Eleven years ago, economic historian Niall Ferguson and I marked the euro’s birth with a Foreign Affairs article titled “The Degeneration of EMU.” We argued that absent centralized fiscal policy, euro-zone countries would fight over how much money the European Central Bank should print to help pay their bills. We gave the euro a decade.
Tragically, we may end up close to the mark. The euro could collapse this fall unless the ECB commits to printing every last euro needed to keep Greece, Portugal, Ireland, Italy, Spain and Lord knows who else (think Belgium and France) afloat. That’s a tall order.
The five most financially strapped euro-area governments collectively owe more than 3 trillion euros ($4.1 trillion), much of it short-term debt. They must roll over these obligations as they come due and issue new bonds to cover their still huge annual budget deficits. If the private sector doesn’t buy their paper, the ECB must. The International Monetary Fund and the European Financial Stability Facility can help, but their lending capacities are limited.
Why not force Greece and other troubled governments to enact deeper spending cuts and larger tax increases? Lots of luck. They don’t fancy more rioting, and their economies are shrinking. In the short run, they have no choice but to borrow or default.
Unfortunately, the private sector has no appetite for Greek, Portuguese, and Irish bonds and is losing interest in Spanish and Italian debt. Greece’s 10-year private borrowing rate is more than 20 percent. Portugal’s is 11 percent. Ireland’s is 8 percent. These rates are simply unaffordable, leaving all three governments as wards of the ECB.
Thanks to recent ECB intervention, Spain and Italy can borrow at 5 percent and 6 percent, respectively. But Spain and Italy must refinance 660 billion euros through the end of 2012. Private lenders might balk.
Germany and other solvent nations won’t raise new taxes to bail out their euro-area neighbors. And they won’t let the ECB print trillions of euros to continue financing Europe’s current malfeasants. They know there are more supplicants, both sovereign states and private banks, waiting in the wings. As important, they have a deep-seated fear of inflation going back almost a century.
Even if the Germans don’t call it quits, struggling governments might. Greece’s latest bailout -- the 109 billion euros “agreed to” in July -- contains conditions that Greece, its private creditors and all euro-area members need to accept. Getting all three to say yes will be tough.
The subtext of this fiscal crisis is the horrendous financial meltdown that sovereign defaults could trigger. The government bonds are held, in large part, by European banks. Many of them would be insolvent today were they marking the bonds to market. But, as the International Accounting Standards Board just confirmed, these lenders are booking this junk at much higher prices than the market will pay.
Formal defaults would force financial institutions to tell the truth and declare their own insolvencies. This could trigger a massive bank run. Euro-zone members guarantee deposits, but they don’t have reserves remotely sufficient to cover a full-scale run. Nor can they print money to back account balances.
Cans of Soup
The ECB might step in and “protect” deposits. But if people kept withdrawing money, this, too, would require printing trillions of euros, which the public would cart off from banks they don’t trust. Then, with their money in unsafe keeping, consumers would try to buy something real: cars, cans of soup, you name it. They would turn the euro into a hot potato, producing hyperinflation. Consequently, those who didn’t run on the banks would retain secure claims to worthless pieces of colored paper.
Sovereign defaults are only the proximate cause of this euro-killing nightmare. The real culprit is bank leverage. If the lenders had no debt, sovereign defaults would reduce the value of their equity, but wouldn’t shut them down, thereby destroying the financial-intermediation system.
Non-leveraged banks are, effectively, mutual funds. If appropriately regulated, mutual funds don’t make promises they can’t keep and never go bankrupt. Yet they can readily handle all manner of financial intermediation as 10,000 of them in the U.S. make abundantly clear.
Countries get into trouble, just like households and firms. Similarly, nations should be permitted to default without threatening the global economy. Forcing the banks to operate with 100 percent equity by transforming them into mutual funds - - as I have advocated in my Purple Financial Plan -- is the answer to Europe’s growing sovereign-debt crisis.
In a nutshell, the ECB tells the banks: “No more borrowing to buy risky assets, including sovereign debt, and forcing taxpayers to take the hit when things go south. You’re now limited to marketing mutual funds, including ones that hold nothing but cash and will constitute our new payment system.”
Banks would convert checking accounts to cash mutual funds, which they would back to the buck with reserves. They would gradually sell their remaining assets to pay off debts, while the mutual funds built up assets with money attracted from new shareholders. In cases where the banks’ assets didn’t cover their debts, governments or the ECB would pitch in money to make up the difference. But once the mutual-fund banks were up and running, there would be no need for further bailouts. And the euro would be safe if and when Greece and other governments defaulted.
(Laurence Kotlikoff, a professor of economics at Boston University, is a Bloomberg View columnist. The opinions expressed are his own.)
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