The problems of the euro turned critical when the Greek government nearly defaulted in May 2010 and the International Monetary Fund and European Union agreed to a bailout. In truth, the 17-nation euro area had deep troubles long before that. Its oversized and undercapitalized banks, its common monetary policy but diverse and fragmented fiscal policies, the persistent economic imbalances among nations that use the euro, and a cumbersome decision-making structure all made the euroarea economy vulnerable. The crisis, which still bears the mark of the Greek tragedy that first set it off, has now spread far beyond Greece.
The euro was created for normal times, but the EU lacked good mechanisms for crisis management. At every step of the Greek drama, policy-maker responses have remained behind the curve of economic deterioration. Slowly but surely, this erosion of confidence ensnared other countries, such as Ireland and Portugal, then spread to Spain and Italy, both perceived to be fiscally vulnerable. If European leaders cannot resolve Greece's problems, they can hardly save the much larger economies of Spain and Italy.
As the Greek crisis unfolded and the focus shifted to sovereign debt, the pressure on policymakers to tackle the endemic capital and liquidity problems in EU banks temporarily eased. However, EU-wide bank stress tests carried out in 2010 were discredited when Irish banks had to be bailed out just months after receiving a clean bill of health. The next set of stress tests in July 2011 were better but still did not inspire confidence, and EU leaders failed, yet again, to adequately address the problems of Greece in a summit at the end of July. Predictably, the money markets began betting against both the securities of banks and the sovereign debt of weaker EU member states.
The fates of the banks and the debt of member states are intimately linked. European banks are not required to hold capital against their investments in holdings of an EU country's debt, so they keep a large amount of sovereign bonds on their books. As the rising borrowing costs of an increasing number of European nations have driven down the market value of their bonds, bank balance sheets have suffered accordingly.
Sovereign states and banks in Europe are now engaged in a dance of death where weak sovereigns pull banks down and weak banks push countries ever closer to default. Bold action is now needed on multiple fronts to break this downward spiral and restore growth and confidence in the euro-area economy. But the unfolding Greek disaster, an ill-suited institutional structure, and the poisoned political atmosphere among EU leaders all limit their room for maneuver as they grapple with multiple challenges.
GREECE'S PROBLEMS are mostly fiscal--tax collection is terrible, and public spending is both high and inefficient. Public debt, at nearly 158 percent of gross domestic product and rising, is clearly unsustainable and unpayable. Yet the EU stubbornly refused to acknowledge this obvious truth and treated Greece as though it only had a temporary liquidity problem. This denial hurt the credibility of EU leaders and institutions. They now insist that Italy and Spain are solvent--but they said the same of Greece, which is not, making it much harder to restore market confidence in sovereign debt. The EU will need to go far beyond anything that is currently on the table--in restructuring the Greek debt, restoring growth, recapitalizing banks, building confidence in European sovereign debt, and reforming the EU system of governance.
By viewing the larger European problems through the lens of the special case of Greece, policy-makers have emphasized the fiscal aspects of the crisis. Lingering problems in the financial sector as well as failures of governance were left to fester. Instead, the EU prescribed austerity as a cure for all troubled member states including Spain and …