The European single currency has entered the stormiest seas it has yet experienced. Sovereign debt anxiety is swelling among global investors. There have been mounting fears over the soundness of Greek debt for several months. And this week those fears spread to encompass the borrowings of Spain and Portugal. Some suggest that the euro ship itself could capsize if this weather gets much worse.
It is important to recognise that, while several European nations have weak public finances, Greece has exceptional problems. Athens' budget deficit is abnormally large, as is its stock of debt. And the European Commission discovered recently that the Greek government had been engaged in dishonest accounting to disguise the scale of its liabilities.
These problems might have been uncovered earlier were it not for Greece's euro membership. Athens was able to fund its extensive borrowing cheaply in the boom years. Euro membership also protected Greece in the 2008 banking crisis. But as Greece's economy has stagnated in the global recession, bond investors have begun to price in default risk. The interest rate demanded by those buying Greek debt has spiked sharply.
And it is impossible to rule out a panic by investors in which they stop buying Greek debt altogether. That would plunge the country into a downward spiral and possibly even force it out of the eurozone. A lethal domino effect could follow, with investors pulling their money out of other eurozone countries with relatively weak public finances such as Spain, Ireland, Portugal and Italy.
So what is to be done? In many ways the necessary medicine is already being prepared. This week the government of George Papandreou announced a programme of fiscal austerity – including a public sector hiring freeze, pension reform and a clampdown on tax evasion – to get the national finances back into a respectable shape. The central problem now is one of credibility. There are doubts about the Greek government's ability to force retrenchment in the face of rising public protests and strikes. There are doubts too about the EU's ability to get Athens to sort out its problems.
Policymakers across Europe need to address these doubts urgently. They must signal to the financial markets that Greece will be compelled to live up to its commitments and, also, that it will not be allowed to go under. These two messages will reinforce each other.
Those who argue that this raises issues of moral hazard are correct. It will be harder to ensure more responsible behaviour from Athens in future if it is bailed out now. So the task for the European authorities in the medium term will be to put in place a credible system of sanctions for national governments which run irresponsible deficits. The existing Stability and Growth pact has plainly not worked. Larger economic imbalances within the 16 nation currency union over wage levels and productivity will also need to be addressed if the eurozone is to avoid future crises.
But European policymakers should focus right now on the immediate danger. If Greece wants to stay in the eurozone its population will need to accept the immediate pain of fiscal austerity. And if richer members such as Germany want to keep the eurozone intact, they need to make it clear to the markets that they will backstop Greece. Only resolute action will calm the storm.