Friday, 19 August 2011

Limited Menu to Save the Euro

19th August 2011
The Malta Independent

“ Some countries have clearly run out of time and space to resolve their sovereign debt problems voluntarily.   But the single-minded focus on austerity to the detriment of sustaining growth, and the unwillingness of policy makers to see the Eurozone sovereign crisis as a regional systemic issue except through gritted teeth, if at all, are damaging to its survival chances.  …..  To be fair, the proposals agreed by European leaders on 21st July did make some progress, but can now be seen as part of a continuum of too little too late.”                                                  
  George Magnus – Economist 16.08.2011

George Magnus was one of the few economist who predicted the financial crisis of 2008.  This quote was pronounced on  the same date the Chancellor Merkel and President Sarkozy ( now jointly referred to as Merkozy) faced a press conference following their meeting in Paris and announced, to the dismay of the financial world,  that their plan to save the Euro is to introduce a financial transaction tax ( Tobin tax).
Anyone with a modicum of financial knowledge ought to know that a financial transaction tax can only be introduced if there is a G20 agreement for its global adoption.  The chances of this happening are zilch.   Even agreement about within the EU is unlikely given that the UK will oppose it  perceiving  it as a veiled attempt by Frankfurt and Paris to challenge London’s international financial eminence.

Finding a lasting solution for the Euro monetary system takes much more then dreaming the impossible and pretending that Germany and France have a moral authority to impose their views  on the whole EU and indeed on the whole world. 

The menu for a Euro solution has now narrowed down to three as shown in the accompanying diagram namely:

·          Increasing the fire power of the EFSF/ESM , the EU rescue mechanism.  Current resources are just about what is required for bailing out Greece, Ireland and Portugal but surely not enough should Italy and Spain need any bailout.
·          Issue of Common Eurobonds to replace the individual sovereign bonds.
·          ECB adopting what I refer to as Defensive Monetisation.

At the Paris conference Merkozy rejected outright the first two options and did not mention the third option at all.

There are good reasons why Merkozy ruled out a bigger rescue fund and the issue of a common Eurobond.   The first is only a short term solution without addressing the underlying problem that  too much austerity and too little growth       is no way to solve the debt problems of Euro countries in distress.   The second will find no political support for approval by the 17 Euro countries’ parliaments without it being framed within a restructuring of the whole edifice including the creation of a common fiscal policy and the creation of a common Euro Treasury which in itself is a red-line no go area for some Euro countries. In the present situation it would be putting the cart before the horse.

That basically leaves the last option of Defensive Monetisation as the only real option left to save the Euro.   The reason why Merkozy could appear relaxed at their press conference is because the ECB has now taken over the politicians’ fiscal role and has stabilised the markets by using its money creating properties to buy sovereign bonds of Italy and Spain on top of past interventions to support the sovereign borrowings of Greece, Ireland and Portugal.

The ECB is now the sovereign lender of the last resort for a big chunk of the Euro area.    So far the official line of the ECB is that this lending  to the sovereigns will not be monetised as the creation of money created through buying sovereign bonds on the secondary market will be neutralised by drawing back liquidity from the money markets.     Given its huge and increasing volume it is doubtful whether the ECB can fully neutralise such money creation at a time when it has to expand its liquidity programmes to keep  liquid banks in Euro distress countries.    Without  such liquidity support  at a time when such banks are losing domestic deposits and are finding difficulty to raise funding on the wholesale markets, many Euro area banks would implode.

I would argue that not only the ECB will not be able to neutralise money creation in this magnitude, but that it should not even try to.   The ECB is the only institution that can keep the markets steady as it can match the market speed through its autonomy which gives its manoeuvrability that is not available to political structures.       

The ECB is the only real entity that can practically save the Euro and address the underlying problems which are destabilising it, whilst concurrently honouring its mandate for price and financial markets stability.

The underlying problem is that many banks in the Euro area are zombies.    They are only alive because they have been permitted to value their holdings of sovereign debts at a price unrealistically detached from their official market price.    Stress tests that have avoided this anomaly have been considered by the market as unreliable.   Equity values of most financial institutions exposed to such sovereign risk continue in their downward trajectory.

The ECB should take the bull by the horns and insist that EU regulators force banks to value their sovereign holdings at their true market price.  This will mean that the equity cushion of many banks will be wiped out.   So be it!   To retain stability and confidence in the system the ECB should create a Euro Bank Recapitalisation Super Fund (EBRSF)         - a European equivalent of the US TARP which because of the EU structure cannot be a fiscal initiative like in the US – to recapitalise as necessary all Euro banks who lose capital through the  mark-to-market stress test.   That is the only stress the market will accept.

Once the problem of loss of confidence in banks  gets addressed,  banks will  become real banks again not zombies.   Credit will start flowing again.    Furthermore banks would be sitting on a portfolio of discounted sovereign bonds that can be converted by a market exchange offer into new debt for the sovereigns concerned who in the process can see a big slice knocked off their official public debt level.

A market driven exercise of debt reduction and banks driving credit again will be the essential ingredients to frame adjustment austerity programmes in a context of growth,  stimulating adherence and acceptance for austerity as a necessary if bitter medicine to straddle back to economic health.

Pain of adjustments would be spread beyond the citizens of the countries in distress making the adjustment more equitable and bearable.  Given that many sovereign bond holdings are cross-border, the pain gets shared with shareholders of foreign banks exposed to distressed bond holdings.   When things go bad it is normal for lenders and borrowers to share the pain.   In the process the claim that the EU’s rescue programmes are meant to rescue their banks not the countries in distress gets also addressed.

In good time the EBRSF will re-privatise its holdings of the equity acquired in Euro banks through the recapitalisation process.   It will refund the credit from the ECB and like the TARP experience in the US will not cost the taxpayer a single cent.

It is time for the ECB to bypass the politicians and let them to play the games they know best in their quest to preserve power.   The ECB has the ability to save the Euro, which bears the signature of its President, through determined, imaginative and creative measures to address the existential problem that it is facing.   It needs to show that with the ability it also has the will.

Alfred Mifsud

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