Are we finally approaching the end game of the Eurozone’s debt crisis? Tuesday’s coordinated central bank action, though welcome, is less a comprehensive solution and more of a reminder of how scared central banks have become.

Private sector lending to European banks has all but stopped and many leading financial indicators are now flashing red, signaling an imminent ‘Lehman Moment’ for the continent. As difficult as the Eurozone’s problems have proved to resolve, systemic financial panics do have a way of focusing minds.   

Perennially behind the curve, the Eurozone’s leaders have not yet missed an opportunity to miss an opportunity, so it might be too soon to call time on this drama. The Eurozone is facing two separate but related crises – a liquidity crisis and a solvency crisis. Resolving liquidity problems requires a lender of last resort, while solving solvency problems requires assigning losses to failed investments – often by redistributing losses from those who made the investments to society at large. 

The Federal Reserve’s decision to lower the cost of dollar liquidity and set up bilateral swap agreements with other central banks is aimed at easing the funding strains afflicting European banks. It is essentially a liquidity operation, but by reducing the cost of borrowing dollars it also entails a slight easing of monetary policy. What it does not do is resolve any of the fundamental solvency problems.   

In practice, it is difficult to disentangle insolvency from illiquidity. Illiquidity can cause insolvency if not halted, while excess liquidity can mask fundamental problems of solvency. Many European banks, though not all, are insolvent. They need massive injections of new capital to keep from failing, but in the meantime are being kept alive by unlimited liquidity from the ECB.  The question is where will this capital come from?  

Many sovereigns are already facing uncomfortably high debt burdens. If they are forced to recapitalize failing banks (whose balance sheets in some cases are larger than the annual GDP of their sovereigns) they too might face insolvency. The sovereigns, however, are not explicitly being backstopped by the ECB. This is why investors are running for the exits.  

The endless negotiations among European politicians are about who, finally, will end up footing the bill. Unfortunately, the Eurozone entered this crisis without existing institutions that could either recapitalize Eurozone banks or provide liquidity to sovereign borrowers. They have, in effect, brought a knife to a gun fight, with predictable results. 

Typically, when a debt goes bad, borrowers lose their collateral while lenders lose all or a portion of their principal. But in a systemic crisis, the losses are so large and insolvency so widespread that the entire economy will collapse without intervention. Intervention in this sense means that losses must be shared by society at large. Is this fair? Perhaps not, but it is the cost of doing business.  

If lenders cannot absorb all the losses from their bad investments, there are only two other ways of resolving bad debts. First, governments can transfer excess losses onto taxpayers by guaranteeing loans, nationalizing banks, or other means. This is otherwise known as fiscal policy. But in the Eurozone, fiscal policy is still the responsibility of member nations, which are often too small or too indebted to perform this task. There is no EU finance ministry with the power to tax and spend. Second, central banks can generate inflation, which will reduce the real value of the debts, but punish savers as a class by forcing them to take a negative real return on their investments.  

Of course, nobody wants to step up to foot the bill. Politicians in the periphery are wary of forcing through unpopular austerity measures, while those in the core fear the wrath of their constituents if they agree to fiscal transfers. The ECB, for its part, wants to maintain price stability and avoid the moral hazard of monetizing sovereign debts. The fundamental challenge facing Eurozone policy makers is figuring out how to share the bill. If they cannot agree, the Eurozone will not survive.  

On the other hand, Spain, Italy and France (and for that matter many European banks) are simply too big to fail. The collapse of the Eurozone would unleash a wave of beggar thy neighbor devaluations and drag the global economy into depression. Once a systemic panic begins, normal political calculations no longer apply: governments and central banks are forced to take extraordinary actions to guarantee the survival of the financial system and the broader economy. Kicking the can down the road no longer works. Tough decisions must be made, and fast. The stakes for Europe – and the world – are extremely high. Brinksmanship is being raised to a tragic art form as politicians and central bankers try to use financial distress as leverage in their negotiations.  

So how might the end game play out? 

The ECB’s reluctance to backstop sovereign borrowing is not simply a matter of wanting to avoid moral hazard. It is also a negotiating tactic. Its refusal to keep Italian yields below 7% did not just force the fall of Berlusconi’s government, it also signaled to Germany and other core countries that the periphery would improve its governance and foot its share of the bill. If the ECB gives in too soon and backstops sovereign borrowers without any conditionality, core Europe will conclude that any fiscal union will become a bottomless pit of transfers, and will decline to share in the losses.  

The ECB will eventually have to back down and provide liquidity to sovereign borrowers in the Eurozone, but it might not ever precisely admit doing so. What is perhaps more likely is that the ECB will announce that the monetary policy transmission mechanism has broken down, and in order to meet its price stability goals, the bank will ramp up its Securities Market Program (SMP) and purchase vast quantities of sovereign debt as it undertakes quantitative easing. Here’s Mario Draghi’s latest stab at euphemism:

“Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

This is the very important monetary policy reason for the ECB’s non-standard measures. But of course, such interventions can only be limited. Governments must – individually and collectively – restore their credibility vis-à-vis financial markets.”

The quid pro quo for such a move cannot, however, simply be the adoption of austerity and fiscal oversight of impaired sovereign borrowers, but also a large fiscal transfer from core Europe to the periphery. Taxpayers across the Eurozone must share in the losses. Again, consider how Draghi turns this phrase:

“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.”

Such transfers could (and should) take the form of a massive bank recapitalization, special resolution funds for toxic assets, and a Eurozone wide deposit insurance scheme. The EFSF might be able to fulfill (at least a part of) this role, and do so in a way that does not require treaty changes, which seem politically impossible at this point.  

Only after these immediate problems have been resolved can Europe take the longer term steps towards an ever closer political and fiscal union. Or not. These are tough decisions, and politicians might not come up with the right answers. If Europe’s solvency problems cannot be solved through fiscal policy, there is only one other option: inflating away the debts. This might seem a bridge too far for the ECB, but don’t expect them to allow the Eurozone to collapse either. 

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. Mr. Carliner has also worked for Barron’s Business and Financial Weekly and WBAI Radio in New York. He holds a B.A. from the University of Wisconsin-Madison and an M.A. in International Political Economy and Public Policy from the University of Texas-Austin. The original article can be found on Ben Carliner’s blog.