Every day we read doom and gloom about the European economy, and rightly so. I will forget about Greece on the ground that it is small enough to be ignored; though perhaps not its contagion, but Spain is worsening constantly. And the Spanish government's statement that it will not let any bank fail has closed one of its possible exit points from the hemorrhage of cash. Nor is anything that I have read about proposals to fix the situation of much utility. Shareholders Unite had a good article on SA on May 31 describing a proposal out of Germany to reduce debt to 60% of GDP, but, frankly, I think that proposal is not workable.
At the heart of the problem lie two major factors that are widely recognized: (1) the difference in competitiveness among the nations, and (2) the extent to which the solvency banks and the solvency of their countries of origin are intertwined.
The competitiveness problem is a long-term issue that has to be addressed by greater labor mobility, greater wage flexibility, and a more friendly climate to new businesses. I have nothing to add to that well-known recipe so long as the nations remain in the euro. But to get to the point of redressing the competitive imbalances-if it is achievable-the uncompetitive nations will need continuing subsidies from the more competitive nations in order to survive to get to the long term.
Getting Germany and other northern European nations to agree to explicit subsidies has been the major stumbling block. Understandably, they do not want to provide subsidies unless they are going to be a bridge to a stronger Eurozone. As a consequence, various more subtle subsidies have been growing without explicit recognition. The subsidies provided through the ECB are, in theory, provided by all the European nations, but in reality by the strongest. The substantial exposures of the stronger central banks to the weaker central banks through Target 2, the European clearing system, appear to be in the hundreds of billions and growing all the time. These also are more explicitly shared subsidies. The EFSF provides such shared subsidies. These also continue to grow, but because they provide support using borrowed money, I assume that the amounts are not yet recorded as spent by any nation. It is easy to forecast that such a process of inadequate and unrecognized subsidies has to end in tears.
The Bank/Sovereign Interlock
Therefore let me turn to the second prong of the problem: The extent to which the solvency of banks and the solvency of their countries of origin are intertwined.
To an American steeped in bank regulation, this is a peculiar problem because American banks use-and are supposed to use-U.S. government securities as a safe and liquid investment. There is no other investment that is preferable. "Excess reserves" at the Federal Reserve Banks are a second choice and pay little interest when they pay at all. The European banks, by contrast, have no safe sovereign securities into which they can put their liquidity. Deposits at the ECB are their only choice. Why is the ECB safer than any of the individual countries or their central banks? Because deposits at the ECB are, in effect, guaranteed by all the countries, and because the ECB has the right to cause additional euros to come into being (the power of the "printing press"). Thus the ECB is the equivalent of the Federal Reserve Banks. But there is no European equivalent of the U.S. treasury security for American banks.
The European banks ought to have access to an equivalent investment to the U.S. treasury security. And it is not very difficult to imagine such a security. It would be a "Eurobond" backed by all the countries of the Eurozone. Without such a security, the European banking system is, of necessity, weak and illiquid.
It happens that (1) the banking system's need for a safe euro-denominated investment, (2) the banking system's need to break the cycle of bank-nation mutual solvency dependence, and (3) the weaker countries' need for a subsidy to tide them over, all can be met by a single concept. That concept is a special Eurobond, backed by all the nations, that can be issued to banks in the Eurozone-and only to banks in the Eurozone-to replace the bonds of the individual nations that they now hold. Each bank would be given a one-time option to exchange individual country bonds (in the amount held on a specified date before announcement of the program) for Eurobonds, issued by the same country but guaranteed by all the nations of the eurozone, of like duration.
Whether central banks should be included in this offer is an open question in my mind. Whether banks should have the right to buy additional such securities after the initial offer also is an open question in my mind.
The new Eurobonds would carry an interest rate 100 basis points above the rate on comparable maturity German Bunds (averaged over the last six months prior to the announcement of the new program). The new Eurobonds could be sold by the banks only to each other. They also could be pledged at the ECB or a country central bank to provide liquidity but could not otherwise be hypothecated.
The Eurobonds issued to replace the bonds of each nation still would be issued by that nation and represent the primary obligation of that nation. The nation would pay the stated interest rate on the Eurobonds and would agree to repay the principal to the banks over a five-year period beginning five years after issuance of the Eurobonds. But the bonds would be Eurobonds because they would be guaranteed as to principal and interest by all the nations, in accordance with their financial size. The template for allocation already exists in the EFSF and the capital of the ECB.
Yes, I know, Germany and other northern countries have been adamant in their refusal to contemplate Eurobonds. I think it is possible that in the right context, they may change their positions. Under this proposal, for example, their banks and their economies would be substantial beneficiaries.
The benefits of this program would be enormous. (1) Banks would be liquid and would have bond assets that would be worth their face value. That would not cure the problems of insolvent banks. But it probably would make some banks whose solvency is now in doubt appear far stronger. Certainly, it would lower the cost of restructuring such banks. (2) Each weaker nation would have the cost of a substantial amount of its debt (in the case of Spain and Italy, the proportion might be 25%) reduced and its tenor automatically adjusted so that its funding needs for five to ten years would be reduced. That should permit the affected nations to issue debt at more reasonable rates, especially if the newly-issued maturities are five years or less. Even the stronger nations would benefit by stretching out some of their maturities. (3) These factors would ease the pressures on the Target 2 clearing system and reduce the exposures of the northern countries through the ECB.
How much debt would this involve? Total outstanding sovereign debt is about eight trillion euros. From the ECB website, it appears that about 1.5 trillion of such debt is on "monetary financial institutions" balance sheets in the Eurozone. "Monetary financial institutions" includes central banks and money market mutual funds. In the case of this data, the ECB, although a central bank, is excluded. 1.5 trillion euros would be about 18% of the total sovereign debt outstanding. (My best guess is that the banks alone, excluding central banks and MMFs, hold closer to one trillion euros of sovereign debt--more like 12-15% of the total.) Would it matter if the total were two trillion-about 24% of the outstanding total? The risks would increase, but, I would submit, not above the total risks now in the system if Spain basically fails. The northern countries already have large risks through the ECB, Target 2, and the EFSF, and they have none of the benefits. This program could buy five years of relative calm within which the weaker countries could seek to restructure their economies and the Zone could advance its process of fiscal consolidation. The program also would reduce the weaker countries' interest expense burdens, thereby possibly helping them-and the Zone as whole-to adopt more growth-oriented fiscal strategies within the confines of already-adopted targets.
The breakdown of holdings among financial companies of the various countries puts Italy at the top, with 327 billion, then Germany 301, Spain 261, France 234, Belgium 95, and Netherlands 86. It appears that in all cases, a substantial majority of securities owned are of the country where the bank is domiciled. (My thanks to Sakari Sakuonen of Reuters for help with this data and for his article on this subject.)
Most importantly, the program would restore confidence in the banking system and in the weaker countries' ability to meet their debt obligations over the next five years, which would promote business growth and increased employment opportunities.
Some major risks are fairly obvious.
The first risk is that the bond markets do not find that this program reduces sovereign exposures sufficiently. But in the key countries, it appears to me that a fairly substantial part of sovereign debt outstanding would be replaced under the program. I do not have precise statistics, but it appears that about 25% of Spanish debt and a similar proportion of Italian debt would be affected. A larger proportion of Greek debt also would be affected, perhaps with the ECB and IMF even agreeing to replace their holdings with new Eurobonds. One also should assume, I think, that breaking the link between the bank solvency and the solvency of their sovereigns should change the nature of the markets for both. It appears to me that these changes should be sufficient to cause the markets to gain confidence for a substantial period of time. If I am wrong, then this program would, like all the others, seem to work for a few weeks, then cease to matter much.
The second risk is that at the end of five years, one or more of the weaker countries might not be able to begin to repay their debts on schedule. But that risk is smaller than the current risks that loom every day and that drag down the economy of the region.
There always are unknown risks, especially when a program is designed by one person sitting at a computer. We will learn what some of them may be if this proposal acquires any level of official backing.
What process of approval each country would have to go through in order to effect such a guarantee I do not know. Nor do I know all the politics involved. Nor do I know which countries would benefit the most. But the banks of every country would benefit. And if the banks of Greece, Spain, Italy, Belgium and Portugal benefited the most and those countries, therefore, benefited the most, that should be a political plus rather than a political minus.
I believe that such a program would be welcomed by financial markets and, unlike previous stop-gaps, would have a lasting beneficial impact.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.