LONDON (Dow Jones)--Greece needs to default, European banks have to be protected and the European Central Bank needs to purchase unlimited amounts of Spanish and Italian government bonds to solve the European debt crisis, said George Magnus, a senior economic advisor to UBS Investment Bank, in an interview with Dow Jones Newswires.
The veteran UBS economist and self-confessed Keynesian said it was time for the private sector to shoulder losses, or there is a risk of creating "zombie banks and zombie sovereigns" as well as further bailouts in the future.
"I think we've reached the point when it's time for the banks to take the hit. They have to realize the losses on their books. We need a financial cleansing: banks need to recognize losses, recapitalize and move on," Magnus said.
He added that if officials don't produce a grand solution to the region's debt crisis by their self-imposed early November deadline, they are risking a run on banks and a freezing of interbank markets.
"Investors know what's coming. My feeling is that at that point, stress will break out and at that late stage the only solution will be to nationalize banks."
Magnus criticized the way European officials have handled the crisis, noting that they failed to spot the strong links between banks and sovereigns, and that the current crisis is the extension of the meltdown in 2008.
"The real shortsightedness is that this is not a Greek problem, but a balance-of-payments problem," he said, noting that Greece could only accumulate a large deficit because French and German banks continued to lend to the country. "Policy makers never really grasped the idea of the circle of sovereign credit worthiness and a banking crisis. You can't solve one without the other."
Still, he said Europe is slowly inching towards the realization that creditors will have to help Greece halve its ratio of debt to gross domestic product by half from the current 142.8%.
"The bottom line has to be transparency of losses, which is the most difficult but probably also the simplest solution," said Magnus. He added that if such an agreement materializes, officials would probably have to close all banks temporarily to allow the market to digest the implications.
Magnus also suggested that Europe needs its own version of the Troubled Asset Relief Program--the U.S. government's plan implemented in 2008 to buy subprime mortgages from banks to keep them from failing.
"In 2008, TARP was the real turning point, that was when confidence returned to the market," he said.
So where does this leave the euro? "In an orderly default, the currency would likely be sold off towards the $1.20-$1 level, but I don't think it would break up. There is too much political glue left."
No one can accuse Magnus of being overly optimistic. "If you twist my arm and ask me, will Greece be allowed to default before Christmas? Sadly, the answer is no. But it should be."
-By Eva Szalay, Dow Jones Newswires; 44 20 7842 9305; eva.szalay@dowjones.com
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