How To Solve The Greek Debt Crisis Without Taxpayer Funds

Includes: FXE
by: George Kesarios

European leaders have so far failed to realize what the real problem in Greece is. As such, the question of how to handle Europe's debt problem remains unsolved.

The main problem as I see it, is that politicians don't want to admit that there is simply too much debt that needs to be written down (I call it cyber debt). Part of the reason for not wanting to see the truth, has to do with the fact that the European Banking lobby is the main financial benefactor of European politicians.

Leaving aside the reason for this mountain of debt (the reasons are different for each country), I say that the only way to solve the problem is via massive write-downs. Many seem to imply that we cannot do this, for the market needs a "risk-free" asset. By writing down several trillion euros of debt, the market will thus not have such an asset.

While I fail to understand the concept of a "risk-free" asset, if an asset manager wants zero risk, then all he has to do is to deposit his money at the local central bank and earn a negative yield. Other than that, one has to take one's chances with the market.

Another problem, many say, with writing down trillions of euros in sovereign debt, is that the banks will be broke and that tax payers will need to nationalize the European banking system. Many argue this will be a tremendous burden to the European taxpayer.

I argue that everyone who says this is wrong and that the politicians have put the rights of stockholders above those of the tax payer. I will also prove that we can indeed write down mountains of debt, without the tax payer having to pay anything.

For those who don't know it, the ECB is not a central bank like other central banks. Rather, it is a confederation of central banks. Each European national central bank can theoretically do the same types of market operations as the ECB and then some. The forefathers of the euro have left many monetary windows open, which, if used correctly, can solve the European debt crisis in a very short period without taxpayer funds.

Please note article 14.4 (pdf) of the Protocol on the Statute of the European System of Central Banks.

14.4. National central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB.

What this basically means is that the National Center Banks can do what the ECB can, but can also do what the ECB can't do. Of course, what can be done or not is not specified anywhere nor is it implied. Nor are, under what conditions, if any, can national central banks do what is not specified. It simply means that any rule can be bent, as long as everyone agrees to it.

Please note that, this paragraph is the reason the Irish Central Bank was able to print 80 billion euros under the code name ELA (emergency liquidity assistance).

Like I said above, any rule can be bent or broken, as long as everybody agrees to it. Having said that, the ECB has, so far during this crisis, broken every central banking rule imaginable. The Fed has also bent the rules by inventing special facilities as the crisis was unfolding. But let me say that, I think the Fed has done an excellent job at handling this crisis (unlike the ECB). Rules were meant to be broken, especially in times of crisis.

Just because 150 years ago Walter Bagehot said that a central bank must provide unlimited liquidity, as long as there was eligible collateral, does not mean that we have to abide by this rule forever.

Yes it is a good rule and I think it provides good monetary checks and balances, but what happens when there is no eligible collateral? Does that mean you let the system blow up? Or does it mean that millions of people must starve to death, because of some orthodox monetary theory stated long ago?

Market participants know that ring-fencing the Greek problem will not work. It might have worked if Greece was the only problem, but it is not. Ireland is next on the default list, so is Italy and Belgium and probably Portugal and yes, France will be on the list in the next decade (if not sooner).

Like I said in the beginning, the real problem is that there is too much debt. So the answer lies in that this debt has to be written down, so that governments and taxpayers get a break from interest payments. At the end of the day, that is the only problem.

So taking advantage of the window of opportunity that the ECB statute has given us, let's say we create a special facility fund and let's call it Greek Bad Bank Fund or, GBBF.

Now let's say that Greece in several months writes down the remaining private sector debt after the current PSI, or an additional 100 billion euros. Greece will only be liable to the official sector, mainly to other regional European central banks and bilateral loans. That would be about 170 billion euros, which is manageable.

Now let's say that the GBBF gets a loan from the Nation Bank of Greece - of say 80 billion euros - and injects these funds in the Greek baking system via common stock capital increases. Common stockholders will be wiped out and the entire Greek banking system will be nationalized (which is going to happen anyway).

However, the Greek debt problem will be solved, Greek banks would be fully recapitalized and best of all, no money would be used from European taxpayers.

In fact, we can extend this idea and have the Greek Central Bank buy up the remaining bilateral loans from other European states (and the IMF) and have the Greek central bank as the sole creditor of Greece (for the time being).

Since the euro-system is a confederation of central banks and since the ELA mechanism has been used to a great extent already (the Greek central bank has printed about 44 billion euros already and Ireland has about 50 billion euros outstanding), the only additional rule we have to break is to allow central banks to provide equity, in additional to liquidity.

At the end of the day, the problem is not about liquidity, but about equity and the fact that the European banking system is not a going concern.

Now once the Greek banking system writes down Greece, its sovereign debt and bad loans (bad loans are as much of a problem as the sovereign debt itself), the Greek banking system will be free and clear of all bad assets, which means, it will be highly profitable. I estimate that the Greek banking system can produce at least 6-7 billion euros of pre-tax profits.

The Greek banking system will be able to provide a very good dividend to the GBBF facility and there will also be plenty of money left over for stock buybacks. That will be more than enough to pay the interest and slowly unfold the facility by paying back the bank of Greece. After several years, the entire banking system can once again be sold to the public at a profit to the Greek state. The S&L problem of the 1980s took about 10 years to unfold.

Further expanding on this idea, Italy can do the same thing. If Italy needs to write down, let's say, 30% of its debt, then Italy can use the same facility and recapitalize the banking system as needed. No need to beg' borrow or steal from the EU or the IMF. Each country can handle as much of its mess as it wants with its own means, without using taxpayer funds or raising taxes or all the other stupid things they are currently doing in Europe.

But because there is no such thing as a free lunch, the one who will take the punch might be the value of the euro. But given the Japanese experience, where one can print and print and then print some more, without the value of the currency being marked down (duo to positive trade flows), the euro might not fall at all.

I am absolutely positive that the current haircut for Greece is not enough. I am also sure that in the future, we will be talking about an OSI as opposed to the current PSI. At the end of the day, debt that cannot be repaid will not be repaid. Excessive debt is either inflated or written down. There is simply no way around it. Ring-fencing or putting you head in a hole wont cut it.

Also, the current crisis will not end for Europe for one simple reason. Europe's population is falling. Even if the current levels of debt are kept constant, on a per capita basis, debt levels in Europe will rise, due to the simple fact that the population is expected to fall by about 20%-30% over the next few decades (if not earlier).

The only answer to the current debt problem in Europe is to use central bank creative financing, by bending the rules a little to provide equity, as opposed to just liquidity.

After that happens, we can talk about what has to be done in order for this mess never to happen again. Anything else will not work and will simply make matters worst.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.