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French President Nicolas Sarkozy walks past Italy's President Silvio Berlusconi and German Chancellor Angela Merkel as he takes his place for family photo at the G20 Summit in Toronto. (Adrian Wyld/Adrian Wyld/The Canadian Press)
French President Nicolas Sarkozy walks past Italy's President Silvio Berlusconi and German Chancellor Angela Merkel as he takes his place for family photo at the G20 Summit in Toronto. (Adrian Wyld/Adrian Wyld/The Canadian Press)

Taking Stock

Euro zone has to stop avoiding the real problem Add to ...

If investors have reaffirmed one market truism in recent days, it's that you can't tell them all hell is breaking loose and that they may be facing serious losses and then expect them to sit on their hands.

So it should surprise none of the shoot-from-the-lip politicians and assorted Eurocrats, led by German Chancellor Angela Merkel and the more hawkish board members of the European Central Bank, that their every utterance only served to drive more rattled bond players to the exits. As a result, the contagion everyone feared has already spread from Greece and Ireland to Portugal and other peripheral parts of the euro zone that still bravely insist they need no handouts. Even Belgium and Italy are showing signs of the virus.

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No one believes Portugal won't soon need a capital infusion. And investors are only slightly less skeptical about repeated Spanish assurances that everything is just fine. Spanish Finance Minister Elena Salgado revealed on Friday that the government would lighten up on its planned debt auctions for the rest of this year, while bravely insisting that none would be cancelled. But that tends to happen when bond yields reach levels not seen since the advent of the euro.

To restore any sort of confidence in the marketplace, the euro zone has to stop avoiding the real problem, which is the region's massive accumulated debt, a large chunk of which is held by major banks in Germany, France and Britain.

The debt overhang is enormous from past excesses, argues prominent Columbia University economics professor Jagdish Bhagwati, "The only way out is some kind of debt restructuring. They're going to have to move in that direction."

Prof. Bhagwati is referring not only to the bond market but to the banks, which have been using their domestic clout to prevent just such a turn of events in Europe.

If the EU says there must be a haircut, "it means your own banks are going to get involved. Therefore, there's going to be a conflict [of interest] It's not simple. And the politics are going to be difficult. If it was someone else's banks, you would say: Restructure. Let them take the loss."

But when it's your own banks with capital at risk, it becomes a different story. Most are still digging their way out of the losses stemming from the global financial debacle and they emphatically don't want to visit the barber again any time soon.

As the Greek crisis unfolded in March, Prof. Bhagwati argued that the best course would be to call on the International Monetary Fund to lead a tough-love rescue. The hardnosed folks at the IMF have a wealth of experience forcing bitter medicine down the throats of spendthrift governments. And Prof. Bhagwati concluded that this would be eminently preferable to having the EU try to do it.

"There are two reasons why this would be imprudent," he observed at the time. "The EU can be sure that Greek populist anger will be directed at the EU for the austerity that the EU would impose. Equally, Germany (if not France, as well) will find that its citizens will object to the … funds transfers to Greece to ease the transition to necessary fiscal prudence."

At the time, EU officials snorted that turning to the IMF would mean abandoning the euro zone's rules and cause enormous grief for the single currency.

Well, in the end, the euro took a big hit anyway, and the Eurocrats effectively tossed out their underwritten rule book as the debt woes ballooned into a full-fledged crisis of confidence. The Europeans had little choice but to bring the IMF on board, but only after triggering exactly the angry public reactions that Prof. Bhagwati feared.

Today, it's plain that the IMF must take the lead "bad cop" role on the deficit-cutting front, while leaving the other hard but essential task - debt restructuring - to the Europeans themselves, Prof. Bhagwati says.

"My sense is that in the end, they will, in fact, rely on the IMF increasingly to try and impose some [fiscal]discipline. It's unfortunate for them, but they will have to do it. And then on restructuring, they will ultimately have to sort out some way of getting their banks to be hit."

Prof. Bhagwati is best known in policy circles for his influential work on international development and his passionate advocacy of free trade and the benefits of globalization. But he attracted much wider public attention in September when his name surfaced during an episode of The Simpsons, of all places.

Lisa Simpson and her pals are staying up late to watch the Nobel Prize announcements, when Prof. Bhagwati is unveiled as the fictitious winner, delighting the one who chose him in the betting pool. So far, life has yet to imitate art.

Prof. Bhagwati says he never watched the popular animated series. "Now, I have to."

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