Back in early December 2010 I wrote a paper on how, just perhaps how, the crisis might, once created, be mitigated. For various reasons I didn’t post it here then but now some seven months later and ahead of tomorrow’s EU summit publication seems timely.
ECB buying bonds not the solution
I disagree that simply buying bonds solves Europe’s insolvency problems. The problem of liabilities not met by assets is unlikely to be solved by unwilling taxpayers handing over ever increasing proportions of their income to bailout a failing system. So, something has got to change. Rather than that change being the end of the single currency, I believe that Merkel will try to save the currency, and by implication the Union, by creating the conditions by which the EU will move closer to fiscal union on the one hand and the recognition that debt restructuring must start, on the other. These would be important steps in securing the long-term viability of the euro. Clearly fiscal union is too bigger step for many, so some brinkmanship will be needed to use crisis, instead of democracy, to bind the Union forever closer.
The facts would seem to suggest that the extent of EU liabilities greatly exceed viable assets available to meet them and once this truth can no longer be ignored (‘the emperor has no clothes’) either the system needs reform or the system will quite simply fail. Without ECB funding the whole system would have failed already and the ECB cannot continue to provide support on this scale without the support of Merkel. Nor can the ECB simply buy up periphery, and worse financial, bonds bloating money supply in an enormous QE exercise with untold inflationary consequences.
I think one should not underestimate the power of political vision. History is littered with impossibilities and immovable impediments that simply melted when necessity demanded; indeed just about every community law concerning the common currency has been simply ignored already. It would be wrong to assume that financial markets can break the euro and by definition the Union. But failure can only be avoided by urgent reform. That reform needs three components: fiscal jurisdiction, debt restructuring and competitiveness adjustment.
Once the EU has the potential to raise taxes (it doesn’t actually have to do so) so an element of stability is reintroduced into the fabric of the euro. Never has the opportunity to introduce direct EU tax income (completing the bodged currency union) been so achievable, and Mrs Merkel I’m sure senses that. The EU could then have the ability to assume the debts of member states with no particular country facing a politically unacceptable share of the burden.
So this looks like the political approach of choice but what should the policy response be?
A three component strategy
The fact remains that the sheer scale of the insolvency is unmanageable as it stands and therefore two additional key remedial mechanisms need to be created. Firstly, one that recognises the mispricing of risk- the stark reality that both some public and private debts cannot realistically be repaid in full; and secondly, a mechanism that addresses competitiveness between member states.
Restructuring debt can either be achieved by the ECB simply buying it up (which I reject due to the inflationary and/or diminished growth implications) or it can be more effectively left on existing balance sheets but via a swap for “serial depreciation bonds”. These substituted bonds would reduce in value by a set (say) 10% per annum to a given residual value, allowing holders to progressively realise the losses rather than the shock of taking the hit in one fell swoop. Obviously regulators would need to turn a blind eye in terms of mark-to-market to these legacy securities, but they have done so in the past (e.g. Brady Bonds) and could do so again.
Turning to converging competitiveness what I have in mind is a two track euro but not the solution put forward by others. Rather I would set the weaker economies apart from Germany and its close satellites, giving each its own Junior Euro. I’ve not fully though through all the moving parts, but the obvious impediments such as currency notes and day-to-day transactions in cash are actually relatively simple and cheap to overcome. The juniors would have to be priced realistically to reflect differing equilibriums in terms of interest rates and initial exchange rates relative to the mother Euro.
However I do not propose countries leave the Eurozone. Rather I propose a “currency board” structure. This has been used on many occasions (by the British) as a means of launching new national currencies and could be used again by the EU to cement countries to the Union; allow for progressive convergence over time, and eventual re-union at a future date. The key political imperatives are the countries didn’t leave the EU nor did they entirely leave the Euro.
The exchange rate for junior euros against the mother euro would be managed within trading bands set by the ECB in consultation with the underlying country. The junior euros would be backed by the existing reserves denominated in the mother Euro allocated, and supplemented, as required, again by the ECB.
Accordingly the markets are presented with countries with currencies that are cheap by design; have appropriate interest rates; are likely to experience improved growth rates but possess constrained inflation potential and domestic debts with (increased) capacity for repayment in (potentially) a strengthening currency.
The residual (mother) Euro members do not suffer a substantial strengthening of their currency (they have the potential to run current account deficits with the junior countries for example) and to the extent they do, then the junior’s reserve backing improves directly and in proportion.
So should buying bonds be abandoned, and a more sustainable approach be introduced, I suggest the solution needs three components that could look like this:
• Giving the Union contingent fiscal powers provides a back-stop should all else fail;
• Allowing credit to be re-priced progressively allows adjustment to be planned and avoids further shocks to the financial system allowing a timely and effective recovery;
• Using a “currency board” approach to managing currencies provides:
• Common and achievable goals within the Union and assurance that the political goal of currency union has not been lost;
• A mechanism to allows convergence to be undertaken at a sustainable rate;
• By a backing the Junior Euros with Euros within the Currency Board structure considerable control can be applied to the open market rate for Junior Euros and the managed trading range permitted for each.
The above measures, together, offer the prospect of recovery within the desired political framework on the one hand, and with the benefit of external financial market support on the other. While I freely admit these ideas constitute pie-in-the-sky thinking they do suggest the potential for outcomes other than simply buying and warehousing bonds in the hope that things will work out.
7th December 2010