Martin Wolf, Chief Economist at the Financial Times, published an open letter to incoming ECB chief Mario Draghi in which he outlined a bold course for the ECB in bailing out the solvent nations of the Eurozone. [Link] The key to Mr. Wolf’s recommendation, as I see it, is his observation that the U.K. is not better statistically than Italy, yet the U.K. is able to borrow at reasonable rates. The reason, observes Mr. Wolf, is that the U.K. is borrowing in its own currency, which means that the Bank of England can create and lend to the Treasury pounds sterling to effect repayments if the nation is otherwise unable to do so. Italy, on the other hand, has borrowed as if in a foreign currency—like dollars—rather than in its own currency—euros. That is because the Italian central bank cannot create euros in order to repay Italian sovereign debt. Only the ECB could do that.
Therefore, Mr. Wolf argues, the ECB should step into the breach on behalf of solvent Eurozone sovereigns and promise to lend to them (effectively creating euros on their behalf), if necessary. This would give the bond markets comfort that such sovereigns will, in any event, be able to repay their debts.
I like the simplicity and symmetry of this proposal. But, without doing some damage to its simplicity, it runs afoul of a few important principles. First, if, say, Italy can rely on the ECB to bail it out no matter what it does, then the proposal cannot be accepted by the stronger nations of the Zone. Second, the rate that Italy pays must not be so low that Italy borrows from the ECB merely to gain a minor rate advantage. Third, there must be some limits on time and amount. Fourth, if possible, this should take the form of a normal commercial transaction.
The normal banking context is available if we look at the ECB’s promise to lend as a standby letter of credit, similar to the LCs that back commercial paper lines for major corporations. The ECB would agree to lend to Italy in order for Italy to repay its outstanding bonds on the following conditions:
· The amount not to exceed a stated maximum.
· The date of the borrowing not to be later than a stated date and the term of the bonds to be repaid not to be longer than a stated duration.
· The interest rate on Italy’s borrowing from the ECB would be a stated number of basis points above the rate on a basket of euro-denominated sovereign bonds at the time of the borrowing. This rate would be, in effect, a penalty rate compared with other sovereigns in the Zone, but nevertheless lower than whatever rate Italy would be forced to pay in the market.
· At the time of a borrowing, Italy must be in compliance with a set of conditions regarding its finances that, at the time the LC is issued, appear (in the opinion of the ECB, of the bond market and of the Italian government) quite possible for Italy to meet for the duration of the LC.
· Italy will pay the ECB a normal standby LC fee.
These sorts of terms are well known in the banking industry. They should make all Europeans comfortable that the current crisis will be ended as far as countries that they deem solvent is concerned. If the stronger nations of the Zone have doubts about the long-term desirability of this solution, they can use the several years that this solution almost certainly would buy in order to effect more permanent restructuring of the Eurozone architecture.
Which nations are solvent? The members of the Zone will have to determine that for themselves. They are the ones putting their futures on the line. At a minimum, I would guess, they would have to find that Italy and Spain are solvent.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.