A leveraged EFSF or an ECB-brokered debt conversion? Europe's recent scheme for resolving the crisis versus our Modest Proposal

In my recent ABC TV interview I suggested that the latest euro agreement (announced on 27th October 2011) was a triumph of Orwellian double-speak. They created discord and they called it agreement. In this post I want to unpick a crucial repercussion of this latest piece of  euro-fraud.

Was it the ‘agreement’ to write down 50% of the pre-May 2010 Greek debt voluntary? Or was there coercion? The ISDA will, surely, rule that, since there is consent by the bankers (however contrived), the agreement is voluntary and the CDSs will not trigger. For the political philosophy of this ruling click here. In this post I want to look at the implications of this decision for the refinancing of the eurozone’s stressed sovereign debt.

Contradiction may be the stuff of an interesting life but, when it exceeds certain limits, it can prove the harbinger of a most peculiar death. Europe’s latest contradiction is that, on the one  hand, it has decided (at Germany’s insistence) that the €3 trillion needed as a backstop to end the public debt crisis will neither be printed by the ECB nor will it be provided by the eurozone’s surplus states. Thus, the only option left is that of leverage; a euphemism for borrowing from the private sector. Yet, on the other hand, and at the very same time, the ‘voluntary’ Greek haircut is signalling to the private sector that, when it suits Mrs Merkel, Europe can turn to private lenders and make them offers that they cannot refuse; e.g. “take a 50% haircut on your investment or else”. The idea that Japanese investors can be intimidated to accept such a ‘voluntary’ deal while Chinese sovereign wealth fund managers will be, during the same week, be wooed to contribute to the EFSF their hard earned cash is not just bordering on insanity; it is well and truly lunatic.

Does this mean that it was a mistake to haircut Greek debt? Yes and no. While public debt ought to be no more sacrosanct than private debt (and haircutting poor people’s pensions is more evil than haircutting bonds), Europe should only proceed with deep haircuts of its periphery’s debt, against the interests of private investors, if it has a decent plan on how, at the same time, to convince private investors to risk their capital again in an effort to re-finance the eurozone’s public debt. As things stand, Europe has proclaimed that this is what it wants but has taken actions that guarantee failure. Alas, there is a way they could have succeeded, if only their mindset could be cured of its current arteriosclerosis.

The recently agreed scheme

Before presenting our alternative, let us revisit the recently agreed scheme that turns on a turbo-charged EFSF. The idea is that Europe’s leaders will do the rounds in the Far East trying to convince investors to lend to the EFSF around €5 for each €1 of loan guarantees that the EFSF already has (and which it has not used up already in Ireland and Portugal). The ‘plan’ is to then insure new issues of bonds by Italy et al, using the EFSF’s privately enhanced funds, so that if these new bonds are haircut in the future, the investors’ losses will be repaid by the EFSF. In effect, the EFSF will be issuing CDS-like contracts on the new Italian bonds.

Note that the scheme’s success depends on three assumptions:

  1. That it is common knowledge that, if and when an Italian haircut hits the new bonds, the EFSF will do automatically what the ISDA is refusing to do now – i.e. declare that its own CDS-like contracts pay out.
  2. That it is also common knowledge that buyers of Italy’s new bonds will not be put off by the collapse in value of existing bonds, which will presumably not be insured (as retrospective insurance is not on the cards), thus losing a large chunk of their value as the new insured bonds come online.
  3. That the investors whose capital will be used to leverage the EFSF will not ask for guarantees which will, in essence, amount to either Germany or the ECB backstopping their capital investments into the EFSF.

Let me be brutally frank here: I have no doubt that each one of these assumptions will prove precisely wrong.

  1. The recent experience of bankers with the ISDA and the way their coercion was christened ‘voluntarism-in-action’, will put a great deal of doubt in the mind of investors about their chances of being paid off by the EFSF in case part of the face value of new Italian bonds is cut (or rolled over at a loss of present value).
  2. The permanent bifurcation of new (insured) Italian bonds and of old (uninsured) Italian bonds will deepen and cause the former to be far less attractive.
  3. To woo the Chinese, the Japanese and assorted investors into the EFSF’s leveraging scheme, either Germany or the ECB or both will have to guarantee their investment. In short, it will be Germany and/or the ECB that leverages the EFSF, with Chinese money playing the role of fig leaf.

A better alternative

Since it is now transparent that the debt crisis will require EU officials wooing private investors’ funds (e.g. Chinese, Japanese) on behalf of eurozone member-states, we might as well do it in a manner that is both more rational and more in tune with Germany’s and the ECB’s priorities. As we saw from the last paragraph, the agreed scheme will, against Germany’s and the ECB’s express wishes, involve a mixture of (A) German taxpayer financing of new Italian bonds and (B) ECB monetisation. It sounds (and is) a very German nightmare. And as if this were not enough, this scheme will not even succeed in ending the run on Italian, Spanish (and soon after) French bonds.

What is our alternative? For more than a year now, Stuart Holland and I have been proposing (see our Modest Proposal for Resolving the Euro Crisis) a simple debt conversion scheme by which the ECB: (A) borrows, in its own name, from the private sector in order to service the Maastricht compliant debt of all of the eurozone, and (B) opens debit accounts for each member-state whose debt it has serviced in which the member-state in question will  be repaying, in the long term, the debt that the ECB shouldered on its behalf (but at the low, low, low interest rate secured in the money markets by the ECB). Private investors are thus contracted directly to the ECB, whose bonds they purchase. No insurance is necessary, no assumption about whether the Italian debt will be relieved, nothing shoddy or complex. They get a cast iron guarantee from the world’s second most important Central Bank that in N years they will receive their money back with interest. Period. They know that the ECB has the way and the means to make Italy, Spain, even Greece pay back that money to the ECB that the ECB has borrowed on their behalf. But even a small doubt on this (e.g. doubt that Greece may not be able to repay the ECB in full) does not matter to the Chinese and other investors since they know that the ECB can, if need be, monetise that missing sum. The beauty of this is that, because the ECB can monetise, it will not have to (as the debt crisis goes away, following the implementation of this scheme).


Europe has just agreed on a scheme that is bound to prove a non-starter without Germany and the ECB committing to something they were so opposed that they… concocted this particular scheme! The fallacy of the scheme has many facets but none more evident than the requirement that private investors lend to the eurozone twice: first to the EFSF and secondly to countries like Italy. Even worse, both times they are expected to turn a blind eye to systemic risks (the risk of lending to an EFSF that may be here today gone tomorrow and the risk of lending to Italy on the assumption that the EFSF CDS-like contracts will be triggered if Italy cannot repay them in full.)

Our alternative proposal is that the ECB borrows in its name, and without any guarantees from Germany, in order to put the eurozone’s Maastricht compliant debt onto a much lower average interest rate trajectory and, thus, cause the debt crisis to subside. Our plan turns on a simple question: Will private investors be happier to lend to the ECB or to a leveraged, toxic EFSF? To answer this, consider the related question: If you were a Chinese sovereign wealth fund manager, who would you rather trust? The turbocharged, toxic EFSF whose success will depend on a CDS-like insurance scheme for the new debt of countries’ like Italy? Or the ECB which can guarantee to pay you back come hell or high water?