We'll start with the obvious (but will be brief on that one as we have covered that in previous articles quite extensively already). However, it can't be left out of a list like this.
ECB unlimited intervention
In principle, the European Central Bank (ECB) could function like most other central banks in the world and function as a 'lender of last resort,' an implicit guarantee that countries that issue their own currency enjoy and which keeps their interest rates much lower compared with many eurozone countries.
Compare for instance the rates paid by the US or Britain versus those of Italy or Spain, while it could be said the public finances of the latter are in many ways in better shape than the former.
(Click charts to expand)
Any massive bond market intervention (or better, an announcement of being 'lender of last resort') would lower Italian bond yields quite dramatically, but here is Bundesbank president Jens Weidmann:
It must not be a lender of last resort for sovereigns because this would violate Article 123 of the EU treaty [prohibiting monetary financing – or central bank funding of governments]. I cannot see how you can ensure the stability of a monetary union by violating its legal provisions. I think the prohibition of monetary financing is very important in ensuring the credibility and independence of the central bank, which allow us to deliver on our primary objective of price stability. This is a very fundamental issue. If we now overstep that mandate, we call into question our own independence. [FT]
Reward Spain
The problem with such intervention is, as Weidmann clearly explains in that FT interview, a problem called 'moral hazard.'
There’s also a risk that you mute the incentives that come from the market. Recent experience has shown that market interest rates do play a role in pushing governments towards reforms. You have seen that in the case of Italy quite clearly. [FT]
There is an ingenious way around this problem, the idea comes from The Economist (blog) and involves rewarding Spain.
Any solution to the euro crisis has to accomplish two goals: prevent a big country like Italy from failing because of illiquidity-turned-insolvency, and maintain the political pressure to reform and adjust.
The article continues noting that Spain has shown quite a bit of resolve, and a new government is likely to continue that, then:
Imagine the ECB were to announce publicly that if the Spanish government continued its reform efforts according to an independent IMF supervision, it would back Spanish debt in full from a certain point in time on
This would give a very positive signal to both Spain and the financial markets. Spain will realize that Europe stands behind it as long as it keeps up its reform efforts and markets will think twice before taking on Spanish bonds again.
And there are important external effects in that all the pressure now shifts on the Italian political system to embark on reforms as well. If they don't deliver, they would be almost solely responsible for wrecking the eurozone. So:
Rewarding Spain might therefore be a strategically clever way to bring Italy's yields under control while sparing German taxpayer money as much as possible (and definitely more so than any limited bond insurance ever will).
It's a clever idea indeed. Reward the well behaving countries, which functions as a carrot for the troubled ones and shifts all the responsibility onto them.
Other central banks intervene
Here is another cracker, let the Bank of England buy Italian bonds. This outlandish idea apparently comes from Jefferies (according to Business Insider). It's more than a little curious for a central bank to become another country's lender of last resort, but as long as there is one, does it matter? Would it be credible?
If so, that would help because if markets perceive some intervention as dubious they're likely to take it on and test the policy (numerous defenses of currencies have bitten the dust this way). If credible, actual intervention is likely to be rather brief and the intervention itself could be cheap. Jeffries makes a good case for BoE credibly buying Italian bonds:
- Eurozone troubles are dampening sentiment (household and business confidence)
- It is leading to funding problems for British banks
- A eurozone implosion is the single biggest risk to the British economy
- Many investment funds have large holdings of euro zone sovereign bonds
So, Britain has a lot to lose, which could make any intervention quite credible, especially if other central banks would join in. The UK government is already embarking on buying its own bonds in the form of a 75 billion pound 'quantitative easing' or QE program. It could be argued that buying Italian bonds would be more effective in reducing risks to the British economy.
We have to say, it's an absolute cracker of an idea, and will cause so much political fall-out that it's not likely to be implemented any time soon.
Liquidate the stuff
You have hard money (the Germans), and than you have.. Ron Paul. Candidate for the Republican presidential nomination, Paul was confronted by a question from Jim Cramer, what would he do in times of an emergency in the markets? Cramer tried to prod him in the 'right' direction:
Surely you must recognize that this is a moment-to-moment situation for people who have 401(k)s and IRAs on the line and you wouldn't just let it fail, just go away and take our banking system with it? (Businessinsider).
Paul didn't bite though:
No, you have to let it -- you have to let it liquidate. We've had -- we took 40 years to build up this worldwide debt. We're in a debt crisis never seen before in our history. The sovereign debt of this world is equal to the GDP, as ours is in this country. If you prop it up, you'll do exactly what we did in the depression, prolong the agony. If you do -- if you prop it up, you do what Japan has done for 20 years...
Brave stuff indeed, especially for someone in a race for elected office. Will it work? We have considerable reservations. Would the world economy survive several sovereign defaults at once (US, Japan, Italy, etc.), not to mention the whole banking system? We don't know, but we really don't want to find out either. Survival seems to be our best shot, after this nuclear option.
So imaginative, certainly. Full marks for daring as well. But the cure is certainly worse than the disease. Paul should read up on Stephane Deo's (from UBS) funny exercises about the consequences of a eurozone break-up, arguably a much smaller disaster than what he is suggesting.
The euro crisis as a balance of payments crisis
Several people have argued that the essence of the euro crisis isn't really a sovereign debt crisis but a balance of payments crisis. In short, the previously devaluation prone euro periphery saw devaluation risk disappear through EMU (European Monetary Union) membership. This caused an inflow of capital and much lower rates, which triggered credit bubbles (apart from Italy) and inflation.
Years of persistently higher inflation made their economies uncompetitive (most notably vis-a-vis Germany) and they don't have access to redress via currency devaluation.
So, if countries cannot devalue, how else can we deal with this? In the balance of payment crisis literature, this is known as the 'adjustment problem,' that is, which countries are supposed to take most of the action to redress the situation
Well, there is 'internal devaluation', a terribly painful process by which all the adjustment falls on the deficit countries. These have to cut wages and prices to restore competitiveness (exerting great downward pressure on their economies in the process, at least in the short-term).
Alternatively, one can let the surplus countries do the adjusting, for instance, through subsidizing the deficit countries via transfers:
Viewed in this light, it is clear that there needs to be a capital account transfer each year amounting to about 5 per cent of German GDP from the core to the periphery. Without that, the euro will break up. [Gavyn Davies, FT]
Or, according to Sid Varma writing on FTAlphaville:
Germany, as the main creditor nation could choose to grow faster, and accept higher domestic inflation for a while, in order to ease the process of adjustment. In practice, Germany shows no sign of accepting this, but it is the best solution available, not only for the debtor economies, but also for Germany itself.
By forcing all the adjustment on the deficit countries the euro zone creates a deflationary bias. However, this is nothing new but can be seen as an extension of the predecessor of EMU, the European Monetary System (EMS), which had fixed but adjustable exchange rates. In practice, deficit countries were tying their currency to the D-mark and had to do all the adjusting in times of crisis.
In fact, EMU isn't all that bad as there is considerable adjustment from surplus countries as well. Not only through the Securities Market Purchases of the ECB (buying bonds of deficit countries), but also through inter-central bank claims and settlements, and this has an important consequence:
A key consequence of this system is that each euro area country has a national balance of payments in the form of the net position of its central bank within Target2. This net position can result in a claim (balance-of-payment surplus) or liability (balance-of-payment deficit) against the ECB, which sits in the centre of the payment system. The consequence of this system is that a country with a balance-of-payments deficit automatically receives unlimited funding. [Varma]
Cool! In the Jens Weidmann interview (the Bundesbank president) cited above he refers to this as "unlimited ECB funding for solvent banks with a liquidity 'problem.'" That 'liquidity problem' stems from having both a capital account and a current account deficit. What kind of amounts are we talking about? Well, judge for yourself:
So, we already have multiple bail-outs. Too bad this can't really be expected to be any kind of permanent solution (you might have noticed the rather impressive changes over time in the table above).
Germany's gold and foreign currency reserves
There were some little noted skirmishes on the G20 summit in Cannes a week ago, take for instance this statement by the German Economy Minister:
Germany will not allow gold reserves held by its central bank, the Bundesbank, to be used to bolster the rescue fund for indebted eurozone countries, Economy Minister Philipp Rösler said on Monday. "German gold reserves must remain untouchable," Rösler said in an interview with ARD public television Monday morning, rejecting a proposal reportedly put forward by France, Britain and the United States at last week's G20 meeting in Cannes. [dw-world]
Apparently, this is what happened, two German newspapers had reported that:
some G20 leaders wanted the Bundesbank to sell about 15 billion euros ($20.6 billion) of its gold reserves, which are worth an estimated total of 139 billion euros. [dw-world]
Bit of a non-starter, this (although certainly imaginative!). However, it turns out to be something of a misunderstanding because the real proposal was slightly different.
Pool European Special Drawing Rights (SDR's) at the IMF to fund the EFSF
According to government spokesman Steffen Seibert:
Seibert did, however, confirm that some G20 delegates suggested that the International Monetary Fund (IMF) could issue more Special Drawing Rights (SDR) - an international reserve asset created in 1969 and based on a basket of international currencies - to help increase the firepower of the European Financial Stability Facility (EFSF). [dw-world]
This is a sad solution because it was ventilated by officials and can be seen as a tacit admission that the present plans for the EFSF (the European Financial Stability Facility) are not up to scratch. These plans involve leveraging the EFSF as a first-loss insurance for newly issued bonds and/or a 'Special Purpose Vehicle' financed by foreign reserves rich emerging markets (via the IMF).
Both proposals received disappointing welcome by the markets (there was a very disappointing bond sale by the EFSF, for instance). Hence new plans emerge even before the old ones are implemented. And the new ideas don't seem to fare any better. Here is Jens Weidmann, Bundesbank president, from the interview with the FT:
SDRs are a part of our foreign exchange reserves. Using foreign reserves as capital of an SPV whose only purpose of is to fund governments is just a thinly-veiled form of monetary financing. For exactly that reason, the IMF itself is not allowed to do this operation. [FT]
Oh, well. Imaginative, surely, but not able to withstand the hard-money Germans.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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