The Eurozone’s austerity strategy has reached a dead end. With the Euro can kicked to the curb of depression and debt deflation, voters, politicians and macroeconomists alike are rebelling against austerity and calling for growth. But with investors increasingly unwilling to lend to shaky banks and sovereign borrowers, what are the alternatives?

The champions of austerity claim that restoring market confidence requires fiscal consolidation, as markets are unwilling to lend to over-indebted borrowers. This is not wrong. But taken as a whole, the Eurozone’s fiscal situation, current account balance and net international investment positions often compare favorably to those of the US, UK or Japan. Europe has the money to solve its problems. What it doesn’t have is an institutional mechanism for distributing the costs of fixing its internal imbalances and bad debts. 

That’s why the prospect of a Greek exit and default prompts fears of contagion. Markets are not just worried about debt ratios. They are worried that the lack of growth will create more non-performing loans. They are worried that banks will fail and sovereign countries – who bear the burden of insuring depositors and recapitalizing insolvent banks – will be forced into default. They are worried that deposits, loans and bonds could be redenominated into drachmas, pesetas or liras. 

When markets lack confidence, investors head for safe havens. For peripheral Europe, the problem is not simply that the markets will not fund massive fiscal stimulus – it is that the sudden stop of capital inflows is triggering a self-fulfilling spiral of debt deflation and default. Assets previously considered safe – bank deposits, asset backed securities, covered bonds and sovereign debt – are safe no longer.

Safe assets are not simply a refuge for cautious investors. In modern capital markets, safe assets have become a critical source of funding for financial institutions. For big firms, good quality collateral is like money: they can use collateral to go to the secured lending markets and raise actual cash. Mortgages and other types of loans used to remain on the books of the banks that made them. But with securitization, these loans – which by themselves were illiquid and carried important credit risks – could be bundled into new securities that were both safer and more liquid. Banks and other financial institutions could then sell these securities or use them as collateral to borrow more.

All money may not be created equal – central bank reserves are not exactly the same as cash – but the ultimate point of money is that you expect to be able to exchange it, at more or less the same price, for a long time into the future. So long as a security is perceived to be safe and liquid enough, it can be used to obtain funding in the wholesale money markets.  In this sense, “safe” assets are a form of “broad” money – like demand deposits and money market mutual funds. 

In the run-up to the financial crisis, the private sector created lots of these safe assets. In 2007, over $3 trillion of safe assets (things like ABS, MBS, Covered Bonds and CDOs) were created by the private sector in the US and the EU. As real estate prices rose and new developments were built, households, corporations and financial firms were all able to borrow more and increase their leverage ratios. As long as times were good, many financial firms were also able to raise unsecured funds through the interbank and commercial paper markets.

Once asset prices peaked, however, this whole edifice began to crumble. As the value of the underlying assets fell, so too did the value of the asset-backed securities. The haircuts lenders imposed on these securities in repo transactions increased. As the solvency of many financial institutions came into question, the interbank markets shut down and it became impossible to engage in any unsecured borrowing at all. Assets that had been considered safe turned out to be much more risky than previously thought.

This change in expectations has had a profound impact on global capital markets. Since the collapse of Lehman Brothers, the US and Europe have seen a succession of runs – beginning in the repo and wholesale money markets in the US, and then crossing the Atlantic to Europe where peripheral banks and sovereigns now face capital flight.  

Central banks have stepped in to provide liquidity and halt these runs. But even as the balance sheets of central banks have expanded, the rise in base money has not been matched by an expansion of the broad money supply. There is a shortage of the good quality collateral that is a major component of broad money, both because of impaired assets and the lack of new supply.

The ECB’s long term refinancing operation has provided liquidity, but it hasn’t been able to stop deleveraging. Many firms and households in both the US and Europe feel the need to rapidly save money to improve their balance sheets and stave off insolvency. But as firms cut back and lay off workers, deleveraging threatens to create a vicious cycle of debt deflation as investment drops, unemployment rises, and asset prices fall. 

Without loans for new homes or automobiles to securitize, the private sector production of safe assets has declined significantly.  From $3 trillion in 2007, private sector production of safe assets fell to $750 billion in 2010. The point to take away is that even after runs are stopped, deleveraging causes a huge monetary shock. The broad money supply contracts sharply, and the monetary policy transmission mechanism ceases to work properly. 

Financial crises are not like normal business cycle fluctuations. During financial crises, the core service provided by financial institutions – intermediating between savers and borrowers by transforming short term deposits into long term investments – begins to break down and in extreme cases ceases to function outright. This is what is happening now in the Eurozone. Investors fear they won’t get their money back, while demand for new loans plummets as borrowers are forced to shrink their balance sheets. 

There is still huge demand for safe assets among investors, but because of the shortfall in the supply of these assets, investors have been forced into the safest of safe havens – US Treasuries, German bunds, and central bank reserves. 

While this is good news for countries that produce safe haven assets – capital inflows mean they can borrow more cheaply – it is preventing the necessary adjustment of imbalances within the Eurozone. Peripheral countries are facing huge outflows of capital as investors move their money out of peripheral banks and sovereign debt securities. Unless the Eurozone’s financial system is fixed, there won’t be growth, there will be depression.

This slow motion run can only be stopped by making financial assets produced in the periphery “safe” again. 

If Europe could agree to recapitalize banks using funds from the ESM and implement a Eurozone wide deposit insurance plan, these steps would go a long way towards reassuring the markets that Eurozone banks are sound. Jointly issued Eurobonds could allow austerity-weary countries to prolong their fiscal consolidation and avoid a debt deflation trap. The ECB could engage in a further round of quantitative easing – ideally by backstopping sovereign borrowing and buying up lots of impaired assets. 

The quid pro quo for such reforms would be continued structural reforms to free up labor and product markets, the end of cozy relationships between politicians and local savings banks that direct lending to state-favored investments, and binding long term fiscal compacts. 

These measures would allow bad debts to be restructured and written down, real estate and labor markets to clear, current accounts to rebalance, and peripheral financial assets to become safe enough for institutional investors to return. Perhaps Europe’s leaders can agree on these measures, and move towards a true fiscal union. Then again, perhaps they can’t. 

All the above reforms threaten particular interests in the name of a common European good. Structural reforms bring yet more short term pain to countries already suffering from austerity and rising populist pressures. Politicians across the Eurozone don’t want to give up their cozy relationships with local savings banks that direct lending to state-favored investments. Voters everywhere are opposed to bailing out the big banks. Leaders of the dwindling number of countries with sound credit ratings are loath to put those at risk by assuming liability for other nations’ debts. And the ECB does not trust politicians to continue with difficult structural reforms if it rides to the rescue by purchasing their sovereign bonds in the secondary markets.

Hopefully, European politicians, staring a messy unraveling of the Eurozone in the face, can take the big steps towards fiscal union. Creating some sort of banking union now would be the best way of halting the crisis as well as the best way of moving towards an “ever closer union.” Banking union, not massive fiscal stimulus, is what a European growth strategy looks like. But it just might be beyond the power of any politician, German or otherwise, to deliver the fundamental surrender of sovereignty that a functioning fiscal union would require. To put it simply, “Europe” is not a country. Unless it becomes more of one, the monetary union will fail. 

If Europe cannot create a banking union in the short term, the result will be fiscal dominance – the ECB will be forced to step in and monetize sovereign debts, leaving the central banks’ monetary and liquidity policies as the only remaining components of Europe’s pro-growth agenda. 

The ECB has shown that it knows how to halt a bank run. But it can’t, on its own, create growth. And only economic growth can allow structural imbalances to adjust and peripheral European economies to improve their competitiveness. Liquidity alone will not convince banks to make – and borrowers demand – new loans. With monetary policy running up against the zero lower bound, central banks cannot change markets’ perception of the future course of growth and inflation by lowering interest rates. Expectations of future inflation won’t rise unless there is evidence that broader monetary aggregates and the velocity of money have increased.  Unless the broad money supply – that universe of “safe” assets that can be used as collateral to secure funding – increases, the ECB will simply be pushing on a string. 

The ECB is not running out of ammunition, but it might be running out of like-minded allies. By monetizing the debts of sovereign and private sector borrowers, the ECB would bring a lot of credit risk onto its balance sheet. If these assets went into default the ECB would either need to be recapitalized or print lots of new money, causing inflation (which would create nominal, but not real, growth). The ECB could save the Eurozone for now, but it can’t create a country called Europe. And that’s really the issue. 

Ben Carliner is a fellow at the Economic Strategy Institute. Prior to joining ESI, Mr. Carliner worked as a financial journalist in New York for Project Finance International. The original article can be found on Ben Carliner’s blog.