Hugo Dixon

When euro zone policymakers are asked if there is a Plan B to cope with a Greek exit from the single currency, their typical answer goes something like this: “There’s no such plan. If there were, it would leak, investors would panic and the exit scenario would gather unstoppable momentum.”

Maybe there really is no plan. Or maybe policymakers are just doing a good job of keeping their mouths shut. Hopefully, it is the latter because, since Greece’s election, the chances of Athens quitting the euro have shot up. And unless the rest of the euro zone is well prepared, the knock-on effect will be devastating.

The Greeks have lost their stomach for austerity and the rest of the euro zone has lost its patience with Athens’ broken promises. But unless one side blinks, Greece will be out of the single currency and any deposits left in Greek banks will be converted from euros into cut-price drachmas.

People outside Greece may think this is simply a Greek problem. Would it really be much worse than Athens’ debt restructuring earlier this year which passed off with barely a murmur? But the process of bringing back the drachma is likely to involve temporarily shutting banks and imposing capital controls. That would set a frightening precedent.

Politicians and central bankers would, of course, argue that Greece was a not a precedent but a one-off. But why trust them? When Greece was first bailed out in 2010, policymakers said it was a special case. Then Ireland and Portugal required official bailouts while both Spain and Italy have had to be helped by the European Central Bank. If savers in Greece get hammered, depositors and investors in these other weak euro member would want to move their money to somewhere safer. Fears would rise of a complete break-up of the euro zone.

Indeed, there already has been significant capital flight from peripheral economies. The best way of seeing this is by looking at so-called Target 2 imbalances – the amount of money that national central banks in the euro zone owe to the ECB or are owed by it. These imbalances are a rough proxy for capital flight.

Four euro zone central banks – in Germany, the Netherlands, Luxembourg and Finland – have positive balances. At the end of April, the Bundesbank was owed 644 billion euros, according to data collected by Germany’s Ifo Institute. The sum has been rising by an average of 33 billion euros a month since the crisis took a turn for the worse at the end of July last year. Meanwhile, all the peripheral countries have big liabilities. Italy and Spain have the largest with 279 billion euros (as of April) and 276 billion euros (as of March) respectively.

A Greek exit from the euro would, at least temporarily, accelerate capital flight. Measures would need to be taken to counteract it – to protect both depositors and governments in vulnerable countries.

Fortunately, it’s not too difficult to construct a contingency plan. To protect depositors, the ECB would have to make clear that a limitless supply of liquidity with very few strings attached was available for banks across the euro zone. This would avoid the possibility that savers would find they couldn’t get money out of their accounts. After a while, calm might return.

To protect governments, the ECB would also need to wade into action. Although it cannot lend to states directly, it can buy their bonds on the secondary market. Indeed, it has already done so. It would, though, need to be prepared to buy bonds in limitless quantities. Otherwise, investors might just run anyway and take the ECB’s money while it lasted.

Although the ECB would have to play the main role in preventing a panic, the euro zone’s so-called firewall should play a subsidiary role. The region will soon have two main bailout funds – the existing European Financial Stability Facility and the European Stability Mechanism. These could be deployed in two ways.

First, they could provide a backstop to national deposit guarantee funds. That way, an Italian saver would know that, if Rome’s own guarantee scheme ran out of money, there were funds in another kitty to fill the hole. Second, the bailout funds could lend cash directly to governments that were no longer able to issue bonds in the markets.

However, the bailout funds are not large enough to stem a panic on their own. They only have 740 billion euros available. Even with help from the International Monetary Fund, they would not be able to douse the flames.

Although it is fairly easy to think of a plan B, that doesn’t mean it would be easy to get political agreement for it from Germany and the other creditor countries. One concern would be that the ECB would be taking huge financial risks by buying government bonds and lending to banks. Another is that such rescues, which would amount to a big step towards fiscal union, would take the pressure off the peripheral governments and their banks to reform themselves and improve their solvency.

On the other hand, failure to act as a lender of last resort in a Greek-exit panic could trigger a domino effect of bankruptcies – of banks and governments – throughout the periphery. The euro couldn’t survive that.

Germany may soon need to decide between going all-in to save the single currency or witnessing its destruction.

It has become fashionable to talk about the need for a euro zone “growth compact” as weariness mounts over a diet of nothing but austerity. France’s new president Francois Hollande has popularised the idea. Even Mario Draghi has backed it. That gives the concept credibility as the European Central Bank president was one of the main supporters of the austerity-heavy “fiscal compact”, which requires governments to balance their budgets rapidly. Olli Rehn, the European Commission’s top economic official, has joined the bandwagon too: at the weekend, he advocated a pact to boost investment, while hinting that there may be scope to ease up a bit on the austerity.

But all this chit-chat won’t lead to much unless politicians are prepared take unpleasant decisions on reforming labour, welfare and banking – measures which would boost growth in the long run. That has to be the quid pro quo for loosening the current fiscal squeeze or further easing monetary policy – measures that would help in the shorter term. 

Without such a grand bargain, any growth compact is likely to amount to little more than extra funds for investment. Rehn mentioned the main ideas at the weekend: using EU budget funds to guarantee lending to smaller firms; encouraging countries with fiscal surpluses to increase public investment; and boosting the capital of the European Investment Bank. While these measures are worthy, they are not of the scale needed to change the course of one of the biggest economic crises in recent history. 

The main guts of a growth compact ought to be somewhat looser fiscal and monetary policy married to deep structural reform. 

Look first at fiscal policy. It is great that policymakers such as Rehn seem to understand the dangers of an austerity spiral – where excessive budget squeezes crush the economy which in turn makes it harder to balance budgets and so requires further austerity. He says Europe’s fiscal rules are “not stupid”. 

 But even if Germany, Europe’s paymaster, can be persuaded to go along with a laxer interpretation of the rules, there is a limit to what will pass muster with the bond markets. While investors aren’t enamoured with growth-crushing austerity, they won’t finance profligacy either. Credible long-term plans to rein in deficits and restore competitiveness are needed. With those in place bond investors would be happy if the European Commission allowed governments another year or so to balance budgets. 

 The need for substantial change is not limited to countries already in crisis. In France, industry is increasingly uncompetitive and the government spends 57 percent of GDP. Tackling that ought to be the government’s priority, though it got little mention during the election campaign. Even Germany would benefit from reforming its weak services industries. Meanwhile, across Europe there needs to be a determined drive to deepen the region’s single market. 

 To gain the full benefits of monetary policy, there also needs to be a quid pro quo with the politicians. It’s important not to misinterpret Draghi’s new fondness for the word “growth”. The ECB is still keen on fiscal rectitude and is not signalling looser monetary policy. When Draghi talks about a growth compact, what he has in mind is structural reform – something that will not bear fruit for some time. Indeed, Draghi talks about the need for a 10-year vision. 

 While the central bank has engaged in exceptional measures to prevent the system collapsing – buying government bonds and spraying cheap money at the banking system – it has done so with a heavy heart. It rightly fears that such monetary rescues reduce the pressure on both governments and banks to reform themselves. Germany’s Bundesbank is even calling for the ECB to prepare to exit from these exceptional measures. While it won’t get its way – Draghi has made clear he thinks it’s too early to do this – talk of an exit is already making the money markets and the banks nervous. And that is undermining some of the benefits of the current loose policy. 

 For the ECB to be happy to pursue further monetary laxity, it will need to be convinced that governments are going to use the time they are being given wisely. A priority is to recapitalise zombie banks. So long as lenders have weak balance sheets, they will find it hard to fund themselves in the markets and will therefore lack the confidence to finance growth. 

 The key short-term imperatives are in Spain and Greece. But weak balance sheets are not confined to these two countries. Other governments have shown themselves unwilling to impose higher capital requirements on their lenders. Last week, for example, both Germany and France argued for changes in the way the new Basel 3 capital rules are applied to Europe so that their banks won’t need to raise so much capital. If politicians could bring themselves to grasp the nettle on banking, lenders would find it easier to fund themselves in the markets and the ECB would be less grudging about providing emergency assistance if it was still needed. 

 The ideal growth compact would match reform of banks, labour and welfare with less short-term austerity and accommodative monetary policy – and throw in some extra money for investment. Given the difficult political choices required, such a deal won’t be easy to pull off. But the tectonic plates are shifting across Europe. Now is the time to push for it.

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

A further difficulty concerns whether such a banking union should stretch across the euro zone or the entire European Union, which includes the United Kingdom, home to the region’s largest financial centre. Britain would argue that it shouldn’t be roped into a system that is designed to shore up the single currency it is not a part of. On the other hand, if the euro countries went ahead on their own, the single market in financial services would fragment.

Quite apart from the politics, a banking union wouldn’t actually solve all the problems. In particular, it would do nothing to stop banks owning too much government debt. Indeed, in the last few months, Spanish and Italian lenders have bought even more of this debt – using cheap money from the European Central Bank. This has helped finance their governments through a rough patch but at the cost of tying the banks’ fate even more closely to that of their countries. Over time, governments ought to be weaned off reliance on their local banks. But, realistically, this isn’t going to happen fast.

Does this mean that a European banking union is a totally dead idea? Not quite. It may be possible to cherry-pick bits of it. The most important part would be to create a Europe-wide “resolution” regime. The basic idea is that such a regime would allow insolvent banks to go bust in a controlled fashion. If shareholders haven’t put in enough capital, bondholders have to be “bailed in”. Only if bondholders also haven’t put in enough capital do deposit guarantee schemes – and possibly taxpayers – have to be activated to make sure savers are repaid. With such a framework, governments such as Ireland’s wouldn’t in future be infected by their lenders’ problems.

At present, many European countries lack such a resolution regime and those that do exist don’t collaborate effectively with one another. What’s more, until recently the European Central Bank has been hostile to the idea that bank bondholders should suffer any losses. It prevented Dublin from bailing in bondholders, fearing that this would trigger contagion.

The mood, though, is changing. The European Commission is planning to publish plans for an EU-wide resolution regime in June. Even the ECB has started lending its support to such a scheme. The devil, of course, will be in the detail. But there finally seems to be momentum behind this proposal.

A second idea that could be cherry-picked is to reinforce Europe’s deposit guarantee schemes. At the moment, every country has its own. The problem is that depositors in weak countries, especially Greece, don’t have confidence that their national schemes have enough money to pay out. So savers have been taking their cash abroad.

It is too much to expect that Germany, Europe’s paymaster, would agree to a euro-wide deposit insurance scheme. But what about some sort of reinsurance scheme? Nicolas Veron from the Bruegel think tank argues that the European Stability Mechanism, the euro zone’s soon-to-be-created bailout fund, could provide national schemes with a backstop.

Europe is not ready for banking union any more than it is ready for political union. But such ideas show there are practical ways of limiting the unhealthy nexus between lenders and their governments. Europe should grasp them.

We’re going to be really tough on the euro zone. If they want more bailouts from the International Monetary Fund, they are going to have to submit to strict conditionality. That was the message delivered by the rest of the world when it agreed at the weekend to participate in a fundraising exercise that will boost the IMF’s resources by at least $430 billion.

But the meaning of the message isn’t quite what it seems. The IMF is actually in some ways calling for less rather than more short-term austerity in the euro zone. So if the Europeans submit to IMF discipline, it will ironically mean less of a hair shirt.

It is easy to see why the rest of the world is unhappy with the special treatment the euro zone receives from the IMF. The managing director, currently Christine Lagarde, has always been a European. Vast resources, way beyond what are normally available in IMF programmes, have been channelled to Greece, Ireland and Portugal.

What’s more, the rest for the world – from developed countries such as America, Britain and Canada to emerging nations such as Brazil – feel that, despite being pretty rich, the euro zone has not done enough to sort out its own problems. Hence, the agreement to beef up the IMF resources only after a long wrangle – and only after scaling back the original request from $600 billion as well as insisting on strict conditionality before the money is ever disbursed.

At the same time, the IMF has three recommendations, as outlined in last week’s World Economic Outlook, which are somewhat at variance with current euro zone policy. First, it wants the region not to overdo short-term fiscal austerity while placing more emphasis on longer-term structural measures to improve budgets. Second, it wants the European Central Bank to continue very accommodative monetary policies. Finally, it wants the euro zone authorities to be prepared to inject capital directly into troubled banks and to accompany that with stronger European-wide supervision of lenders. All these ideas would help reduce the pressure of the current euro zone recession and so ease the crisis.

Will the IMF, though, get its way? Well, certainly not immediately. The euro zone doesn’t have to listen to it unless another country – say Spain or Italy – needs a bailout. Even then, only the country requiring cash would technically have to pay heed to the IMF. The rest of the euro zone, led by Germany, could argue that the IMF has no business interfering with the monetary policy or banking supervision of the entire 17-member euro zone when only a few peripheral nations are receiving help.

What’s more, the bulk of the money from any future bailouts would continue to come from other euro zone countries rather than the IMF. These other countries would argue that they should have a big say, even on fiscal policy, because they will be bankrolling most of any deficit shortfall.

But even if the IMF can’t get its way immediately, the debate is shifting slowly in its favour. The euro zone may not like interference in monetary policy. But the ECB has shown itself willing to spray 1 trillion euros in long-term loans at the region’s banks in the heat of the crisis in recent months. Some of the central bank’s members, with the notable exception of Germany’s Bundesbank, are saying it is too early to plan for an end to such policies.

Or take fiscal policy. Euro zone leaders may have agreed the so-called fiscal compact which will require them to balance their budgets and cut their debts. But no sooner had the deal been signed than Spain varied its fiscal targets. Italy has followed up by saying it won’t react to a deeper than expected recession by pushing through more cuts – a policy that would just lead to further recession.

Now the Dutch government, previously the high priest of austerity, has found it cannot push through its own budget cuts. Meanwhile, Francois Hollande has promised to push for a more growth-orientated policy if he wins the French election. The austerity consensus is fraying.

Finally, consider banking policy. The intertwining of lenders and their states is unhealthy. Banks which get into trouble need to be bailed out. That makes their governments less creditworthy which, in turn, further infects banks which loaded up on their bonds. That occurred in Ireland and could be repeated in Spain.

The IMF’s proposal is to sever this incestuous relationship by getting the euro zone to put money directly into troubled banks rather than by lending to governments which, in turn, would inject capital into the banks. Such a policy would be matched by euro zone-wide supervision of banks.

The idea is rational. That, of course, doesn’t mean that it will be adopted. But with an expanded warchest, the IMF has greater ability to be heard on this and other issues – especially if it keeps reminding the euro zone that the rest of the world has insisted that strings are attached before any more countries are given bailouts.

Can the euro omelette be unscrambled without provoking the mother of all financial collapses? With the crisis heating up again as Spanish 10-year bond yields hit 6 percent last week, the question has renewed urgency. The conventional wisdom is that such unscrambling is impossible. The economic, political and legal complications of bringing back national currencies are so immense that the euro zone’s 17 nations are effectively locked in a prison with no exit.

A 250,000 pound prize offered by Simon Wolfson, a UK businessman, has aimed to turn this conventional wisdom on its head. In offering what is the second-largest economics prize after the Nobel, Wolfson hoped to stimulate creative juices. In one case, he has – although even it is no silver bullet.

Of the myriad problems with returning to the drachma, peseta and lira, the most intractable is how to prevent it triggering bank runs and ultimately financial chaos. Depositors would flee if they thought their euros were set to be converted into a national currency certain to suffer dramatic and immediate devaluation. This has already been happening to some extent in Greece. If the Greeks knew for sure that their old currency was coming back, the current fast walk would turn into a stampede. Even worse, the damage wouldn’t be confined to Greece.

Depositors in other peripheral countries would pull savings from their banks. Bond markets in these other countries would also seize up. Why would anybody want to lend money to Rome or Madrid in euros if they thought they were going to be paid back in devalued liras or pesetas?

The solution proposed by most Wolfson Prize finalists is secrecy. Plans for a country’s exit from the euro should be kept under wraps and then sprung on the unsuspecting world on a Friday evening. But this is impractical. How could 17 governments keep secret something that will involve lots of wrangling? Would a democratic country really be able to foist such a momentous decision on its people without a parliamentary debate? Even if secrecy was possible, it wouldn’t stop contagion to other countries.

Catherine Dobbs, a private investor who used to develop algorithms for an investment firm in the City of London, has come up with an ingenious solution. At the point of break-up, every euro – wherever it is located – is replaced by a basket of two (or more) new currencies. This is a radical shift in thinking. Until now, most people had envisaged all economic activity in the exiting country being redenominated in its new local currency while all the other countries kept the euro.

Dobbs illustrates her idea using the unscrambling the egg metaphor. The euro zone is broken up into two sub-zones: the yolk and the white. For some bizarre reason, she equates the yolk with the periphery (Greece, Spain etc) and the white with the core (Germany, the Netherlands etc). But I’m going to flip it round as it’s more intuitive to think of the yolk as the core. The idea is that every euro is swapped for a fixed ratio of yolk currency and white currency, roughly in proportion to the relative size of the two sub-zone’s economies. Say for every euro, people got 70 percent of a yolk and 30 percent of a white.

Once this has happened, the yolk and white are free to float – with the yolk presumably appreciating and the white currency depreciating. New contracts are denominated in yolk or white. But existing euro contracts have to be honoured by delivering the fixed proportion of yolks and whites in the basket.

The one exception to this – which Dobbs hints at but doesn’t spell out – would be employment contracts: they would need to be redenominated into their new local currency. This would effectively allow wages in the periphery to fall, which is vital if competitiveness is to be restored.

The beauty of the scheme is that there’s no incentive for citizens in the periphery to grab their savings in the run-up to such a switchover and pop them into a core bank. Their euros will be worth the same wherever they are located. As a result, the detailed planning for the break-up can be done in public rather than in secret.

Neat as Dobbs’ idea may be, the politics of it are problematic. While savers in peripheral countries would like receiving a mixture of yolk and white for their euros, those in core countries could hate it. They would feel that a chunk of their savings was being forcibly swapped into the weak white currency even though, in theory, the value of the basket should still be one euro. Workers in the periphery who would be paid only in the depreciating white currency wouldn’t be happy either. While their wages would effectively be slashed, their debts, rents and other costs wouldn’t be. Many would face hardship and bankruptcy.

Perhaps that is just too bad. Somehow wages have got to come down in the periphery and devaluation would be a faster way of getting there than the current grinding austerity, which isn’t pleasant either. The snag is that such vested interests mean it’s most unlikely that heads of government could discuss the yolk/white scheme one day and back it. Rather, there would be lots of debate over what the right plan was. And before any decision had been reached, there would have been a massive capital flight. Sadly, the euro egg looks pretty well scrambled.

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.

The risk is that, as the short-term funding pressure comes off, governments’ determination to push through unpopular reforms will flag. If that happens, the time that has been bought will be wasted – and, when crisis rears its ugly head again, the authorities won’t have the tools to fight it.

Early signs of such fatigue are emerging. One is the tendency of politicians – most recently, Italian Prime Minister Mario Monti – to say that the worst of the crisis is over. They may wish to take credit for their crisis-fighting skills or relax. But it is too early to declare victory.

Italy is a case in point. Monti should have pushed through crucial reforms to the labour market earlier, while his popularity was high and the electorate was afraid that Italy would be engulfed by the crisis. He did not. And although he has now come up with a good package, his honeymoon period as the unassailable technocratic prime minister is nearing its end. His popularity fell to 44 percent from 62 percent in early March, according to a poll published last week by ISPO. Two-thirds of Italians oppose his labour reforms.

It’s a similar story in Spain. Mariano Rajoy, the incoming prime minister, should have cracked on earlier with a budget to bring the government’s finances into balance. To be fair, his administration did publish plans last Friday to curb its deficit – though it won’t be possible to judge how credible these are until Madrid explains how the health and education spending of Spain’s free-wheeling regional governments is to be reined in. Meanwhile, Rajoy’s honeymoon is also over. Last week, he failed to win the regional election in Andalucia and faced his first general strike.

Both Monti and Rajoy are still in strong positions. Although Italy’s political parties could theoretically kick Monti out, they are even less popular than him. Meanwhile, the Spanish prime minister has a sound majority in parliament. But as each month passes, it will get harder to push through reforms. Both men must hold their nerve and implement their full programmes while they can, without compromise.

Further afield, the appetite for austerity is also flagging – sometimes in unexpected places. The Dutch government, one of the high priests of fiscal rectitude, is finding it difficult to cut its own deficit. The ruling coalition may even collapse under the strain.

There is also increasing unhappiness about the fiscal discipline treaty Germany rammed through in December. Francois Hollande, the French socialist who is the front-runner to be France’s next president, wants to add a growth component to it. So do Germany’s social democrats, whose support is needed to ratify the treaty even though they are in opposition.

A fudge will probably be found that adds a protocol to the treaty which emphasises the importance of growth as well as discipline. Indeed, that would be no bad thing: too much austerity can be self-defeating as severe budget squeezes can crush an economy and make it even harder to raise taxes and cut deficits.

However, governments can’t ease up on short-term austerity and do nothing. What is needed is a vigorous programme of long-term structural reforms such as freeing up labour markets and introducing more competition into services industries. This could ultimately boost GDP by about 15 percent in large euro countries such as France, Italy and Spain, according to the Organisation for Economic Cooperation and Development. Even Germany, whose services markets are sclerotic, could benefit by about 13 percent of GDP.

Such a programme would make the euro zone’s economies fit enough to stand on their own feet when the anaesthetic of cheap money fades. But do governments have the will to make these changes given that the cheap money is lulling them and their people into believing the worst of the crisis is over?

A prod from the markets may be what is required. There are indications that this is beginning to happen. Spanish 10-year bond yields briefly reached 5.5 percent last week. The art, though, will be in the calibration. If markets move too little the politicians will be complacent. If there is too much, the euro zone will slip back into full-blown crisis.

Move over, Robin Hood tax. Make way for the FAT tax and the hot money levy.

The European Union’s plan to put an impost on financial transactions, popularly known as a Robin Hood tax, is dying. That’s a good thing. The idea was taken up by the Occupy movement as well as luminaries such as Bill Gates. But it never made economic sense. Taxing transactions wouldn’t have dealt with any of the causes of the financial crisis such as too much leverage and excessive reliance on hot money. It would just have driven business offshore.

Britain has always opposed the tax, meaning it had no chance of being adopted by the EU as a whole. Now the Netherlands has come out against it, so it can’t even be applied across the whole euro zone. With Germany’s finance minister saying that the “smallest thinkable unit” for the tax is the euro zone, it is only a matter of time before the Robin Hood tax is buried.

EU finance ministers will discuss alternative ways of taxing finance later this week in Copenhagen. The guiding principles should be to rein in excess risk-taking and remove distortions that bias one form of economic activity over another. With these ideas in mind, there are three specific things Europe, and for that matter the rest of the world, should do.

First, countries should impose a “hot money” tax on banks. Such a levy would apply to a bank’s wholesale borrowing. Ideally, short-term wholesale money should face an especially high levy: excessive reliance on such easy-come-easy-go funding was a big reason why banks from Royal Bank of Scotland to Lehman Brothers came a cropper. A hot money tax would encourage banks to raise longer-term money or attract relatively stable retail deposits. It would also mean that, if governments did have to bail out banks in future, the industry would at least have paid towards its own rescue.

So far 11 of the 27 EU countries – including Germany, Britain and France – have imposed such a levy, according to KPMG. The rest should follow suit. So should the United States, which has been toying with what the Obama administration calls a Financial Crisis Responsibility Fee. Although nothing will happen before the presidential election, a hot money tax could be one of the ways America eventually brings down its deficit.

Second, countries should remove the tax system’s bias in favour of debt. In most places, companies can deduct interest payments from profit before paying corporation tax. This encourages firms to leverage themselves up to the gills. The whole economy, not just the banking sector, is affected. But lenders are doubly exposed. Not only do they have an incentive to pile on the leverage themselves; they periodically get exposed to over-indebted customers, especially real estate developers and leveraged buyout houses.

Third, financial services should no longer be exempt from value-added tax. VAT is a consumption tax which is applied at each stage in the chain of production. Companies add VAT to what they sell other firms, but get a credit for what they purchase. This means only the final customer ultimately pays the tax. But in the EU and other jurisdictions, banks are not covered. They neither apply VAT to the services they provide customers nor get a credit on the VAT they pay on their purchases.

This anomaly causes several distortions. Final customers are undercharged for financial services, meaning they consume too much of them. Business customers, by contrast, are overcharged as there is no VAT they can reclaim on what they pay banks. Meanwhile, lenders have an incentive to perform activities in-house which would be more efficiently done by other companies – because they can’t recover the VAT they pay to outsourcers.

The VAT exemption probably also loses governments money. No proper calculations have been done. But a tentative estimate for the UK puts the lost revenue at 10 billion pounds a year, according to last year’s Mirrlees Review.

Given all these problems, it might seem mad that financial services are exempt from VAT. But there is a reason. Banks don’t charge fees for most of their services. Instead, they make the bulk of their income from the spread between the interest they charge for loans and what they pay depositors. Dividing up this spread among specific customers so that VAT can be applied to every bill would be quite tricky.

There are broadly speaking two solutions. One is to work through the technical complexities. The other is to introduce a financial activity tax, known as a FAT tax. This is applied to a bank’s earnings and the compensation it pays employees on the theory that the sum of these is just value added by another name.

The FAT tax has potential populist appeal, not just because of its name. After all, in the current environment, who would object to taxing banker pay and bank profit? One wrinkle, though, would need to be ironed out before FAT was an ideal tax. Some way would have to be found of giving business consumers a FAT tax credit.

There’s no disguising the fact that it would be complicated to revamp the way that banks are taxed. But given the havoc they caused in the crisis, the fact that the sector is under-taxed and the way in which the current system distorts economic activity, it is well worth the effort. The near-death of the Robin Hood tax provides a golden opportunity to do so.

At a dinner in Madrid earlier this month, the main complaint about Mariano Rajoy was that the new prime minister was treating the electorate like children. Many of the guests, supporters of Rajoy’s Popular Party (PP), understood that Spain had to cut its fiscal deficit and restore its competitiveness. But they didn’t like the fact that the prime minister hadn’t been frank about his plans.

In advance of last November’s general election, Rajoy said he wouldn’t raise taxes, make it cheaper to fire people or cut the welfare state. But he has now done the first two. After this week’s election in Andalusia, Spain’s largest region, he is expected to do the last.

Rajoy’s camp doesn’t see any problem in failing to be upfront. It would have been foolish to talk too much about austerity in the general election campaign as that might have frightened the voters. For the same reason, it would be foolish to tell them about reforming the welfare state in advance of the Andalusia election.

In the long run, the failure to treat the population like adults could cause trouble. But in the short run, the strategy has paid off. The socialist party lost nearly 40 percent of its votes in the general election, not least because it had done a poor job in government. It is now expected to lose control of Andalusia, its last main bastion, according to an opinion poll by Metroscopia.

Rajoy has already used the absence of any serious opposition – even a general strike called for next week doesn’t pose much threat – to push through one batch of reforms. The most important is of the labour market. He has made it cheaper for companies to fire people and largely dismantled the nationwide system of collective bargaining. The net effect will be that wages, which rose rapidly during the early years of the single currency, will fall – so restoring Spain’s competitiveness.

Between end 1998 and end 2009, Spain’s unit labour costs rose 38 percent, compared to 23 percent for the euro zone as a whole. In the past two years, they have come down 4 percent. The latest labour reforms could cut wages another 5 percent this year, according to Fernando Fernandez, economics professor at Madrid’s IE Business School. If the trend continues for another year or so, Spain will no longer be out of kilter with its euro peers.

The other main reform – cleaning up toxic loans from banks’ balance sheets following the country’s real-estate bubble – has had more mixed reviews. The government has told the industry to take provisions and stash away capital to the tune of 50 billion euros. While the number sounds high, the detailed rules mean many banks won’t need to raise capital and some of the rest could have nearly two years to do so. The government itself has been reluctant to put any more of its own money into banks. So it is trying to push weak banks into the arms of stronger ones and fill any capital shortfalls with guarantees from an underfunded deposit insurance scheme rather than with real cash.

The litmus test of whether this financial jiggery-pokery works will be whether banks are able to borrow in the markets and are then willing to support economic recovery by lending to businesses and consumers. There are some positive signs: Santander last week issued 1 billion euros in five-year senior debt. But most of the industry is still relying on handouts from the European Central Bank.

Rajoy’s second blast of reforms will be about putting the public finances onto a sustainable basis. In 2011, the budget deficit hit 8.5 percent of gross domestic product. Spain last week reached a deal with its euro zone partners to cut it to 5.3 percent this year. Although this is not as severe as the 4.4 percent originally pledged, it will still constitute a severe squeeze. What’s more, the government remains committed to bring the deficit down to 3 percent next year.

The prime minister has already given some ideas about what he will do. Income taxes were raised and some spending cut in an emergency budget just before the New Year. Rajoy is also putting in place a straitjacket to control the borrowing of the country’s profligate regional governments. If he wins this week’s Andalusia election, he will be in an even better position to impose his will as the vast majority of the regions will then be under the PP’s control.

But more will be needed. The regions, which are responsible for education and healthcare, will probably be allowed to charge people for part of the cost. And Rajoy will have to cut the number of public-sector employees and increase taxes further in next week’s budget.

Economically, this is logical. The concern is that Rajoy’s failure to be frank with the electorate could increase its cynicism. The people already have little trust in politicians of all stripes. Witness last year’s indignado movement, when hundreds of thousands of protestors took to the streets to complain.

This won’t matter if the economy, which the government expects to shrink 1.7 percent this year, stabilises next year. But what if GDP keeps shrinking, unemployment (now 23 percent) continues rising and the deficit remains stubbornly high? Spain would face renewed bond market jitters and further pressure from its euro partners to cut its deficit. Rajoy would then have to sell another dose of austerity to voters that wouldn’t believe him. Having treated them like kids, they might even throw a tantrum.

Francois Hollande’s sins are more those of omission than commission. The headlines might suggest otherwise. The socialist challenger to Nicolas Sarkozy as France’s next president has promised to cut the pension age to 60, tax the rich at 75 percent, renegotiate Europe’s fiscal treaty and launch a war on bankers. But these pledges aren’t as bad as they look. The real problem is that Hollande, who has a strong lead in the opinion polls, isn’t addressing the need to reform the country’s welfare state.

Hollande is a moderate. Like Sarkozy, for example, he is promising to cut the budget deficit to 3 percent next year, from 5.8 percent as estimated by the European Commission in 2011. But he still had to throw the left some red meat in the election campaign, which runs until May. That’s not just to prevent votes drifting to Jean-Luc Mélenchon, the far-left candidate. It’s also to avoid being outflanked by Sarkozy’s own populist attacks on corporate fat cats and bankers.

Still, the precise pledges probably aren’t what they seem, as I discovered on a trip to Paris last month.

Look at pensions. Hollande has said he’ll cut the pension age from 62 to 60 – at a time when Germany and other countries are raising theirs to 65 or more. But the fine print is more nuanced. This lower retirement age will only apply to people who have worked 41.5 years – in other words, since the age of 18. Given that increasingly people start working later, less than 5 percent of the workforce is affected, according to UBS.

Or take the 75 percent tax rate on income above 1 million euros. If Hollande as president really instituted such a rate, he would drive most of France’s remaining big earners off shore. But within hours of advocating the measure, an advisor was saying off the record that it might last only a few years. By the time it comes to implementation, enough exceptions and loopholes could also have been introduced to reduce the measure’s real bite.

Much the same goes for Hollande’s promise to renegotiate the euro zone’s new fiscal compact treaty. He is, in many ways, right to criticise this mutual austerity pact, the brainchild of Germany’s Angela Merkel. The snag is that he has no chance of changing the chancellor’s mind. While Hollande could theoretically refuse to ratify the treaty, that would create a mega-crisis. As a strong pro-European, the socialist is unlikely to want that – especially since France has its own huge borrowing needs.

More likely, Hollande would seek to “complete” rather than “renegotiate” the pact by adding some wording about the importance of growth. There is a precedent. The stability pact in the original Maastricht Treaty was rechristened the Stability and Growth pact in 1997 after France’s incoming socialist prime minister, Lionel Jospin, kicked up a fuss.

Finally, consider Hollande’s war against bankers. His headline-grabbing promise – to separate “socially useful” finance from “speculative” activities – isn’t scaring French financiers. Partly this is because there is a global trend. The United States has the so-called Volcker Rule, which bans banks from proprietary trading. Britain has the even more extreme Vickers plan, which will force banks to put their retail operations into ring-fenced subsidiaries to protect them from infection by investment banking business.

The other reason French bankers aren’t too fussed is because the Hollande camp has been indicating that it prefers Volcker to Vickers. One only has to look at how long it is taking America to implement the Volcker rule to see how a French version could be diluted by the time it is implemented.

There is a risk that, caught in his campaign anti-capitalist rhetoric, Hollande might have no other choice than actually trying to implement some of these proposals to the letter. The more he insists that he wants “substantial” changes to the euro treaty, for example, the more difficult it will be for him to climb down once he is president.

Still, the problem is not so much what the presidential candidate is saying but what he isn’t saying. France has a generous welfare system that it has only been able to finance by racking up debts and imposing high taxes. Spending stood at 56.6 percent of GDP in 2011, 11 per cent more than in Germany, while taxes amounted to 50.8 percent of GDP, 6 percent more than its neighbour across the Rhine. The bloated state machine, where unions still rule, is resisting reform. Meanwhile, various rules and privileges prevent the labour market functioning efficiently or add to labour costs, notably the 35 hour week or the over-regulation of services. These high taxes and rigidities help explain why French annual growth averaged 0.6 percent less than Germany’s in the five years to 2011.

Other euro zone countries, such as Italy and Spain, are being forced by the crisis to reform. But France is not. Ten-year bond yields, at 2.9 percent, are admittedly 1.1 percentage points more than Germany’s, but that’s still a lot less than Italy’s and Spain’s levels of 4.8 percent and 5 percent respectively. To be fair, Sarkozy is now talking about supply-side measures such as cutting social security payroll taxes. But he wasted the opportunity to reform during the last five years and is unlikely to be given another chance. Hollande, meanwhile, isn’t even talking about such matters – and is keeping characteristically mum about how he will cut public spending.

This suggests two main scenarios for a Hollande presidency. One is that financial markets calm down, there is no reform and France wastes another five years. The other is that a new phase of the euro crisis erupts, forcing Hollande to embrace reform at last. But given his failure to prepare the French people for change, and their predilection for taking to the streets to protest at reductions in their privileges, this could be a rocky ride.

Bailout may not be a four-letter word. But many of the rescue operations mounted to save banks and governments in the past few years have been four-letter acronyms. Think of the TARP and TALF programmes that were used to bail out the U.S. banking system after Lehman Brothers went bust. Or the European Central Bank’s LTRO, the longer-term refinancing operation. This has involved lending European banks 1 trillion euros for three years at an extraordinarily low interest rate of 1 percent.

The markets and the banks have jumped for joy in response to all this liquidity being sprayed around. So have Italy and Spain, whose borrowing costs have dropped because their banks have been able to take cheap cash from the ECB and recycle it into their governments’ bonds — making a profit on the round trip. But as has been the case with other four-letter bailouts, the LTRO has come in for criticism — most of it a variation on the theme that the way to treat debt junkies isn’t to give them another heroin injection.

One problem is that European governments could now feel less pressure to reform their labour laws and do the other painful things that are needed to get their economies fit. Another is that banks may delay actions that are required to let them stand on their own two feet: such as rebuilding their capital buffers and raising their own longer-term funds on the markets.

As if this were not bad enough, undeserving banks will be able to make bumper profits on the back of the ECB’s cheap money and, potentially, route them into fat compensation packages — although two British banks, Barclays and HSBC, have said they won’t allow bonuses to be inflated in this way. Meanwhile, the ECB could incur losses if the commercial banks that have borrowed all this money can’t pay it back and the collateral they have pledged turns out to be insufficiently valuable. Oh, and don’t forget that this is just a three-year operation. There could be another crisis when the banks need to find 1 trillion euros to repay the ECB in 2015.

The charge sheet is a long one. But the LTRO was a necessary evil. Just think back to early December when panic was stalking the euro zone. Without some form of bailout, there would have been a severe credit crunch that would have dragged the economy into a deep recession rather than the mild one it now seems likely to suffer. Large countries such as Italy and Spain could also have easily been shut out of the markets, potentially leading to a break-up of the single currency.

The ECB faced a too-big-to-fail problem. If it didn’t bail out the system, it would be faced with catastrophe; if it did, it would reward foolish behaviour. One can argue with the details. Did the money, for example, really need to be so cheap? But the central bank made a rational choice. The priority now is to limit the bad side-effects.

Mario Draghi, the ECB president, has made a start by telling European Union leaders at their summit last week that the three-year cash injection would not be repeated, according to Reuters. He said it had merely bought the euro zone time and it was essential that structural reforms were pushed through.

Hopefully, such lectures will be sufficient to do the job. But countries rarely reform unless their backs are to the wall. Take Italy. Mario Monti has made a remarkable start pushing through pension changes and liberalising services since taking over from Silvio Berlusconi. But there is much left to do: freeing up the labour market, privatising assets, revamping public spending and fighting tax evasion. How easy will he find it to push all that through now that Italy’s 10-year borrowing costs are below 5 percent?

Similar points can be made about Spain, where Mariano Rajoy’s reform programme has only just begun. Meanwhile, France, which has so far largely escaped the crisis, will not be under pressure to address its deep-seated labour market and pension problems. Francois Hollande, the socialist who will probably be the country’s next president, certainly has no ideological desire to do so.

But won’t the new European fiscal treaty deal with the issue? Sadly not. The demand for fiscal austerity was, indeed, the quid pro quo for the ECB’s bailout. But it was the wrong sort of conditionality. Balancing budgets is not the same as structural reform. The only thing pushing Europe’s governments down the latter route is exhortation and the warning that there won’t be any more bailouts.

With the banks, more tools are available to mitigate the damage from the LTRO. After all, governments, the ECB and regulators can tell lenders what to do. The most important changes – requiring them to build stronger capital bases and rely less on short-term funding — are already under way. The key thing will be to resist lobbying to delay and dilute these rules.

But there is also a case for revisiting the industry’s lax tax regime, especially if compensation remains high. Politicians have given most of their attention to taxing financial transactions, the so-called Tobin tax. But a better alternative could be to introduce what is known as a financial activities tax or FAT tax. Most countries do not apply VAT to banking. FAT, which would tax profits and compensation, would do a similar job. A three-letter tax could be part of the answer to a four-letter bailout.