Three ways to stabilize the euro

December 15, 2010: 5:00 AM ET

The European debt crisis has weakened the euro considerably, but there are opportunities to help put it back on even ground before it's too late.

euroWhen the euro was introduced in 1999, proponents of the official currency of the eurozone associated it with economic progress and a chance for Europe to increase trade and investments throughout the region. Since then, it's become the world's second-most actively traded currency, next to the U.S. dollar, and is used in more than one-third of all foreign exchange transactions.

But pressures are mounting over the value of the currency as Europe's debt crisis -- which has already hit Greece and Ireland with force -- unfolds. With Portugal and Spain possibly next, the question becomes what will happen to the euro? Though the currency has risen some recently, it's down 5.6% from Nov. 4, according to Bloomberg. For the year, it has fallen 6.8% following a 2.51% rise in 2009.

European leaders including German Prime Minister Angela Merkel insist it will survive the crisis. While some have questioned whether gains from the currency have really been worth it given the financial mess, most economists agree that dumping the euro at this point would be catastrophic.

Moving forward, experts at the Peterson Institute for International Economics weigh in on three ways, at this point, to stabilize the euro.

A real look at Europe's banks

Part of what spun Europe's economy into crisis mode was an era of cheap credit and reckless borrowing and spending. Until Europe can really assess the health of its banks, investor confidence over the state of the euro and the region's overall economy will be shaky, says Nicolas Véron, senior fellow at the Peterson Institute for International Economics.

Similar to stress tests of US banks during the height of the financial crisis, Europe tested its own banks to determine their strength as the debt crisis unraveled throughout the continent. In July, it was revealed that seven of the 91 banks flunked the stress tests -- banks based in Spain, Germany and Greece were under the most pressure to raise capital.

The results were far rosier than what many investors expected. Although the tests did provide a glimpse into Europe's banking sector -- where many institutions aren't publicly traded and therefore financial details aren't as transparent -- critics say they weren't stringent enough.

And as European leaders gathered late last month to negotiate the $115 billion package to save Ireland from its debt crisis, it was clear the tests didn't say much. Two Irish banks – Allied Irish Banks (AIB) and Bank of Ireland – need bailouts but were given a clean bill of health. "It was largely a flawed process because in the end there was no confidence from investors that they really tested the banks," Véron says.

Ireland's banks are going through what amounts to be another stress test, but what about the rest of Europe? For leaders to meaningfully deal with its financial crisis, a look at the true health of its banks is paramount.

Insure against future crisis

It's anyone's guess how far, deep and wide Europe's debt crisis could eventually spread, and what financial pressures might be ahead years from now.

Research fellow Jacob Funk Kirkegaard of Peterson says a key step toward euro stability is a permanent sovereign bailout fund, which would provide insurance against future crises.

European leaders are currently working one out. The temporary fund, called the European Financial Stability Facility, was established in May and it pools together resources of eurozone governments to finance bailouts for Greece and Ireland. The $575 billion fund has Germany, Europe's biggest economy, on tap for the largest contribution. This surely has some German leaders irked for having to assume responsibility for problems they probably don't see as their fault.

Kirkegaard says a permanent fund is needed to help stabilize the eurozone. The EFSF expires in 2013 but the fund will likely be a permanent fixture in Europe through the European Stability Mechanism, which has been introduced to provide financial support to eurozone countries that suffer liquidity (but not solvency) problems.

It's true the fund might just encourage risky behavior as eurozone members know they will probably be saved by their neighbors if their finances should falter. Kirkegaard argues that probably won't happen though, as the program places stringent conditions on the loans so that members have an incentive to shape up their balance sheets.

Hold private sector accountable

It's easy to see how a permanent fund to resolve financial crises could easily turn into a habitual crutch for eurozone members. Germany and France, the zone's biggest and richest members, will probably have to bear the brunt of the costs.

To be fair, there needs to be a system in place to get governments to do everything they can to prevent another sovereign debt crisis.

Under the permanent fund, European leaders will likely have private sector investors to take a loss in case of a sovereign restructuring. This is significant, since it puts market pressure on governments to prevent another sovereign debt by way of enforcing sound fiscal policies.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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