Eurozone leaders nearing a “break the glass” moment

President of the World Bank Robert Zoelick argues that Europe will very soon need an emergency response plan.

Eurozone leaders may be nearing a “break the glass” moment: when one smashes the pane protecting the emergency fire alarm. While those living in the eurozone building, especially those on the executive floors, will not want to hear an alarm, they had best read the instructions. Events in Greece could trigger financial fright in Spain, Italy, and across the eurozone, pushing Europe into a danger zone.

The summer of 2012 offers an eerie echo of 2008. Markets are signalling anxieties about a major asset class. In this round, eurozone sovereign debt has replaced mortgages as the risky investment. Banks are under stress. Depositors have not yet begun to run, but they are starting to jog. The European Central Bank, like the US Federal Reserve in 2008, has sought to reassure markets by providing generous liquidity, but collateral quality is declining as the better pickings on bank balance sheets are used up.

If Greece leaves the eurozone, the contagion is impossible to predict, just as Lehman had unexpected consequences. A Greek exit would trigger a hit to confidence in other sovereign euro assets. Eurozone leaders need to be ready. There will not be time for meetings of finance ministers to discuss the outlook and debate the politics of incrementalism. In panicked markets, investors flee to safe assets, sparking other flames.

Even massive injections of ECB liquidity may not be enough. When I ask developing-country veterans of financial panics what advice they would offer, their response is uniform: governments have to guarantee bank deposits and probably other liabilities. In the eurozone, the guarantees of some national sovereigns are unlikely to be sufficient and only that of the “euro-sovereign” will suffice. It is far from clear that eurozone leaders have steeled themselves for this step.

When financial markets get anxious, peril often strikes two or three links down the financing chain. So eurozone leaders need to be monitoring liquidity risks in the corporate sector. And if banks get emergency assistance, bank executives will need to be pressed to keep providing customers with cash.