Where next for Europe?

What's the latest?

Greece has been in on-off talks with private bondholders for the past six months, and intensively for the past several weeks, on a deal to write down its €360bn debt. A deal needs to be reached if the stricken nation is to receive the next tranches of bail-out funds and meet bond repayments (worth €14.4bn) due to mature on 20 March.

According to Charles Dallara, managing director of the Institute of International Finance and de facto lead negotiator for private creditors, those bondholders are already at the "limits of a voluntary deal" believed to be an effective loss of 65%-70% of the bonds' long-term value. If no voluntary deal can be done, then Greece will default.

Has the Greek bail-out worked?

So far, Athens hasn't officially defaulted, though it may yet. What is clear, according to the International Monetary Fund (IMF), is that the €130bn bail-out plan for Greece agreed in October 2011 will no longer enable Athens to get its €360bn debt pile to a sustainable level by 2020 because the Greek economy has deteriorated.

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So bondholders will have to agree to more losses and/or eurozone governments will have to fund more bail-out loans or let Greece default. Even if a deal goes through, the best-case scenario is that Greece's debt-to-GDP ratio falls from 180% to 120% still not a sustainable level.

Are there any grounds for optimism?

If a private-sector deal is done soon, without triggering credit default swaps (which could unleash contagion to the banks), then it could build on the momentum in both equities and credit markets seen since the beginning of the year.

While much has been made of S&P's sovereign downgrades, the countries involved including Italy, Spain and France have repeatedly defied expectations in recent weeks by issuing big batches of bonds at rates significantly lower than at the height of the crisis (so far).

That's mainly due to the intervention of the European Central Bank (ECB) which, since late December, under new president Mario Draghi, has provided hundreds of billions of euros of (virtually) interest-free loans to Europe's banks and, in effect, through the banks to national governments.

Is that a long-term solution?

Highly unlikely. "If we are lucky it might get us through the intense debt rollover period this spring," says Wolfgang Munchau in the FT. "But a liquidity shower cannot address the underlying problem of the lack of a macroeconomic adjustment."

Moreover, the politicians' focus (led by German chancellor, Angela Merkel) on a fiscal pact is "at best an irrelevant distraction". A growing chorus (from IMF boss Christine Lagarde to an FT editorial) warn that the threat to debt sustainability now comes as much from economic stagnation as from fiscal incontinence. "Europe's deficit obsession fails to discriminate between states that must cut and those with room for fiscal manoeuvre.

With predictable results," says the FT. As Lagarde put it: "Resorting to across-the-board, across-the-continent, budgetary cuts will only add to recessionary pressures" and to markets' concerns about the public debt burden. As economist Joseph Stiglitz warned two weeks ago, the eurozone risks entering into a "mutual suicide pact" by imposing fiscal austerity plans that will collapse economies.

What is likely to happen next?

The European Financial Stability Fund (EFSF) was itself downgraded by S&P, reflecting the downgrades the ratings agency has issued to several eurozone countries, including France. Policymakers now want the European Stability Mechanism (ESM) the zone's permanent rescue funding operation in place by July 2012, a year earlier than planned.

The debate now is how big it should be. The eurozone's current position is that the combined capacity of the ESM (once operational) and the existing EFSF will be limited to €500bn. However, there are many, including Lagarde, who believe there would be "disastrous implications" from not having bigger firewalls to protect Spain or Italy from bond-market runs. This week Lagarde delivered a sobering speech in Berlin, warning of a "1930s moment" if the eurozone is not stabilised and the bail-out funds not boosted.

Will the Germans agree?

Reports suggest Merkel might let the EFSF, which has €250bn left (of its original €440bn), run side by side with the ESM, taking eurozone rescue funds to €750bn.

However, Merkel wants eurozone countries to sign a fiscal pact enforcing even harsher cuts in budget deficits and during economic downturns. The crunch should focus on Italy, and whether it can avoid a debt restructuring: Italy has over €1.9trn in debt, and bringing this under control by austerity alone is unlikely.

IMF should give tough love, not bail-outs

The euro crisis has radically undermined the International Monetary Fund's (IMF) credibility, says Jeremy Warner in The Daily Telegraph. That's because its support seems "directed more at sustaining the single currency than helping individual nations out of their difficulties".

This slavish support for the euro has led the IMF to routine prescriptions of "inappropriate policy repeated rounds of fiscal austerity with none of the compensating support of monetary stimulus and devaluation" that countries such as Britain have been free to adopt. "Tough love, not more bail-outs, is the appropriate IMF policy for Europe" forcing political leaders to confront reality.