The longer-term refinancing operations launched by the European Central Bank in December have relieved the liquidity problems of European banks, but not the financing disadvantage of the highly indebted member states. Since high-risk premiums on government bonds endanger banks’ capital adequacy, half a solution is not enough. It leaves half the eurozone relegated to the status of developing countries that became highly indebted in a foreign currency. Instead of the International Monetary Fund,Germany is acting as the taskmaster imposing fiscal discipline. This will generate tensions that could destroy the European Union.
I have proposed a plan, inspired by Tomasso Padoa-Schioppa, the Italian central banker, that would allowItaly andSpain to refinance their debt by issuing treasury bills at about 1 per cent. It is complicated, but legally and technically sound.
The authorities rejected my plan in favour of the LTRO. The difference between the two schemes is that mine would provide instant relief to Italy and Spain, while the LTRO allows Italian and Spanish banks to engage in a very profitable and practically riskless arbitrage but has kept government bonds hovering on the edge of a precipice – though the last few days brought some relief.
My proposal is to use the European Financial Stability Facility and the European Stability Mechanism to insure the ECB against the solvency risk on any newly issued Italian or Spanish treasury bills they may buy from commercial banks. This would allow the European Banking Authority to treat the T-bills as the equivalent of cash, since they could be sold to the ECB at any time. Banks would then find it advantageous to hold their surplus liquidity in the form of T-bills as long as these bills yielded more than bank deposits held at the ECB.ItalyandSpainwould then be able to refinance their debt at close to the deposit rate of the ECB, which is currently 1 per cent on mandatory reserves and 25 basis points on excess reserve accounts. This would greatly improve the sustainability of their debt.Italy, for instance, would see its average cost of borrowing decline rather than increase from the current 4.3 per cent. Confidence would gradually return, yields on outstanding bonds would decline, banks would no longer be penalised for owning Italian government bonds andItalywould regain market access at more reasonable interest rates.
One obvious objection is that this would reduce the average maturity of Italian and Spanish debt. I argue that, on the contrary, this would be an advantage in current exceptional circumstances, because it would keep governments on a short leash; they could not afford to lose the ECB facility. InItaly, it would deter Silvio Berlusconi from toppling Mario Monti – if he triggered an election he would be punished by voters.
The EFSF would have practically unlimited capacity to insure T-bills because no country could default as long as the scheme is in operation. Nor could a country abuse the privilege: it would be automatically withdrawn and the country’s cost of borrowing would immediately rise.
My proposal meets both the letter and the spirit of the Lisbon Treaty. The task of the ECB is to provide liquidity to the banks, while the EFSF and ESM are designed to absorb solvency risk. The ECB would not be facilitating additional borrowing by member countries; it would merely allow them to refinance their debt at a lower cost. Together, the ECB and the EFSF could do what the ECB cannot do on its own: act as a lender of last resort. This would bring temporary relief from a fatal flaw in the design of the euro until member countries can devise a lasting solution.
For the first time in this crisis, the European authorities would undertake an operation with more than sufficient resources. That would come as a positive surprise to the markets and reverse their mood – and markets do have moods; that is what the authorities have to learn.
Contrary to the current discourse, the long-term solution must provide a stimulus to getEuropeout of a deflationary vicious circle: structural reform alone will not do it. The stimulus must come from the EU because individual countries will be under strict fiscal discipline. It will have to be guaranteed jointly and severally – and that means eurobonds in one guise or another.