There seems to be no end in the creativity of finding the holy grail to solve the euro crisis. Here is another little run-down, mostly involving some cavalry arriving just in time.
Fed's euro zone QE
This is quite a funny one, but it isn't as crazy as it sounds. Because the ECB is so far refusing to function as a lender of last resort to back stop sovereign debt, the Fed could do it for them. There is nothing to stop the Fed from buying up euro zone sovereign debt en-mass, or even better, announce such program.
This is what Bernanke said in 2002, discussing the dangers of deflation:
The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt. Potentially, this class of assets offers huge scope for Fed operations [The Telegraph]
Why would this be credible? Well, there is no doubt that the euro zone crisis is the single biggest threat to the stability of the world economy, and that the US would not escape grave consequences if the euro zone would implode (which it is, on its current trajectory).
Also, it would save US banks, which have considerable exposure to euro zone debt (and credit default swaps), which is why Brad DeLong has argued that the Fed should start buying up every single euro zone bond owned by every US bank.
There are some pitfalls. The Fed should not limit itself in buying only the peripheral sovereigns. That risks upsetting delicate balances as well as making it liable for losses in case things do go wrong (which is actually much less likely with Fed intervention in scale).
The euro could rise significantly against the dollar, both because of the credibility of the solution and as a result of the sudden spike in foreign demand for euro zone sovereigns (that is, as a result of Fed intervention itself). This could either trigger the euro zone into a recession, or force the ECB to loosen monetary policy.
The latter would be an added bonus as the euro zone has a rather urgent need for some inflation in the core countries to lessen the adjustment burden of the periphery who suffer from a drastic loss of competitiveness.
Gold backed bonds
This is another interesting idea, we have to say. The European Financial Stability Facility (EFSF) could introduce bonds backed by gold.
As at the end of October, eurozone nation central banks owned 347m ounces of gold worth $604bn. [Guardian]
That's more capital than the EFSF. The biggest holders are Germany ($195B), and... France and Italy (each $140B). Hence Italy could start on its own issuing gold backed bonds. Also:
if EFSF bond issues had the backing of gold plus interest, it would be surprising if European and international investors didn't snap them up. Depending on demand, gold backing could be 25% to 50% of the total value of an Italian bond, for example. [Guardian]
It's not a new idea either, South Africa (who else?) did it in the early 1980s. The IMF could also help. They hold $161B euro of gold themselves, and could use this as collateral to borrow funds on the markets, funding a rescue program for the euro zone.
Since we included the US as a possible vehicle for a euro zone solution above, it might even be worthwhile to enlist some of its whopping $455B gold reserve.
A similar idea is a joint crisis fund:
Leading gold holders such as the US, Germany, France, China, Switzerland, Russia, Japan, India and the European Central Bank, which hold the bulk of the world's 988m ounces, could allocate a proportion to form the crisis institution. This new fund could issue gold-backed bonds to European and other nations as bridging finance whenever there is a threat of default. [Guardian]
After all, this is sort of how the IMF itself was set up. One thing we would stress though, the IMF would have to play an important role to guarantee that this last 'gold' bullet won't be laid to waste and allay German fears of moral hazard and the euro zone becoming a transfer union.
Conditional euro bonds
John Muellbauer came up with another creative idea, conditional euro bonds. The key difference with conventional euro bonds is that conditional euro bonds reward good behavior and punish bad behavior. New bonds would be collectively underwritten but they would contain:
a formula that defines the spread that each country has to pay into a central fund and the distribution of the payments resulting from the spreads to the guarantor governments. I argue that spreads should be determined by relative unit labor costs, and by relative government debt- and current account–to-GDP ratios. Including unit labor costs introduces incentives for improved competitiveness, promoting long-run economic growth. [Muellbauer]
Well, that's quite creative (apparently the idea was originated by Boonstra from the Dutch Rabobank). It's somewhat complex but it takes care of the moral hazard problem, which is something bugging the Germans in particular.
Administrative Discipline
A similar program was proposed by Karl Smith. He argues that the present use of 'market discipline' to get peripheral countries to behave responsibly (that is, cut their deficits and debts, and reform their economies) is a double edged sword:
It only works if you are actually willing to drive the bond markets over a cliff and if you are actually willing to do this and the markets believe you then you go over the cliff automatically [Karl Smith]
What he proposes is replacing all national bonds by euro bonds and introducing what he calls 'administrative discipline,' in which
member states come to the EC or the ECB for financing and that the financing may face a penalty or be outright refused. This means that the EC or the ECB can force a government shutdown without having to force a bond market crisis. This is the power it really wants. It wants the power to say that Greek retirees will not get their pension checks unless Greece shapes up. It does not want the power to say Greek bondholders will not get paid.
There are some peculiarities of this plan that could lead to trouble. For instance, since there are only euro bonds, (which are the only ones accepted by the ECB as collateral as well), an excess supply of bonds over desired savings could be inflationary.
Administrative discipline via the IMF
Several plans have emerged. The IMF will have a standby facility (600 billion euro) for Italy, and/or it will borrow from the ECB and/or serve as a vehicle for emerging market contributions to solving the euro zone crisis. The communality in these plans is the IMF conditionality, the decades of experience that the IMF has acquired (with a few mistakes in-between, most notably during the Asian crisis) in providing emergency financing in return for a credible reform program. Bring it on, we're inclined to say.
Stability Union
More important forces are working on another form of 'administrative discipline.' Germany itself is leading the charge against moral hazard and the dangers of a transfer union. They know that without discipline, collective solutions like eurobonds or ECB acting as a lender of last resort, they will ultimately be liable if other countries misbehave. So it's not surprising they want guarantees.
Now, there is a current stability pact limiting countries deficits to 3% of GDP and its debt to 60% of GDP. That clearly hasn't worked (in fact, Germany was the first violator a decade ago). Which is why new efforts are underway, driven by Germany. Here is Wolfgang Schaüble, the German finance minister:
"The common currency has the problem that the monetary policy is joint, but the fiscal policy is not," Germany's Finance Minister Wolfgang Schaeuble said in a meeting with foreign reporters in Berlin. "Consequently, we are working now to expand the common currency through a common stability policy." [Moneynews]
They want a limited Treaty change (involving all 27 EU member states), but that isn't likely to work, so efforts are concentrated in getting an agreement amongst the 17 euro zone member countries.
Apparently, a first outline could be ready for the year-end EU summit on the ninth of December. Details are sketchy, it could involve a common Treasury or Fiscal Commissioner with wide-ranging powers.
These plans could involve giving up a considerable amount of national sovereignty (which will be anathema to the British, hence the reason of starting with the euro zone countries). It's not clear why it would work any better than the old Stability Pact, but perhaps we should just wait for the details to come out. Here is Kantooseconomics (reacting to the proposal from Karl Smith mentioned above):
Karl proposes “administrative discipline”. Well, good luck with that. Not only is the record of European fiscal oversight dismal, it is also potentially a good way to destroy the friendship between countries in Europe, the original purpose of the European project.
(Kantoos Economics has it's own proposal in which it carves a member countries' liabilities in tranches like those of banks, with 'equity' the last of four tranches carrying the most risk and least seniority, where any crisis manifest itself first but the tranches function like breaches holding an avelanche).
Indeed. However, the real importance of this seems to lie elsewhere.
Grand Bargain
In fact, these plans for a stability union in and by themselves are insufficient to douse the flames. Their significance is likely to be situated elsewhere. The stability union could be the German price for yielding to more decisive ECB action. Countries signing up with legal binding and automatic sanctions to keeping their public finances in order in exchange for the ECB to behave more as a normal central bank.
We think this is probable. The Germans are, like everybody else, also able to peer into the trajectory of the euro crisis, especially after their own failed bund auction. They will see the same abyss as everybody else is perceiving.
They will know something has to give, something quite drastic, and something pretty soon, otherwise the game is up. We can't possibly fathom a situation in which the Germans will let the situation implode without ever enlisting the last line of defense in full, the ECB.
That would be folly, unless it's part of an end-game in which the Germans are purposely shedding themselves of some peripheral 'baggage' countries to arrive at a more homogeneous euro zone. We don't think that is very likely, although we have to say that the Germans are making it as hard as possible for most of the periphery to hang on to the euro.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
