How to End the Crisis Now

It’s funny what passes for good economic news in Europe these days. The euro zone is finally expanding, but it will struggle to grow GDP by even 1% this year. Consumer spending is up a bit, and borrowing costs for weaker countries are finally starting to come down. If that doesn’t sound like much to cheer, that’s because it isn’t. Still, it was enough for European Commission president José Manuel Barroso to stand up recently in front of a crowd in Athens during the launch of the Greek presidency of the Council of the European Union and say that not only had Europe emerged from recession, but “the existential crisis of the euro” was “behind us.”

Sadly, he’s wrong. The European economic experiment is no longer on the brink of dissolution, and the future of the common currency appears secure for the moment. But the longer-term stability of the euro zone is still very much in question. And that remains the major foreseeable risk to global markets in the long-term future. Europe, along with the U.S. and China, is one of the three major legs on the stool on which the global economy rests. If Europe collapses, everyone is in trouble.

The European Central Bank (ECB) calmed the markets and bought some time 18 months ago with a promise to do “whatever it takes” to save the euro, mainly via a program of aggressive and supposedly unlimited buying of short-dated European bonds. But euro-zone unemployment continues to sit stubbornly at a record high of over 12%. Youth jobless rates in places like Greece, Spain, Portugal and Italy are sky-high.

Austerity, a policy of public-sector budget cutting, continues in part because Germany refuses to believe that not every country in Europe can be, as Germany is, a manufacturing powerhouse running a surplus. Meanwhile, despite French President François Hollande’s recent calls for tax cuts and economic reform, things in France — the euro zone’s second largest economy — seem to be getting worse, not better. Business activity dropped in December. Manufacturing, which is starting to drive growth in much of Europe, is faltering in France, which has a sector that is less competitive than its two major rivals, Italy and Germany.

Throughout much of the euro zone, labor markets remain sclerotic and public spending is still far too high. (Indeed, the budget deficits of Italy and Spain are starting to grow again.) “Europe needs drastic reform, and it’s nowhere near doing it,” says Harvard economist Ken Rogoff, a sovereign-debt expert. “Mario Draghi [the ECB president] built Europe a bridge to make some of the big structural changes that need to be made in order to ensure the stability of the union longer term. But those changes aren’t yet happening.”

Indeed, the day after Barroso made his cheery proclamation, Draghi called the European Commission president’s comments “premature,” saying the euro-zone economy remained “fragile.” Draghi made it clear that the ECB was committed to keeping interest rates low and wanted to do more to help stimulate the economy. Meanwhile, political extremism and anti-euro sentiment continue to grow. When Europeans go to the polls in May to elect a new European Parliament, early surveys suggest that as many as a quarter of new members will be associated with parties with anti-E.U. tendencies.

All of which has left world leaders and economists worrying that the euro-zone economy is like a patient moved out of ICU but still facing a long, difficult convalescence. “It’s hard to imagine that if growth remains as weak as it is, and the periphery is kept in permanent recession, that things won’t eventually blow up in Europe,” says Rogoff, echoing a view widely shared by many economists. The question now is, What can Europe do to put its debt debacle behind it once and for all? Here are four things that are badly needed to ensure that happens.

1. Create a Real Banking Union
Making the euro zone viable over the long haul requires a common fiscal policy. The first step in that direction IS A BANKING UNION that creates a common mechanism for winding down failing banks as well as a credit line for backstopping any bank that threatens to explode in a Lehman Brothers — style meltdown. Unfortunately, so far efforts to do just that have been anemic.

The euro zone’s financial sector has assets of about $43 trillion. Yet the bank resolution fund being suggested to support the sector would amount to only $75 billion, and only after 10 years of fundraising via levies on individual banks. That’s not enough to bail out a regional bank in, say, Slovakia, let alone a major Italian or French institution.

The Germans, for example, could cough up more in support, but they’ve shied away from wholehearted and aggressive support of a banking union. Despite Germany’s calls for more centralized fiscal policy, the country’s leaders have resisted a strong and independently regulated banking union because “they don’t want a European regulator [most likely the ECB] shining bright lights on the regional banks that have had long and cozy relationships with Germany’s regional governments,” says University of Michigan economist Jim Adams, a Europe specialist. While corporate Germany is often a model of fiscal prudence, German state-owned banks were among the most highly leveraged during the financial crisis. Many experts believe the banks may still be holding a good amount of low-quality peripheral-European sovereign debt. But that’s no excuse for not creating a banking union with enough resources to actually do something in a crisis.

Anything less, and the markets won’t feel that Europe really believes in itself, and bond-yield spreads (which have been narrowing, indicating a greater trust in the growth potential and financial health of a number of European nations) will quickly diverge again at the next sign of economic turbulence, creating a chicken-and-egg cycle of banking and sovereign crises.

2. Force Germany to Evolve
Rather than Europe’s emulating Germany, Germany must become more European. The Germans laud their economic model, which relies on making a highly competitive export sector even more globally competitive via artificially suppressed wages and a currency that is weaker than their economy deserves. (The euro, as a regional currency, was always going to be weaker than the deutsche mark.) This has made German exports cheaper and more attractive. As a result, Germany grows stronger while its neighbors, who can neither devalue their own currency to compete nor receive fiscal transfers from the stronger core nations, flounder. Or, as Peking University professor and economist Michael Pettis puts it, “Germany is the China of Europe.”

What Germany needs to do is create a stronger consumer society of its own, boosting internal demand for Italian cars and French luxury goods the rest of the world can’t get enough of. It should reduce consumption taxes and continue to raise wages. (Last year’s broad-based union raises were a step in the right direction, but not enough to bolster wage growth that has been kept flat for a decade.) Chancellor Angela Merkel should also make it completely clear that if other euro-zone nations continue to carry out structural reforms as Portugal and Ireland have, then the Germans will guarantee future bailouts and underwrite the economy of the union in exchange for having greater fiscal and ultimately political power transferred to the center.

3. Launch a European QE
The U.S. is starting to slowly scale back central-bank asset purchases, known as quantitative easing (QE), and will eventually begin to tighten monetary policy as the economy recovers. (Incoming Fed chairwoman Janet Yellen told TIME she’s “hopeful” that GDP growth this year will be 3% rather than 2%.) But there is a strong argument to be made that Europe should do the opposite.

Europe appears to be headed toward a dangerous, Japanese-style deflationary spiral. Headline-inflation figures fell recently, and private-sector loans contracted. With European markets still fragmented and being priced on the basis of national risk, banks still under stress and high debt levels, there’s plenty of reason to think disinflation will only get worse. And despite the ECB’s tough talk about doing “whatever it takes,” the bank’s strategy of simply conveying promises to keep interest rates low doesn’t really seem to be getting the money flowing in Europe — certainly not in a way that will truly bolster growth and wages.

As Morgan Stanley’s chief global economist Joachim Fels puts it, “Yes, Mario Draghi and his ECB council have ‘strengthened’ their forward guidance, but to me this is still no more than an attempt to use cheap talk rather than decisive action in the face of a major threat — the Japanification of the euro area. I don’t think investors really have this on their radar screen.” The solution could be for the ECB to start doing what the Fed has been doing for 41/2 years: buy a big and broad range of longer-dated assets in an effort to create more liquidity in the market and push the private sector into growth-oriented investments.

The problem is that European treaties, crafted in large part under the influence of the Germans — who are forever worried about the inflationary aspects of loose monetary policy — are fuzzy about whether that’s actually legal. The upcoming German Federal Constitutional Court ruling on OMTs, outright monetary transactions (or purchases of a broader variety of assets), will be an important moment in that debate. If the court finds that the OMTs actually constitute legitimate monetary policy, rather than a kind of stealth means of bailing out failing nations, then Draghi and company would be free to do more to support the barely-there recovery.

4. Reaffirm a Commitment to a True Political Union
European leaders say economic unification was always meant to be the first step in greater political union. The truth is that at a number of key points during the development of the E.U. — from the formation of the original coal-and-steel-producing alliance in 1951 to the creation of the single currency 48 years later — Europe has opted to take the easy road and do just enough to reap the benefits of closer economic ties without really giving up on national politics.

On the one hand, it’s understandable — the very idea of a pan-European identity is a post — World War II creation, something entirely new and manufactured in an era in which all boats were rising. On the other hand, the beggar-thy-neighbor politics of the E.U. is no longer sustainable.

Europe is at an economic turning point in which the status quo threatens stability rather than secures it. Europe’s treaties and constitutions need to be changed to allow for true fiscal union, which should be the beginning of a movement toward true political union. The E.U. needs to become a United States of Europe, in which the strong can support the weak and the weak get stronger and, ultimately, enrich the union.

Otherwise, it’s inevitable that the next time there’s a flare-up in the debt crisis, or any other kind of major sovereign crisis — be it a year from today or five — the world will have to wonder whether Europe really believes in itself. Given that postwar Europe has been the most politically benign and prosperous example of globalization that the world has ever known, everyone should hope it does.