Behind the scenes the European Central Bank (ECB) is struggling to construct a barrier that will prevent the firestorm which started in Greece from breaching the Iberian defences and, eventually, from turning to Italy. It is only right and proper that the ECB should try to accomplish this. The only trouble is that the barrier it is building is a new Maginot Line; a white elephant of a construction that costs Europe a bundle and which the ‘enemy’ will simply bypass and strike unimpeded at the heart of the eurozone.
Having realised that the insolvency of states like Greece and Ireland can never be overcome by gargantuan new (high interest) loans in combination with spending cuts that only exacerbate the debt-deflationary cycle, the ECB is now forced to consider bringing out its big guns. During the past few days, what started in May coyly will take on new dimensions: the ECB is readying itself for a massive increase in its bond purchase program. From less than €70 billion to something closer to €2 trillion. (See here for the relevant news story.)
The significance of this type of intervention, whatever its size, is not to be scoffed at. The moment, back in May, the ECB stepped into the secondary bond market and purchased its first Greek or Irish bonds, a new chapter in the history of the eurozone began. For the first time, the eurozone’s central bank acknowledged that the currency union over which it has sole custody could not go on as it was initially designed. Against the wishes of Axel Weber, the Bundesbank’s chief and Germany’s representative on the ECB board, the ECB did the unthinkable: It used its powers to create something completely new: European debt. For until that moment, the only debt that existed was nation-state debt and the EU had exactly zero debt. The moment, however, the ECB bought member-state bonds, Europe acquired its own debt. And since the acquisition of debt is the first step to financial adulthood, we can at least celebrate the eurozone’s coming of age.
So, the die was cast last May. The eurozone is now, whether Mr Weber likes it or not, a fully fledged, though still irrationally structured, economic entity. A currency union with its monetary policy on the one hand and its own debt on the other (however small that debt may be at present). Rather than denying its new status, our European leaders ought to sit down and discuss the best way of making use of this feature of our currency union; of this new debt category that belongs to us all. Alas, they show no sign of doing this. As Gavyn Davies correctly pointed out in yesterday’s FT, our politicians are steadfastly refusing to “accept fiscal transfers” while, at once, none of them want “…to see the monetary union breaking up. Something, somewhere has to give.” Quite so.
The ECB understands all this. If it is considering an acceleration of its bond purchase program it is because it is the only thing it can do within its current remit. Unfortunately, it is unlikely to do the trick. To stop the dominoes from falling, the ECB would have to purchase a mountain of worthless bonds in the secondary markets at the risk of seriously undermining both the euro and the ECB’s political support in the surplus countries (Germany et al). On the other hand, anything less than a couple of trillions of bond purchases would not stop the dominoes from toppling. Seemingly, the ECB is caught between a rock and a hard place. But appearances are deceptive. For there is something that the ECB can do tomorrow morning that would help.
As we suggest in our Modest Proposal, it could knock the wind out of the domino dynamic simply by convening a meeting in Frankfurt between the heads of the indebted countries (Greece, Ireland, Portugal, Spain, Italy and Belgium) and the representatives of the European banks which hold these countries’ bonds and which are being kept solvent by the ECB’s lavish kindness to failed bankers. In a few hours, a deal can be hammered out according to which the ECB guarantees the banks’ long term liquidity in exchange for their agreement to take a hit on the indebted countries’ debt (by, for instance, accepting a trade of new bonds with a smaller face value and longer maturity for the old bonds).
The announcement of this agreement would, by itself, stop the crisis from spreading to Spain. Then, to complete the reversal of the eurozone’s outrageous fortunes, the ECB could announce that it takes on its books 60% of the states’ remaining debt (the limit set by the Maastricht Treaty), issuing at once eurobonds of the same value and floating them on the international markets. These eurobonds would sell like hot cakes and help the ECB finance the debt-reduction operation, strengthening the demand for euros in the meantime (possibly paving the ground for its elevation to reserve currency status). Member states will, naturally, continue to repay these debts to the ECB but at considerably low interest payments (e.g. that of the eurobonds plus a small margin to cover the ECB’s costs) thus causing the sovereign debt bubble to deflate fully.
Compare and contrast this two-step policy intervention with the Maginot Line under construction. The former involves a rational negotiated restructuring of the debt and then follows it up with a costless (to the ECB) exercise in using the new form of eurozone debt (which is already in place, albeit in different form) for the purposes of ending the domino effect without invoking moral hazard issues, without loosening the member-states’ responsibility viz. their accumulated debts and, remarkably, while enhancing the euro’s appeal globally.
Alas, instead of this kind of rational stewardship of its area of responsibility, the ECB is planning to spend trillions to purchase junk bonds with, in the end, no real prospect of arresting the crisis that is gradually undermining the euro’s very existence. Why is the ECB heading for this ignominious yet so easily avoidable catastrophe? Because Europe’s leaders, in denial of the simple truth that European debt has already come into being, are refusing to extend its remit ever so slightly to enable the ECB to end a needless slide into the abyss.