EUROPE's leaders have finally understood that the bootstrap operation by which Europe lends money to the banks to save the sovereigns, and to the sovereigns to save the banks, will not work. Likewise, they now recognise that bail-out loans that give the new lender seniority over other creditors worsen the position of private investors, who will simply demand even higher interest rates.
What is now proposed is recapitalisation of the European Investment Bank, part of a growth package of about $150bn. By some accounts, the new money is a small fraction of that amount, and even that will not get into the system immediately. In short: the remedies - far too little and too late - are based on a misdiagnosis of the problem and flawed economics.
The hope is that markets will reward virtue, which is defined as austerity. But markets are more pragmatic: if, as is almost surely the case, austerity weakens economic growth, and thus undermines the capacity to service debt, interest rates will not fall. In fact, investment will decline - a vicious downward spiral on which Greece and Spain have already embarked. Germany seems surprised by this. Like medieval blood-letters, the country's leaders refuse to see that the medicine does not work, and insist on more of it - until the patient finally dies.
Eurobonds and a solidarity fund could promote growth and stabilise the interest rates faced by governments in crisis. Lower interest rates, for example, would free up money so that even countries with tight budget constraints could spend more on growth-enhancing investments.
Matters are worse in the banking sector. Each country's banking system is backed by its own government; if the government's ability to support the banks erodes, so will confidence in the banks. Even well-managed banking systems would face problems in an economic downturn of Greek and Spanish magnitude; with the collapse of Spain's real-estate bubble, its banks are more at risk.
In their enthusiasm for creating a "single market", European leaders did not recognise that governments provide an implicit subsidy to their banking systems. It is confidence that if trouble arises the government will support the banks that gives confidence in the banks; and, when some governments are in a much stronger position than others, the implicit subsidy is larger for those countries. In the absence of a level playing field, why shouldn't money flee the weaker countries, going to the financial institutions in the stronger?
Indeed, it is remarkable that there has not been more capital flight. Europe's leaders did not recognise this rising danger, which could easily be averted by a common guarantee, which would simultaneously correct the market distortion arising from the differential implicit subsidy.
The euro was flawed from the outset but it was clear that the consequences would become apparent only in a crisis. Politically and economically, it came with the best intentions. The single-market principle was supposed to promote the efficient allocation of capital and labour.
But details matter. Tax competition means that capital may go not to where its social return is highest, but to where it can find the best deal. The implicit subsidy to banks means that German banks have an advantage over those of other countries. Workers may leave Ireland or Greece not because their productivity there is lower, but because, by leaving, they can escape the debt burden incurred by their parents. The European Central Bank's mandate is to ensure price stability, but inflation is far from Europe's most important macroeconomic problem today.
Germany worries that, without strict supervision of banks and budgets, it will be left holding the bag for its more profligate neighbours. But that misses the key point: Spain, Ireland and many other distressed countries ran budget surpluses before the crisis. The downturn caused the deficits, not the other way around.
If these countries made a mistake, it was only that, like Germany today, they were overly credulous of markets, so they allowed an asset bubble to grow unchecked. If sound policies are implemented and better institutions established and growth is restored, these countries will be able to meet their debt obligations, and there will be no need to call upon the guarantees. Moreover, Germany is on the hook in either case: if the euro or the economies on the periphery collapse, the costs to Germany will be high.
Europe has great strengths. Its weaknesses today mainly reflect flawed policies and institutional arrangements. These can be changed, but only if their fundamental weaknesses are recognised - a task that is far more important than structural reforms within the individual countries. While structural problems have weakened competitiveness and economic growth in particular countries, they did not bring about the crisis, and addressing them will not resolve it.
Europe's temporising approach to the crisis cannot work indefinitely. It is not just confidence in Europe's periphery that is waning. The survival of the euro itself is being put in doubt. © Project Syndicate, 2012. www.project-syndicate.org
. Stiglitz, a Nobel laureate in economics, is professor of economics at Columbia University.