Fixing Europe's Impossible Algebra

In simple arithmetic terms, European leaders have been struggling to patch up a €4 trillion gap (€1 trillion of potential bank re-capitalisations plus €3 trillion of stressed sovereign debt) by stretching a €250 billion patch (the EFSF’s remaining funds). In algebraic terms, they are bamboozled by the task of solving a system of two equations in three unknowns. Whatever alchemy they employ this coming Wednesday, unless they add either the missing numbers or the missing equation, they will fail to produce a solution without violating the rules of primary school mathematics.

Our leaders’ task is made harder by two axioms insisted upon by surplus countries, fearful of the idea of ‘importing’ higher inflation and higher interest rates from the deficit countries:

  • Axiom 1 is that no part of the missing €4 trillion will be printed by the ECB.
  • Axiom 2 is that it will not come from some form of fiscal union involving a eurobond jointly and severally guaranteed by member-states.

On the basis of these two axioms, Europe is being called upon to solve two equations in three unknowns. One equation determines the existing stressed debt (primarily that of Italy and Spain) while the other determines the potential losses of the banking sector. Turning to the three unknowns we have:

  • X = the Greek haircut percentage
  • Y = the sum committed to helping Italy, Spain et al
  • Z = the total capital to be pumped into the banking sector.

Unsurprisingly, this ‘system’ of equations cannot be solved unless we arbitrarily fix one of the variables. Germany tried to fix the Greek haircut, X, at around 60%. Alas, the ECB and France screamed blue murder (counter-proposing that a large Y is fixed instead), while the Americans and the IMF (mindful of how Europe’s banks are threatening to unleash another 2008 upon the global financial sector) insisted on a larger Z. In short, fixing one of the three variables led to a political impasse.

Having failed their algebra test, our leaders turned to ways of stretching the arithmetic. The brightest idea around was to turn the EFSF into an agency which insures buyers of new bonds (presumably issued by Italy and Spain) against pre-specified losses (e.g. 20%; so that 20c of insurance can ‘liberate’ investors fearing a 20% haircut in Italian debt to buy a €1 Italian bond happily).

The first problem with this trick is that it does not stretch the EFSF’s funds sufficiently (leaving two thirds of the debt mountain intact). Secondly, since a large part of the EFSF’s funds are guaranteed by Italy and Spain, this insurance scheme would be asking the ‘accident’s victim’ to self-insure ex post. (A little like Dexia when it was lending its shareholders the money to buy… Dexia shares!)

Is there a solution? Yes, there is. Just introduce an additional equation. E.g. add a debt conversion scheme, under the auspices of the ECB. The ECB prints no money (thus respecting Axiom 1) but, instead, borrows from the international markets, issuing 20yr bonds in its own name (respectful of Axiom 2). It uses the borrowed money to service the Maastricht-compliant part of the eurozone’s existing debt and, at once, creates the mechanism by which the member-states themselves service this new debt (within the next twenty years). Meanwhile, the EFSF, freed from its bailout function, is assigned the sole duty of re-capitalising the banks. If need be, it can be beefed up at will since, just like America’s TARP, German taxpayers can rest assured that the EFSF will pay all its bills, with interest, once the banks’ equity (that will be given in exchange of EFSF capital injections) is sold back to the private sector (after the banks recover).

The solution exists. But not until we give up alchemy in favour of algebra.