Original URL: http://www.theregister.co.uk/2011/07/22/saving_the_euro/
Four illegal ways to sort out the Euro finance crisis
And one of them is about to be used
Comment Saving the euro isn't the easiest of things: solving the current problems actually would be quite easy, if expensive, except for all the laws and regulations that rule out all of the easy ways.
The basic problem is well explained here. Don't worry too much about what the Taylor Rule is: just accept that if you're going to have a well-functioning currency across an area then the interest rate derived from the Rule should be the same for all the parts of that area.
And Europe, the eurozone, simply fails this test. Interest rates were about right in the boom and are about right now for the eurozone as a whole. But they were waaaaay too low for the periphery (most especially Ireland and Spain) in the boom, and they're similarly way too high for Portugal, Spain, Greece and Ireland now. They're just fine and toasty for France and Germany though: which is the very problem that the currency area faces. Because the different areas are so out of whack, partly for structural reasons, partly because they're on different cycles of boom and bust, the necessarily single interest rate associated with a single currency just won't be right for some areas all of the time.
In the jargon, the question is: "is the eurozone an optimal currency area?" And this result from looking at the Taylor Rule (which is by no means the only such test that gives a negative result) tells us that the answer is "No". Thus the current eurozone should not be the current eurozone; many of the countries that are in it should not be in it.
Which brings us to our first possible solution for the current woes. Break up the euro. This is simple and would be a good economic solution in the medium to longer term. However, it would also be an entire nightmare in the short term and, yes, you've guessed it, would be illegal. For, as we know, the whole point about the European Union itself is "ever closer union" and so everything has been set up to make it easy enough to join the euro, but you're not actually allowed to leave once in.
That "not allowed" may well get severely tested before this is all over, but currently there is no legal mechanism for anyone to leave.
At the other end of the spectrum we could work on making the eurozone an optimal currency area. This would involve much closer economic union. No, not just more economic power going to the EU and up from the nation states. It would need substantial subsidy from the richer areas to the poorer. Yes, I know we all moan about how much we already pay but current spending is a rounding error compared to what would be needed. We'd be talking about the sort of sums that the south east of England sends to the north east, the sums that west Germany has been sending to the east: several percentage points of GDP. Germany is still, 20 years on, sending 2 per cent of GDP to the east. To really sort out Spain (and, possibly, Italy) we'd be talking about 3 to 5 per cent of the northern European economies being collected in taxes and sent south.
Leave aside the political difficulties of this: this again would be illegal as the current rules stand, both at the EU level and almost certainly in the German constitution as well.
German mum could sign off on the southern kids' credit cards
Then we've the two methods of dealing with the immediate problems. Rather than looking at the long-term reasons about how this all happened – how did the periphery get so screwed, etc – look instead at what we're going to do about the mountain of debt and imminent bankruptcy right now.
The first is to simply create the Mother of all CDOs. A CDO, you will recall, is the piling up of loans into one great big bond, whacking a guarantee on it, and then flogging it off. It caused a few problems when American mortgages were treated this way, you might remember. However, we could take some or all of the Greek, Portuguese etc debt, stick it all together in one girt big bond, whack an EU guarantee on it (the real guarantee would be Germany) and then sell it off. The interest that Greece etc would have to pay would fall in just the same way that if your parents signed for your 16-year-old self's credit card, you would get a better interest rate, and if they have to pay less interest then they're not quite bust.
This is attractive as a solution, as long as Germany doesn't then become AIG Financial Products and go titsup itself, but it's also illegal the way everything is set up at the moment.
The final way would certainly work. Currently, you can buy, say, Greek bonds at 50 to 70 per cent off. So, why doesn't the European Central Bank do this? Or the EFSF (the special fund set up to try and deal with these matters)? They could buy the debt at this discount, cancel the bit that is the discount and hey presto, Greece's debt burden falls by 50 to 70 per cent. They're saved! The people who lose money here are the banks selling that debt at a discount and they don't care because they know they've already lost that money: that's why they're selling it at that discount.
Yes, you've guessed it, this too is illegal. The ECB etc can only buy new Greek debt. They're not allowed to go into the secondary market, they can only buy in the primary.
So, the four major ways we could solve this are all illegal. Not that that really worries the EU, rules and laws are for the little people. Which is why in the announcement today we get this:
- 7. To improve the effectiveness of the EFSF and address contagion, we agree to increase the flexibility of the EFSF, allowing it to:
- intervene on the basis of a precautionary programme, with adequate conditionality;
- finance recapitalisation of financial institutions through loans to governments including in non-programme countries;
- intervene in the secondary markets on the basis of an ECB analysis recognising the existence of exceptional circumstances and a unanimous decision of the EFSF Member States.
Let's change the rules so we can opt for solution 4.
It's not actually a bad solution, and if it had been done six months ago would almost certainly have worked. But will it work now? Phone your local sovereign bond trading desk and ask them.
The rest of the draft agreement that has been leaked is an attempt to make sure that nothing like this ever happens again. Might work, might not: for they've still not solved the basic underlying problem. The eurozone just isn't (and is unlikely to be for many decades to come) an optimal currency area and thus, if we look at economic reasoning rather than political, just shouldn't be trying to have a single currency. ®