The Road from Depression

Three bold steps are needed. First, the governments of the eurozone must agree in principle on a new treaty creating a common treasury for the eurozone. In the meantime, the major banks must be put under the direction of the European Central Bank in exchange for a temporary guarantee and permanent recapitalization. Third, the ECB would enable countries such as Italy and Spain temporarily to refinance their debt at a very low cost.

These steps would calm the markets and give Europe time to develop a growth strategy without which the debt problem cannot be solved. Indeed, the importance of developing a growth strategy cannot be overstated, because the debt burden – the ratio of debt to annual GDP – rises and falls in part as a function of the rate of economic growth.

Since a eurozone treaty establishing a common treasury will take a long time to conclude, in the interim the member states must appeal to the financial authority that already exists, the ECB, to fill the vacuum. In its current form, the embryo of a common treasury – the European Financial Stabilization Facility – is only a source of funds; how they are spent is left to the member states. Enabling the EFSF to cooperate with the ECB will require a newly created intergovernmental agency, which will have to be authorized by Germany’s Bundestag and perhaps by other eurozone members’ parliaments as well.

The immediate task is to erect the necessary safeguards against contagion from a possible Greek default. Two vulnerable groups – the banks and the government bonds of countries like Italy and Spain – need to be protected.

To accomplish these related tasks, the EFSF would be used primarily to guarantee and recapitalize the banks. Systemically important banks would have to agree with the EFSF to abide by the ECB’s instructions as long as the guarantees are in force. Banks that refuse would not be guaranteed, but enough would agree to provide the ECB with the required critical mass.

The ECB would then instruct the banks to maintain their credit lines and loan portfolios while closely monitoring the risks they run for their own accounts. These arrangements would stop the concentrated deleveraging that is one of the main causes of the crisis. Completing the recapitalization would remove the incentive to deleverage, at which point the blanket guarantee can be withdrawn.

To relieve the pressure on the government bonds of countries like Italy, the ECB would lower its discount rate. It would then encourage the countries concerned to finance themselves entirely by issuing treasury bills – and encourage the banks to buy them. The banks could rediscount the bills with the ECB, but they would not do so as long as they earned more on the bills than on the cash.

These measures would allow Greece to default without causing a global meltdown – which does not mean that Greece would be forced into default. If Greece met its targets, the EFSF could underwrite a “voluntary” restructuring at, say, 50 cents on the euro. The EFSF would have enough money left to guarantee and recapitalize the European banks, and it would be left to the IMF to recapitalize the Greek banks. How Greece fared under these circumstances would be up to the Greeks.

I believe that these steps would bring the acute phase of the euro crisis to an end by staunching its two main sources (weak banks and vulnerable sovereigns) and reassuring the markets that a longer-term solution is in sight. The longer-term solution itself would be more complicated because the regime imposed by the ECB would leave no room for fiscal stimulus and the debt problem cannot be resolved without growth. How to create viable fiscal rules for the euro would be left to the treaty negotiations.

Many other proposals are under discussion, because officials now realize that “kicking the can down the road” has brought them to the end of the highway. Most of these proposals seek to leverage the EFSF by turning it into a bank, an insurance company, or a special-purpose vehicle that takes the riskier tranche of a public-private partnership. While practically any proposal is likely to bring temporary relief, the financial markets are just as likely to see through them and find them wanting, especially if they violate Article 123 of the Lisbon Treaty (the no-bailout clause), which my proposal scrupulously respects. That said, some form of leverage could be used in recapitalizing the banks.

The course of action outlined here does not require leveraging or increasing the size of the EFSF. But it is more radical, because it puts the banks under European control. That is liable to arouse the opposition of both the banks and national authorities – opposition that only public pressure can overcome.