Policymakers in the euro zone face two major challenges to the recovery: sovereign risks and banking risks. Because these two challenges are deeply intertwined, both must be solved to clear the way to a recovery. There are three key steps that Europe should take to address them.
First, sovereign finances need to be sustainable, which means more fiscal action and more financing. It does not necessarily mean drastic upfront belt-tightening—if countries address long-term fiscal risks like rising health-care or pension costs, they will have more space in the short run to support growth and jobs. But without a credible financing path, fiscal adjustment will be doomed to fail. After all, deciding on a deficit path is one thing, getting the money to finance it is another. Sufficient financing can come from the private or official sector—including continued support from the European Central Bank, with full backup of the euro area members.
