The European Union and the European Central Bank (ECB) can no longer just kick the can down the road if they hope to solve the financial crisis in the Eurozone. That’s the conclusion of the Executive Board of the International Monetary Fund’s (IMF) review of Eurozone policies.

The report notes:

The euro area crisis has intensified. Adverse links between banks, sovereigns, and the real economy have deepened, driving sovereign borrowing costs and risk premiums to record levels. … Economic activity has weakened and is likely to remain subdued, particularly in the hard-hit periphery countries. … There are severe downside risks to the outlook, with possible substantial regional and global implications. Reinforced negative bank-sovereign linkages could further weigh on confidence, growth, and public debt trajectories, while boosting sovereign spreads and risk premiums.

The IMF believes that the crisis in Europe has reached a “critical stage” and that the Eurozone must come up with a banking union, greater fiscal integration, and structural reforms “to break the adverse loops between banks, sovereigns, and growth prospects.” The IMF recognizes that solving these issues will take time and urges more immediate action such as increased financing through the European Financial Stability Fund/European Stability Mechanism (EFSF/ESM), a monetary policy that increases easing if downside risks continue to grow, and fiscal consolidation “that is as growth friendly as possible.”

The IMF expects Eurozone GDP to fall by -0.3% in 2012 before rising by 0.7% in 2013, and forecasts an output gap of -2.3% in both years. Unemployment in the Eurozone is expected to reach 11.1% this year and 11.3% next year, compared with a high of 10.2% in 2010.

Paul Ausick