By Cambiz Alikhani
The sovereign debt crisis currently being experienced in Europe has many analogies with the global banking crisis that erupted in 2008. In both cases insolvency was at the heart of the problem. But in the early stage of the financial crisis authorities were essentially in denial of that and instead only recognised and dealt with the liquidity problem that had arisen from what was essentially a solvency issue.
The banking crisis was eventually only addressed when the bankruptcy of Lehman Brothers meant that a solvency problem could no longer be denied. Only then did the US Treasury ask the legislature for a taxpayer-funded bail-out of the banking system in the form of Tarp (Troubled Asset Relief Programme).
The solvency problem in peripheral Europe has two key elements to it. With regards to Greece, we are dealing with a simple inability to repay debt at the prevailing market rate of refinancing. Without European Union support, Greece would by now have had to restructure its debt and triggered an event of default.
Spain, on the other hand, has a severe solvency problem from within its banking system, in particular the “Cajas” that are exposed to bad loans made during the real-estate bubble. This simply has not been dealt with in a meaningful manner. Once it is, the balance sheet of the sovereign entity is likely to be affected as the US and the UK discovered when bailing out their banking systems. If done poorly, a solvency issue may arise at the sovereign level.
European policymakers have therefore been naïve, so far, in painting their woes as being a consequence of liquidity problems created by “speculators” and not recognising the true extent of the solvency issue that faces them. The lessons of 2008 show that such an approach is doomed to failure and that if not addressed correctly, the eventual problem and its cost is likely to be even bigger than it is now.
So what should they do? Below is a four point plan that may be sufficient to stem the crisis and deal with it in a pro-active, rather than reactive manner as well as addressing the medium-term necessity to move closer to fiscal union.
1. Announce the immediate creation of the European Monetary Fund (EMF), supported by all EU states and utilise the €750bn ($908bn) rescue package agreed to in May to fund the EMF.
2. The EMF’s first action should be to arrange a reverse auction that bids for all Greek government debt outstanding. The size of this is about €260bn (based on Bloomberg data). This would allow it to take control of Greek debt and to negotiate with Greece as one single creditor. If a debt restructuring does occur, the ensuing default does not affect previous holders of Greek government debt or the European banking system. In return for a restructuring of Greek debt, the EMF has total oversight of Greece’s deficit reduction plans.
3. The EMF also announces that for the next 18 months (until January 2012) all the funding needs of Spain and Portugal will be taken care of by the EMF. These countries will therefore not tap international bond markets over that period. This action helps to “ring fence” Spain and Portugal for the foreseeable future. The EMF then decides the appropriate course of action in Spain and Portugal both with regards to deficit reduction measures and with regards to financial system restructuring. Spain agrees to work with the EMF and to assume the ensuing increase in sovereign indebtedness that arises from bailing out its defunct “Cajas”.
4. EU puts into motion its plans for fiscal union at a future date such as 2015 and goes through the necessary process to achieve this over the next three-and-a-half years. The EMF would therefore eventually become the European Treasury and countries that do not wish to accept fiscal union exit the euro and possibly peg their currencies to the euro. This would not be disruptive to markets in the near term as the eventual plan (and possible euro exit) is still a long way away.
The sum of the above would not only allow EU policymakers to get ahead of the curve with regards to the short-term issues at hand but would also allow a long period of deliberation towards fiscal union. It has the advantage that the institutional framework for an eventual European fiscal authority would already be in existence.
The plan would go to the heart of addressing the solvency issues facing different European peripheral states. Politicians could explain to their electorates that by implementing it, the eventual cost of “restructuring” in Europe is likely to be significantly less to the European taxpayer than a disorderly collapse of the financial and currency system and that the foundations for a fiscal union would be built. This would stop the mistakes of the past being made in the future.