Spain and Italy are looking dicey. The credit ratings of several major French banks have been downgraded. Eurozone authorities have to act decisively now.
Dozens of European banks hold Greek bonds. The banks need to be recapitalized. If Greece defaults, its bonds and those of half dozen Eurozone countries will be worth a fraction of the value at which they are carried on banks’ books.
The problem with the Eurozone is that its currency, the euro, is centralized but each of its 17 member countries issues bonds and deals with their debt separately. If a weaker country (like Greece) cannot devalue the currency it uses, it can’t lower the cost of its debt.
The Eurozone isn’t prepared to deal with an economic crisis of this magnitude because its funding mechanisms are embryonic and each nation’s sovereignty is at stake. That doesn’t prevent the problems of one country from affecting the rest.
In 2008 when Lehman defaulted causing a global credit crunch, the U.S. coordinated rescues through the Federal Reserve and the Treasury Department, immediately lowering interest rates, which made it cheaper to pay off dollar-denominated debts and setting up facilities to provide liquidity to virtually insolvent institutions. However, it missed the boat by not requiring anything in return. Perhaps that’s why a new crisis erupted so quickly on the heels of the last. The collapse of 2008 was never resolved.
Experts are offering detailed solutions. As to whether they’re politically realistic, that remains to be seen. George Soros proposes:
#1: The 17 member countries must agree to a centralized European Union authority of its national economies. They must agree on a treaty to create a common treasury.
A centralized authority could issue Eurobonds to back the debt of its member nations. However, issuing collective Eurobonds requires the pooling of risk. In other words, a bond’s value is as strong as its creditworthiness. For the Eurobond to be financially viable, it must rely heavily on Germany. Germany has the strongest economy and credit rating, giving it the biggest seat at the table.
#2: There are two separate, major Eurozone financial mechanisms that can work together to staunch the bleeding: the European Central Bank (ECB) and the temporary lending facility, the European Financial Stability Facility (EFSF).
Using the most generous estimates, the size of the EFSF fund is a fraction of what is needed. Previous EFSF bailouts for Ireland, Portugal and Greece have reduced the size of the rescue fund (even with Germany’s recent support) to E440bn ($590bn).
#3: There should be a new intergovernmental agency to enable the EFSF to co-operate with the ECB:
The countries comprising the Eurozone must be put under ECB control in return for temporary guarantee and permanent recapitalization.
The ECB’s guarantees will allow member countries currently paying high interest rates to attract investors at sustainable levels. It could lower its discount rate for the troubled countries to refinance for about 1% during the emergency.
The EFSF would guarantee and recapitalize banks. In exchange, the countries involved would have to sign a contract that they will abide by ECB directives, which include maintaining their credit lines and loan portfolios while closely monitoring risks in their own accounts.
Another theory to prevent a bank meltdown and a run on sovereign debt from Peter Siegel of the Financial Times is to have the EFSF inject capital into banks and purchased distressed sovereign bonds on the open market, lowering borrowing costs that way.
Because the fund’s resources are inadequate, there are several ideas about how to stretch its money, mostly by leveraging (in other words, using the money to raise five times as much in debt):
#1: The EFSF guarantees losses of up to 20% on sovereign bonds rather than buying the bonds outright. This would increase the value of EFSF support 500% with no upfront payments.
#2: Speed up the creation of the EFSF’s replacement, the permanent European Stability Mechanism. ESM capital would come from member countries, which is more easily leveraged in the marketplace.
#3: Rely more on the ECB: turn the EFSF into a bank and allow it unlimited borrowing power. Or have the ECB continue purchasing sovereign debt but have the EFSF guarantee bond purchases, moving potential losses to the fund rather than the ECB.
#4: The EFSF could have creditors take a “voluntary” haircut of 50 cents on the euro. If Greece defaults, they would get far less. Lehman debt discharged in bankruptcy was worth 15 cents on the dollar.
The proponents I quote in this article agree that the only long-term way out of this debt crisis is economic growth, not austerity. When GDP increases, then there is money to make payments. Austerity programs cause massive unemployment, retard growth, diminish tax revenue, and reduce consumer demand. When all countries are on austerity programs at the same time, the recessionary effect is multiplied.
There are no guarantees that the Eurozone authorities can implement these solutions. The resolution of the Euro contradiction requires that each of the 17 member countries submit to a central authority, losing some of their sovereignty. Acting with urgency in the face of looming economic catastrophe can backfire politically. Some citizens are angry about the deep wage cuts, massive layoffs and large tax increases of an austerity program. Others are angry that they were frugal yet have to bail out their profligate neighbors. At any rate, the taxpayers end up footing the bill.