Europe’s banking system is on the verge of melting down, as the ECB and the IMF struggle to contain the crisis that began in Greece and has spread throughout most of the continent and the world. Barry Eichengreen, professor of economics and political science at the University of California, Berkeley, has been a forceful critic of those institutions. Eichengreen, whose most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar, has argued that the policymakers have been in denial about the depth of the financial and economic crisis. Here Eichengreen – himself a former senior policy advisor to the IMF – explains why he believes Europe is once again at the precipice and how to pull it back from the brink. Here are highlights of his conversation with Institutional Investor contributing writer Steve Rosenbush.

Institutional Investor: How critical is the debt crisis in Europe and is world political and economic leadership managing it properly?

David Eichengreen: As I put it in a recent article, Europe is at the precipice. The survival of the euro and the European Union itself are at stake. So far, the policy response has been ineffective. (“Ineffective” is the most polite description I can think of.) To address the crisis, three things must be done, immediately. Most important is that European banks be recapitalized. There is absolutely no doubt that Europe has a bank funding problem. So far, the euro area has preferred to deny the existence of that problem.

Second, Greece needs breathing room. The debate is over how much of a haircut investors will have to take, and over the timing of that haircut. The markets are finally recognizing the extent of the problem. They are now asking: Will it be taken all at once, or over time? Investors may be left with less than one half, or as little as one third, of the original value of that debt.

Third, Greece and Europe more generally need to promote growth, with labor market reform and tax reform that encourages investment. Coordinated fiscal stimulus and lower taxes would be ideal, but if that is not possible, then the ECB must act by lowering interest rates and buying debt. Over the longer run, leaders in Europe can address deficit reduction and structural changes in the euro zone.

On Tuesday, Greek finance minister Evangelos Venizelos said that satisfactory progress had been made in reaching an agreement with EU and IMF lenders, so that the next installment of Greece’s bailout can be released, and the country can avoid an immediate default. Do you buy it? Have the odds, or the timing, of a default, now priced into the markets, changed in the last two days?