orientated policy if he wins the French election. The austerity consensus is fraying.

Finally, consider banking policy. The intertwining of lenders and their states is unhealthy. Banks which get into trouble need to be bailed out. That makes their governments less creditworthy which, in turn, further infects banks which loaded up on their bonds. That occurred in Ireland and could be repeated in Spain.

The IMF’s proposal is to sever this incestuous relationship by getting the euro zone to put money directly into troubled banks rather than by lending to governments which, in turn, would inject capital into the banks. Such a policy would be matched by euro zone-wide supervision of banks.

The idea is rational. That, of course, doesn’t mean that it will be adopted. But with an expanded warchest, the IMF has greater ability to be heard on this and other issues – especially if it keeps reminding the euro zone that the rest of the world has insisted that strings are attached before any more countries are given bailouts.

Can the euro omelette be unscrambled without provoking the mother of all financial collapses? With the crisis heating up again as Spanish 10-year bond yields hit 6 percent last week, the question has renewed urgency. The conventional wisdom is that such unscrambling is impossible. The economic, political and legal complications of bringing back national currencies are so immense that the euro zone’s 17 nations are effectively locked in a prison with no exit.

A 250,000 pound prize offered by Simon Wolfson, a UK businessman, has aimed to turn this conventional wisdom on its head. In offering what is the second-largest economics prize after the Nobel, Wolfson hoped to stimulate creative juices. In one case, he has – although even it is no silver bullet.

Of the myriad problems with returning to the drachma, peseta and lira, the most intractable is how to prevent it triggering bank runs and ultimately financial chaos. Depositors would flee if they thought their euros were set to be converted into a national currency certain to suffer dramatic and immediate devaluation. This has already been happening to some extent in Greece. If the Greeks knew for sure that their old currency was coming back, the current fast walk would turn into a stampede. Even worse, the damage wouldn’t be confined to Greece.

Depositors in other peripheral countries would pull savings from their banks. Bond markets in these other countries would also seize up. Why would anybody want to lend money to Rome or Madrid in euros if they thought they were going to be paid back in devalued liras or pesetas?

The solution proposed by most Wolfson Prize finalists is secrecy. Plans for a country’s exit from the euro should be kept under wraps and then sprung on the unsuspecting world on a Friday evening. But this is impractical. How could 17 governments keep secret something that will involve lots of wrangling? Would a democratic country really be able to foist such a momentous decision on its people without a parliamentary debate? Even if secrecy was possible, it wouldn’t stop contagion to other countries.

Catherine Dobbs, a private investor who used to develop algorithms for an investment firm in the City of London, has come up with an ingenious solution. At the point of break-up, every euro – wherever it is located – is replaced by a basket of two (or more) new currencies. This is a radical shift in thinking. Until now, most people had envisaged all economic activity in the exiting country being redenominated in its new local currency while all the other countries kept the euro.

Dobbs illustrates her idea using the unscrambling the egg metaphor. The euro zone is broken up into two sub-zones: the yolk and the white. For some bizarre reason, she equates the yolk with the periphery (Greece, Spain etc) and the white with the core (Germany, the Netherlands etc). But I’m going to flip it round as it’s more intuitive to think of the yolk as the core. The idea is that every euro is swapped for a fixed ratio of yolk currency and white currency, roughly in proportion to the relative size of the two sub-zone’s economies. Say for every euro, people got 70 percent of a yolk and 30 percent of a white.

Once this has happened, the yolk and white are free to float – with the yolk presumably appreciating and the white currency depreciating. New contracts are denominated in yolk or white. But existing euro contracts have to be honoured by delivering the fixed proportion of yolks and whites in the basket.

The one exception to this – which Dobbs hints at but doesn’t spell out – would be employment contracts: they would need to be redenominated into their new local currency. This would effectively allow wages in the periphery to fall, which is vital if competitiveness is to be restored.

The beauty of the scheme is that there’s no incentive for citizens in the periphery to grab their savings in the run-up to such a switchover and pop them into a core bank. Their euros will be worth the same wherever they are located. As a result, the detailed planning for the break-up can be done in public rather than in secret.

Neat as Dobbs’ idea may be, the politics of it are problematic. While savers in peripheral countries would like receiving a mixture of yolk and white for their euros, those in core countries could hate it. They would feel that a chunk of their savings was being forcibly swapped into the weak white currency even though, in theory, the value of the basket should still be one euro. Workers in the periphery who would be paid only in the depreciating white currency wouldn’t be happy either. While their wages would effectively be slashed, their debts, rents and other costs wouldn’t be. Many would face hardship and bankruptcy.

Perhaps that is just too bad. Somehow wages have got to come down in the periphery and devaluation would be a faster way of getting there than the current grinding austerity, which isn’t pleasant either. The snag is that such vested interests mean it’s most unlikely that heads of government could discuss the yolk/white scheme one day and back it. Rather, there would be lots of debate over what the right plan was. And before any decision had been reached, there would have been a massive capital flight. Sadly, the euro egg looks pretty well scrambled.

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.

The risk is that, as the short-term funding pressure comes off, governments’ determination to push through unpopular reforms will flag. If that happens, the time that has been bought will be wasted – and, when crisis rears its ugly head again, the authorities won’t have the tools to fight it.

Early signs of such fatigue are emerging. One is the tendency of politicians – most recently, Italian Prime Minister Mario Monti – to say that the worst of the crisis is over. They may wish to take credit for their crisis-fighting skills or relax. But it is too early to declare victory.

Italy is a case in point. Monti should have pushed through crucial reforms to the labour market earlier, while his popularity was high and the electorate was afraid that Italy would be engulfed by the crisis. He did not. And although he has now come up with a good package, his honeymoon period as the unassailable technocratic prime minister is nearing its end. His popularity fell to 44 percent from 62 percent in early March, according to a poll published last week by ISPO. Two-thirds of Italians oppose his labour reforms.

It’s a similar story in Spain. Mariano Rajoy, the incoming prime minister, should have cracked on earlier with a budget to bring the government’s finances into balance. To be fair, his administration did publish plans last Friday to curb its deficit – though it won’t be possible to judge how credible these are until Madrid explains how the health and education spending of Spain’s free-wheeling regional governments is to be reined in. Meanwhile, Rajoy’s honeymoon is also over. Last week, he failed to win the regional election in Andalucia and faced his first general strike.

Both Monti and Rajoy are still in strong positions. Although Italy’s political parties could theoretically kick Monti out, they are even less popular than him. Meanwhile, the Spanish prime minister has a sound majority in parliament. But as each month passes, it will get harder to push through reforms. Both men must hold their nerve and implement their full programmes while they can, without compromise.

Further afield, the appetite for austerity is also flagging – sometimes in unexpected places. The Dutch government, one of the high priests of fiscal rectitude, is finding it difficult to cut its own deficit. The ruling coalition may even collapse under the strain.

There is also increasing unhappiness about the fiscal discipline treaty Germany rammed through in December. Francois Hollande, the French socialist who is the front-runner to be France’s next president, wants to add a growth component to it. So do Germany’s social democrats, whose support is needed to ratify the treaty even though they are in opposition.

A fudge will probably be found that adds a protocol to the treaty which emphasises the importance of growth as well as discipline. Indeed, that would be no bad thing: too much austerity can be self-defeating as severe budget squeezes can crush an economy and make it even harder to raise taxes and cut deficits.

However, governments can’t ease up on short-term austerity and do nothing. What is needed is a vigorous programme of long-term structural reforms such as freeing up labour markets and introducing more competition into services industries. This could ultimately boost GDP by about 15 percent in large euro countries such as France, Italy and Spain, according to the Organisation for Economic Cooperation and Development. Even Germany, whose services markets are sclerotic, could benefit by about 13 percent of GDP.

Such a programme would make the euro zone’s economies fit enough to stand on their own feet when the anaesthetic of cheap money fades. But do governments have the will to make these changes given that the cheap money is lulling them and their people into believing the worst of the crisis is over?

A prod from the markets may be what is required. There are indications that this is beginning to happen. Spanish 10-year bond yields briefly reached 5.5 percent last week. The art, though, will be in the calibration. If markets move too little the politicians will be complacent. If there is too much, the euro zone will slip back into full-blown crisis.

At a dinner in Madrid earlier this month, the main complaint about Mariano Rajoy was that the new prime minister was treating the electorate like children. Many of the guests, supporters of Rajoy’s Popular Party (PP), understood that Spain had to cut its fiscal deficit and restore its competitiveness. But they didn’t like the fact that the prime minister hadn’t been frank about his plans.

In advance of last November’s general election, Rajoy said he wouldn’t raise taxes, make it cheaper to fire people or cut the welfare state. But he has now done the first two. After this week’s election in Andalusia, Spain’s largest region, he is expected to do the last.

Rajoy’s camp doesn’t see any problem in failing to be upfront. It would have been foolish to talk too much about austerity in the general election campaign as that might have frightened the voters. For the same reason, it would be foolish to tell them about reforming the welfare state in advance of the Andalusia election.

In the long run, the failure to treat the population like adults could cause trouble. But in the short run, the strategy has paid off. The socialist party lost nearly 40 percent of its votes in the general election, not least because it had done a poor job in government. It is now expected to lose control of Andalusia, its last main bastion, according to an opinion poll by Metroscopia.

Rajoy has already used the absence of any serious opposition – even a general strike called for next week doesn’t pose much threat – to push through one batch of reforms. The most important is of the labour market. He has made it cheaper for companies to fire people and largely dismantled the nationwide system of collective bargaining. The net effect will be that wages, which rose rapidly during the early years of the single currency, will fall – so restoring Spain’s competitiveness.

Between end 1998 and end 2009, Spain’s unit labour costs rose 38 percent, compared to 23 percent for the euro zone as a whole. In the past two years, they have come down 4 percent. The latest labour reforms could cut wages another 5 percent this year, according to Fernando Fernandez, economics professor at Madrid’s IE Business School. If the trend continues for another year or so, Spain will no longer be out of kilter with its euro peers.

The other main reform – cleaning up toxic loans from banks’ balance sheets following the country’s real-estate bubble – has had more mixed reviews. The government has told the industry to take provisions and stash away capital to the tune of 50 billion euros. While the number sounds high, the detailed rules mean many banks won’t need to raise capital and some of the rest could have nearly two years to do so. The government itself has been reluctant to put any more of its own money into banks. So it is trying to push weak banks into the arms of stronger ones and fill any capital shortfalls with guarantees from an underfunded deposit insurance scheme rather than with real cash.

The litmus test of whether this financial jiggery-pokery works will be whether banks are able to borrow in the markets and are then willing to support economic recovery by lending to businesses and consumers. There are some positive signs: Santander last week issued 1 billion euros in five-year senior debt. But most of the industry is still relying on handouts from the European Central Bank.

Rajoy’s second blast of reforms will be about putting the public finances onto a sustainable basis. In 2011, the budget deficit hit 8.5 percent of gross domestic product. Spain last week reached a deal with its euro zone partners to cut it to 5.3 percent this year. Although this is not as severe as the 4.4 percent originally pledged, it will still constitute a severe squeeze. What’s more, the government remains committed to bring the deficit down to 3 percent next year.

The prime minister has already given some ideas about what he will do. Income taxes were raised and some spending cut in an emergency budget just before the New Year. Rajoy is also putting in place a straitjacket to control the borrowing of the country’s profligate regional governments. If he wins this week’s Andalusia election, he will be in an even better position to impose his will as the vast majority of the regions will then be under the PP’s control.

But more will be needed. The regions, which are responsible for education and healthcare, will probably be allowed to charge people for part of the cost. And Rajoy will have to cut the number of public-sector employees and increase taxes further in next week’s budget.

Economically, this is logical. The concern is that Rajoy’s failure to be frank with the electorate could increase its cynicism. The people already have little trust in politicians of all stripes. Witness last year’s indignado movement, when hundreds of thousands of protestors took to the streets to complain.

This won’t matter if the economy, which the government expects to shrink 1.7 percent this year, stabilises next year. But what if GDP keeps shrinking, unemployment (now 23 percent) continues rising and the deficit remains stubbornly high? Spain would face renewed bond market jitters and further pressure from its euro partners to cut its deficit. Rajoy would then have to sell another dose of austerity to voters that wouldn’t believe him. Having treated them like kids, they might even throw a tantrum.

Francois Hollande’s sins are more those of omission than commission. The headlines might suggest otherwise. The socialist challenger to Nicolas Sarkozy as France’s next president has promised to cut the pension age to 60, tax the rich at 75 percent, renegotiate Europe’s fiscal treaty and launch a war on bankers. But these pledges aren’t as bad as they look. The real problem is that Hollande, who has a strong lead in the opinion polls, isn’t addressing the need to reform the country’s welfare state.

Hollande is a moderate. Like Sarkozy, for example, he is promising to cut the budget deficit to 3 percent next year, from 5.8 percent as estimated by the European Commission in 2011. But he still had to throw the left some red meat in the election campaign, which runs until May. That’s not just to prevent votes drifting to Jean-Luc Mélenchon, the far-left candidate. It’s also to avoid being outflanked by Sarkozy’s own populist attacks on corporate fat cats and bankers.

Still, the precise pledges probably aren’t what they seem, as I discovered on a trip to Paris last month.

Look at pensions. Hollande has said he’ll cut the pension age from 62 to 60 – at a time when Germany and other countries are raising theirs to 65 or more. But the fine print is more nuanced. This lower retirement age will only apply to people who have worked 41.5 years – in other words, since the age of 18. Given that increasingly people start working later, less than 5 percent of the workforce is affected, according to UBS.

Or take the 75 percent tax rate on income above 1 million euros. If Hollande as president really instituted such a rate, he would drive most of France’s remaining big earners off shore. But within hours of advocating the measure, an advisor was saying off the record that it might last only a few years. By the time it comes to implementation, enough exceptions and loopholes could also have been introduced to reduce the measure’s real bite.

Much the same goes for Hollande’s promise to renegotiate the euro zone’s new fiscal compact treaty. He is, in many ways, right to criticise this mutual austerity pact, the brainchild of Germany’s Angela Merkel. The snag is that he has no chance of changing the chancellor’s mind. While Hollande could theoretically refuse to ratify the treaty, that would create a mega-crisis. As a strong pro-European, the socialist is unlikely to want that – especially since France has its own huge borrowing needs.

More likely, Hollande would seek to “complete” rather than “renegotiate” the pact by adding some wording about the importance of growth. There is a precedent. The stability pact in the original Maastricht Treaty was rechristened the Stability and Growth pact in 1997 after France’s incoming socialist prime minister, Lionel Jospin, kicked up a fuss.

Finally, consider Hollande’s war against bankers. His headline-grabbing promise – to separate “socially useful” finance from “speculative” activities – isn’t scaring French financiers. Partly this is because there is a global trend. The United States has the so-called Volcker Rule, which bans banks from proprietary trading. Britain has the even more extreme Vickers plan, which will force banks to put their retail operations into ring-fenced subsidiaries to protect them from infection by investment banking business.

The other reason French bankers aren’t too fussed is because the Hollande camp has been indicating that it prefers Volcker to Vickers. One only has to look at how long it is taking America to implement the Volcker rule to see how a French version could be diluted by the time it is implemented.

There is a risk that, caught in his campaign anti-capitalist rhetoric, Hollande might have no other choice than actually trying to implement some of these proposals to the letter. The more he insists that he wants “substantial” changes to the euro treaty, for example, the more difficult it will be for him to climb down once he is president.

Still, the problem is not so much what the presidential candidate is saying but what he isn’t saying. France has a generous welfare system that it has only been able to finance by racking up debts and imposing high taxes. Spending stood at 56.6 percent of GDP in 2011, 11 per cent more than in Germany, while taxes amounted to 50.8 percent of GDP, 6 percent more than its neighbour across the Rhine. The bloated state machine, where unions still rule, is resisting reform. Meanwhile, various rules and privileges prevent the labour market functioning efficiently or add to labour costs, notably the 35 hour week or the over-regulation of services. These high taxes and rigidities help explain why French annual growth averaged 0.6 percent less than Germany’s in the five years to 2011.

Other euro zone countries, such as Italy and Spain, are being forced by the crisis to reform. But France is not. Ten-year bond yields, at 2.9 percent, are admittedly 1.1 percentage points more than Germany’s, but that’s still a lot less than Italy’s and Spain’s levels of 4.8 percent and 5 percent respectively. To be fair, Sarkozy is now talking about supply-side measures such as cutting social security payroll taxes. But he wasted the opportunity to reform during the last five years and is unlikely to be given another chance. Hollande, meanwhile, isn’t even talking about such matters – and is keeping characteristically mum about how he will cut public spending.

This suggests two main scenarios for a Hollande presidency. One is that financial markets calm down, there is no reform and France wastes another five years. The other is that a new phase of the euro crisis erupts, forcing Hollande to embrace reform at last. But given his failure to prepare the French people for change, and their predilection for taking to the streets to protest at reductions in their privileges, this could be a rocky ride.