Three steps to a solutionThe only question is, Would it really work?
The first step deals with the existing stock of public debts.
- The ECB should set a floor on public debt values by offering a guarantee.
The guarantee should be partial to allow defaults for countries unlikely to serve their debts. A guarantee could cover each country’s debt up to, say, 60% of GDP.
- Markets would promptly re-price debts. Greece’s debt would likely trade at 60% of its GDP, about 50 cents to the euro;
- Others would trade higher all the way to Germany’s, which would stay at par.
The market price would offer a clear guide for governments to negotiate a restructuring. The ECB – and German taxpayers – would suffer no loss. The crisis would be over, moving to the resolution phase.
The second step is designed to shift from fiscal austerity to growth-enhancing action.
- To allow governments to borrow again, the ECB should guarantee all future public debts – excluding the rollover of non-guaranteed debts.
Without complementary policies, this would obviously create endless moral hazard (ie temptation for Eurozone governments to issue cheap debt irresponsibly on the back of the guarantee).
To eliminate the moral hazard created by both guarantees, two conditions are needed.
- First, each country would have to adopt domestic institutional arrangements (fiscal rules, independent fiscal councils, etc.) that lock in lasting fiscal discipline as a matter of national law. (Just as US states avoid the problem with state constitutions that require balanced budgets.)
To be credible to the domestic body politic, each nation’s arrangements must fit local political institutions – but the proposed change would be subject to approval by the European Commission and the ECB.
- The second condition for the ECB’s guarantee would be that each country strictly enforces its own arrangement.
Access to the ECB guarantee on new issues will start only once an arrangement has been validated. It would be suspended if and when particular nations failed to respect their approved arrangement. Such suspensions would immediately raise the cost of further borrowing by the delinquent country, but it would not affect the guarantee already given to debt issued previously– that guarantee would be meaningless if the ECB could renege.
Step three addresses banks' vulnerabilities arising from the fact that sovereign defaults are likely to result in bank failures.
- Given that some countries will default, the EFSF will have to recapitalise failed banks.
Here the ECB would act as lender of last resort with the EFSF guaranteeing its interventions. Well-crafted recapitalisations do no need to be costly. For example, the Swiss National Bank is now making profits on its creative recapitalisation of UBS during the global crisis.
Importantly, these schemes would be voluntary. No country would be forced to accept the ECB guarantees but any country could ask for it at any time.
Could the ECB suffer losses? A crucial element of this solution is that the ECB would spend almost no money if the guarantees are well-specified enough to be credible.
Thursday, 29 September 2011
Posted by Paul Walker at 3:46 pm