How to bring Germany on Board and save the Euro

The end seems nay. Banks and businesses are setting up contingency plans for the break up of the euro. After the euro, the single market and in time the European Union will follow. Depression, unemployment, mass poverty and social unrest will sweep over Europe.

Merkozy have now produced the nth exit plan for the crisis. It consists of six points:

1. Automatic sanctions. In case of non-compliance with the deficit rule, countries are subject to automatic sanctions, which will require a majority of 85% to overturn.
2. Golden Rule: All EU member states, but in particular the Euro Area, should subject themselves to uniform debt limits. The ECJ will adjudicate in case of a dispute, and should have the right to declare national budgets illegal.
3. Private sector participation will follow the rules of the IMF. The PSI agreement on Greece remains valid, but is a unique case that should not be repeated;
4. Start the ESM by the end of 2012.
5. The heads of state and government meet once a month as the Euro Area’s economic government.
6. No Eurobonds.

In essence, this is a plan to impose austerity without any stimulus for growth. It reflects German ordoliberal thinking. It assumes that the crisis is due to economic fundamentals (excessive borrowing and lack of competitiveness), and that it is not a liquidity crisis, which requires stabilizing financial markets. This plan will not end the crisis.

Due to the gross political mishandling of the crisis by Mrs. Merkel, financial investors have lost trust in the euro and are selling their portfolio of European government bonds. In a climate of general uncertainty, liquidity is trump. If no one buys these securities, prices collapse and the balance sheet of investors deteriorate rapidly. This causes a credit crunch and spills over into the real economy by destroying growth and jobs. Hence, what is needed is a buyer of last resort for European sovereign debt that restores trust.

While this is well known to economists, German fundamentalists refuse easy solutions. Chancellor Merkel does not want to commit more of taxpayers’ money to help states which may ultimately default. The Bundesbank does not want to buy securities which may lose their value, as this may impair the ECB’s balance sheet and make it impossible to withdraw excessive liquidity, thereby causing inflation. They argue that stricter fiscal discipline is needed. These are laudable arguments. However, Germany needs to consider the devastating consequences a breakup of the euro would have for Europe’s and Germany’s economy and the stability on the continent, which has prevailed for over 60 years and has been the basis for German re-unification. And it must consider solutions that can be implemented immediately.

A different school of monetarist economists, many on Europe’s left, hope for a quick fix: if the ECB would guarantee all government bonds, financial markets would immediately calm down.[1] But this is a dangerous road as well, because it does not take into account the constraints imposed by the ECB’s balance sheet.

To understand this, let us first look at the relative sizes of debt and money. The total outstanding public debt in the Euro Area is €8107bn. Germany has the largest outstanding debt with €1956bn, followed by Italy €1912 and France €1747bn. Greece’s debt is €340bn. Money comes in two forms: Base money is the liquidity banks need to be able to make payments. Broad money is created when banks make loans and keep deposits for their clients. The Eurosystem has issued base money (M1) of €4780bn, and broad money (M3) is €9849bn. So far, the ECB has bought approximately €200bn of sovereign debt. This is nearly 3% of the total outstanding debt or 2.5% of Euro Area GDP. By contrast, the Fed in the USA has bought US government securities worth 19.1% of the outstanding debt or 17.7% of GDP. Thus, the risk of excessive monetization of debt is minimal in Europe. If we take the USA as a benchmark, the ECB could buy up to €1500bn sovereign debt, which is close to a third of total base money supply M1. This volume would leave a sufficient reserve for sterilisation and control of base money.[2] Hence, €1500bn are the reasonable, but not unlimited, “firing power” for ECB interventions in the secondary market for European government bonds.

Nevertheless, there is an important difference between buying US Treasury bonds or Greek and Italian debt titles. The first are considered riskless, the later highly risky. Buying risky assets is contrary to conventional central bank practices. A central bank is the “bank of banks”. It provides liquidity to the banking system against good collateral and sound counterparties. The problem is that the United States has “good” treasury bonds, but Europe has no good Eurobonds. Filling the ECB balance sheet with risky paper would undermine its credibility.

The European Commission has now come up with a Green Paper suggesting three options for creating Stability Bonds. The first two require several guarantees, which is hardly attractive for Germany and would need a Treaty change, which would take years to get ratified. The third option is based on several but not joint guarantees, similar to the EFSF issued bonds. However, it is clear that additional guarantees are hard to sell to German and Northern European tax payers.

There is another solution that could be implemented very rapidly. The EFSF or the new ESM,  could be transformed into a European debt management authority that issues Union Bonds, which are backed by a mixed portfolio of different national debt titles. The EFSF would buy not only Italian, Greek and other risky debt titles, but also German, Dutch, French government bonds, so that the Union Bond would represent a weighted average of Euro Area debt. The weights could reflect the share holdings of member states in the ECB. Because this portfolio reflects also “good” securities, it should be rated AAA, although some limited additional guarantees may have to be given by member states.

If the EFSF bought up to 60% of national debt, this would create a market for Union Bonds worth roughly €6000bn. The ECB could then buy a share of these Union Bonds in the open market, just like the Fed buys Treasury bonds. They would be “good” assets in the ECB balance sheet and this would increase the credibility of both the European Central Bank and the political commitment to preserve the euro as the European currency. This is precisely what is needed today. It is a solution that should also convince Germans that the price to pay for peace and prosperity is small.

1. What Can Save the Euro?