Radical action needed as euro zone remains on amber alert

The euro zone's "softly, softly" approach to the financial crisis is not working. The economy is sinking into deflation, dragged down by a zombie banking system and spiralling government debt. It is slipping back towards recession. A future break-up of the euro zone remains a potent threat.

Policymakers can ill afford to keep kicking the can down the road. The bailout earlier this month of Portuguese lender Banco Espirito Santo was a sharp reminder to investors the euro zone was not out of the woods by a long stretch.

The root causes of the crisis have not been tackled. High unemployment, chronic underinvestment, poor productivity and falling competitiveness continue to hamper recovery. Banks saddled with toxic loans and tightening capital requirements are starving the economy of much-needed finance. Governments battling burgeoning budgets with tough austerity policies pose a drag on growth.

Radical action is required. The European Central Bank has tinkered far too long over quantitative easing - buying bonds and pumping cash back into the markets. In the past five years, it has missed a vital window of opportunity to bring the economy back to strength.

The United States and Britain both bit the bullet early on with quantitative easing and zero interest rates, fast-tracking their economies to quicker recovery. The benefits are clear to see.

By comparison, the euro zone is struggling with 0.9 per cent growth. Some economies like Italy have already slipped into recession. Even Germany's economy has lost drive. Fallout from the crisis in Ukraine and the European Union's sanctions against Russia are gnawing on economic confidence, spending plans and investment intentions. Recession could be on the cards for Germany by the third quarter.

This is bad news for the euro zone. Policymakers have long hoped that the worst of the financial crisis and the recession were behind them. A strong German economy was supposed to provide the vanguard for recovery. Those hopes seem to be going up in smoke.

Without stronger growth, the euro zone is unlikely to see a dent in unemployment levels, especially in Spain and Greece, where the jobless rate is running upwards of 25 per cent. It will become harder for these economies to break the spiral of low growth, rising budget deficits and huge public debt.

Policymakers need to start thinking outside the box. Shock tactics are needed. Fast-tracking quantitative easing, flooding the market with liquidity and pushing interest rates even deeper into negative territory are needed to get recovery flowing again. ECB president Mario Draghi needs to stop teasing the markets with the promise of easing and put words into action.

Banks need greater latitude on capital adequacy to free up lending. Legislation may be required to ensure banks lend the money rather than hoard the ECB's handouts. Loans to consumers and companies are still contracting. This must be reversed.

While debt deflation, deleveraging and balance-sheet restructuring take a toll on economic confidence, fiscal stimulus must be stepped up. There is a strong case for a temporary moratorium on the fiscal side of the EU's stability and growth pact to ensure growth takes a higher priority. The austerity cutbacks being thrust on the euro zone's beleaguered countries should be shelved until the battle for sustainable recovery is won.

A weaker euro should be marshalled to help boost recovery. The euro is probably 15 per cent overvalued. Policymakers could afford to let it weaken by as much as 20 per cent to give euro-zone economies a chance in boosting exports. A weaker euro would help in the ECB's fight to stave off deflation.

There is also a growing case that some euro-zone economies should be allowed to leave the monetary union and exit the euro altogether. For countries saddled with bailout costs, the temptation to opt out and drop the euro remains strong. Political opposition to the single currency continues to gather momentum.

For those countries in the hard centre of the euro zone pinning their hopes on the euro's continued existence, "survival of the fittest" may become a future rallying point for the currency. Less may mean better - or not at all.

David Brown is the chief executive of New View Economics