'Euro can be saved if PIGS bow out'

European Union policy makers will meet in Brussels today to thrash out an agreement on the size of the permanent crisis mechanism, or the European Stability Mechanism, which will oversee future bailouts in the region.

While there are considerable differences among major members of the bloc about the size and composition of the fund, which is supposed to replace the current 750-billion-euro bailout fund by 2013, there is also the strengthening view that sovereign bailouts will not solve a crisis that looks daunting enough to force a severe banking crisis in the whole of western Europe.

The crisis-hit peripheral countries have more of a 'solvency problem' than a liquidity problem and their public finances cannot be brought to order without leading to a deep and prolonged recession, as long as they are part of the eurozone, analysts have said.

According to Desmond Lachman, a resident fellow at American Enterprise Institute (AEI) for Policy Research, the repeated bailouts are more like kicking the can forward in the forlorn hope that something might turn up to rescue the periphery.

He says the PIGS -- Portugal, Ireland, Greece and Spain -- will eventually have to opt out of the eurozone to make sure the crisis doesn’t bring the common currency down. It's not as if the future of the ambitious common currency union is etched in stone and it either goes down or survives as a bloc. There is a feasible a third way -- the exit of the debt-hit peripheral members.

Failure over many years of the Eurozone's members to play by the budget rules of the Stability and Growth Pact makes a sovereign debt default of at least one of the peripheral countries almost inevitable. A default by any member country is more than likely to trigger contagion to the rest of the periphery and to lead to the eventual exit from the Euro of Greece, Ireland, Portugal, and Spain, Lachman said.

The European Commission stood down on its no bailout policy when the Greek debt crisis began to take threatening shape early in the year, and since then it went ahead to create massive European Financial Stability Facility, bailed out Greece and Ireland and is now racing against time to create a permanent bailout mechanism. However, this has not calmed the markets and the cost of borrowing has gone up in the region and the common currency has fallen.

According to Lachman, a bailout could help the bloc members in trouble if they faced short-term cash shortages, but a rescue of the kind offered to Greece and Ireland will not cure deep-rooted problems caused by crippling debts brought about by chronic overspending, and by governments incapable of imposing a spending clampdown on electorates.

He says the only way to avoid a catastrophic new banking crisis like the 2008 global meltdown would be for the PIGS to bow out.

The peripheral economies are small in size, except for Spain, but the overall public and private sector debt of these countries is quite hefty. And more alarmingly the core European banking system is exposed to a big chunk o their debt. As such, the present debt crisis in the European periphery has the potential to precipitate a major European banking crisis that would almost certainly reverberate throughout the global financial system. It would do so in much the same way as the 2008 sub-prime crisis in the United States precipitated a global banking crisis, Lachman says.

He says the European policymakers know full well the impact of a sovereign crisis in any of the member states and as such are unlikely to stop the bailout money from trickling down to the peripheral economies although the chances of the crisis snowballing eventually are stronger than otherwise.

However, it also makes sense for the peripheral countries to get out of the euro as it would help them readjust their fiscal policies in a much better way then when they are attached to the stringent austerity guidelines imposed by the rescue regime. Countries in the periphery might do well to consider the advantages of an early exit from the Euro, which might facilitate the needed fiscal adjustment without provoking the deepest of domestic economic recessions, he says.

For example, unlike Iceland, which caved in 2008 and was bailed out, Ireland, Greece and the like don’t have the luxury of devaluing their currencies and exporting their way out of trouble. At the same time, political instability is worsening in these countries as public anger over harsh austerity measures and budget cuts is unmitigated.

Chronic failure in adhering to the bloc's budget rules has resulted in a massive pile of debt in these countries which is impossible to be managed within the Euro-zone straitjacket. The Eurozone's periphery has more of a solvency problem than a liquidity problem, says Lachman. He adds that the correction of the periphery's public finances will provoke the deepest and most prolonged of domestic economic recessions unless it is accompanied by a debt restructuring and an exit from the Euro.

Papering over these solvency issues by simply advancing these countries large amounts of EU-IMF official financing will not address their underlying solvency problem.