When economic policy falls victim to political will, there are more questions than answers
Wherever you look for a solution to the euro crisis, there's a problem. That's because the losses have already been incurred, and we're now trying to work out who shoulders the liability. This second stage to the financial crisis is a double challenge because it covers potential sovereign and bank insolvency.
The most radical option is to do nothing. If there's a financial crisis and contagion, then let banks and other financial institutions fail and pick up the pieces as the market reveals its own answers.
Free-market economists like me see the intellectual appeal of this kind of solution, but we also spot the practical impossibility. There probably isn't a politician on the planet, and certainly within the euro zone, with the courage to do this.
Economic policy operates within political constraints and this makes the pure market solution utterly unrealistic – and euro-zone politicians are not the strongest advocates of market forces.
Deep haircuts of Greek and other bonds, up to 50 per cent or more, are certainly logical. But unfortunately there are problems here, too.
This would be considered a credit event triggering credit default
swap insurance – and turmoil on derivatives markets. So is massive government intervention the answer? Should euro-zone governments engage in massive public-funded recapitalisation
of the banking system?
These solutions sound good in theory but somebody will have to shoulder a greater burden – and that somebody will be Germany. Will German taxpayers agree to dig deeper? The EU political imperative to keep on track for greater integration suggests that they might, but this will open up deep fissures within German politics. It also explains ECB reluctance to purchase Greek and other government bonds.
This unwillingness, known as moral hazard, says that if you reward bad behaviour now, it will only get worse in the future. Irish politicians might also moan about naughty Greeks "getting away with it" when they didn't.
But it remains highly likely that individual governments, such as France's, will inject public capital into their banking systems. Even here there are concerns that a big commitment of public funds might threaten their triple A sovereign debt rating.
The seemingly straightforward recapitalisation of the banking system, funded by the private sector, is the worst of all worlds. This would just suck money out of the economy, reduce the money supply and threaten deflation and depression. It cannot be stressed too much why such a recapitalisation is highly dangerous.
Graeme Leach is the IoD's chief economist and director of policy