Imagine a rosebush laden with fresh red roses glistening in the morning dew. What feelings and sensations come to mind?

Now imagine the Eurozone. What feelings and concerns come to the minds of tens of millions of people? As always, Google has our answer:

Nowadays, when the average person thinks of the Eurozone, they think of crisis, debt crisis, collapse and recession. The not-so-average persons, like the treasury officers of multinationals such as WPP, Reckitt Benckiser and Diageo, sweep Euros from accounts on a daily basis in anticipation of a breakup. Depositors in Greece and Spain are voting with their feet.

The ECB will not cut off the southern central banks from the TARGET2 system which enables all deposit withdrawals to be met, any more than a parent would knowingly send a child to its death, meaning that the ongoing deposit flight from south to north will be accommodated all the way up to the bitter end.

It is time for the Eurozone leadership elite to take a deep breath and admit that efforts of the past 3 years have been an abject failure. Only then it will be possible to pursue new efforts which at least have a chance of working.

A Fresh Start

As posted here six months ago, One Euro is Not Enough. Accordingly, the first step should be to split the Euro in two successor currencies – say, the Northern Euro and Southern Euro. But it is critical to reassure Europeans that one Euro today will be worth one Euro tomorrow, especially now that the deposit flight appears to be well under way already. Catherine Dobbs’ NEWNEY Approach to Unscrambling the Euro (PDF) – one of the five finalists for the Wolfson Prize – is an interesting way to achieve this: each claim on one Euro in existence today, regardless of which bank it is deposited in, shall be exchanged for a claim to a fixed basket containing both Northern Euros and Southern Euros. (Presumably, the Southern Euro will be printed by the SECB, and the Northern Euro by the NECB, and there are no prizes for guessing the acronyms).

The splitting up of the Eurozone in an organized fashion is a healthy capitulation to overwhelming market forces. It removes the exchange rate risk which is a prerequisite to the growth strategy that the elites have lately realized will be necessary. Which investor in his right mind would plough much needed investment Euros into Greece today, when the Greek Euros are fleeing already in the opposite direction?

The second step is to clean up the banks. A proven framework that has worked several times in the past exists, and for the most part it is not being followed. Adam S. Posen, until recently a member of the Monetary Policy Committee of the Bank of England, delivered a 12 page summary of this framework to a Congressional hearing in February 2009. The key features are temporary nationalizations, conservative (i.e. deep) discounting of assets, changes of management, sale of these assets to a “bad bank”, convincing recapitalizations and resale of the cleaned up banks to the private sector within 2-3 years.

In the case of Cyprus, whose banks balance sheets exceed 625% of GDP, it will be necessary to shrink the size of the banking system before the cleanup, so that the cleanup is affordable to the Cypriot taxpayer. This could be accomplished by exchanging each share in a multinational Bank holding company with a basket of shares in separate Bank national holding companies. This is generalizable to the entire EU by admitting the principle that no taxpayer should be liable to backstop the foreign banking activities of his country’s banks.

The third step is the much-needed growth strategy for Europe’s periphery. I will not go into its main components here, which are internal fiscal and governance reforms and external investment, because without the first (two Eurozones) and second (clean banks) steps already completed and in place, the smart money will not respond to any incentive to invest in Europe’s periphery, and the current doom loop will continue up to the disorderly bitter end.

What about Greece?

Everyone is talking and fretting about Greece, as if the feared end-of-the-world outcome hinges on what happens next in a small country at Europe’s Mediterranean border. This post did not mention Greece, except to note the deposit flight from Greek banks, because Greece is just a symptom of the underlying European diseases.

Keep treating the symptoms, as the policy elites have been doing for the last three years, and the patient gets sicker and sicker. Even more alarming, on present trends, there is a serious danger that the patient will die. Cure the diseases, with steps one, two and three above, for the whole of Europe at the same time, and the symptoms will eventually go away everywhere, including Greece.