We published an earlier version of this commentary on November 29, 2011, also forthcoming at the Financial World blog (http://jibsblogs.se/cfg/).
Europe continues to struggle with its banking, structural, and fiscal problems. The market’s reaction to Spain’s proposed €100 billion bank bailout was short-lived, suggesting that it was not likely to fix the banking problems. At the same time, the Irish positive vote on the fiscal treaty and ECB president Draghi’s comments have sent strong messages about the need to become more integrated and united. Recapitalizing banks and establishing both fiscal balance and commitment to it are essential components for ensuring the viability of the European Monetary Union (EMU). But they certainly will not in themselves solve the problems. Rather, budget balance is but one of a series of structural and banking changes that will be required. Desperate times sometimes require radical, out-of-the-box solutions. What follows is one roadmap that could put Europe on a path to financial and fiscal stability.
To begin, there are some interesting comparisons to the US that may help to illustrate the sources of Europe’s structural problems. Unlike in the US, there is no federal debt at the EMU level. Instead, all sovereign debt is at the country level. Politics dictated that all sovereign debt would be treated the same, regardless of the country of origin, regardless of its true underlying risk. That debt has found its way onto the balance sheets of EMU commercial banks, National Central Banks, and the European Central Bank (ECB). It now threatens the stability and solvency of the European financial system based on the euro. Herein is the major source of the current problem and an important key difference between the US and Europe.
In the US, state and local debt is priced and sold in the market at rates reflecting its true underlying value. This is even more the case now, with the demise of the monoline bond insurers. To be sure, such debt receives favorable tax treatment (though the recent but short-lived success of the Build America Bonds experiment suggests that favorable tax treatment may not be needed and may actually reduce the supply of funds to the municipal securities market). Most important for this discussion, however, is the fact that in the US, state and local debt did not find its way onto bank balance sheets in significant amounts. This is largely because of limitations defined by US tax laws, and not necessarily the result of enlightened regulatory or capital policies. Equally important, state and local securities are not held by the Federal Reserve in its portfolio, nor does the Fed have significant discount-window exposure to state and local securities, since these are not major components of bank asset holdings. US banking system and Federal Reserve holdings of government securities consist of federal government securities backed by the taxing authority of the federal government. This attribute suggests part of the needed solution to Europe’s problems.
What should be done? What follows is a radical, five-step program that could constitute a path to fiscal stability for the European Monetary Union. The first step is to federalize all EMU sovereign debt and make it the debt of the EMU. The second step is to put in place a tax system – be it a VAT (which the Europeans are used to), a sales tax, or some form of income or property tax, that will fund the debt in proportion to a given country’s debt that had been nationalized. Third, strict limits should be placed on both private bank and National Central Bank investment in any newly issued country debt. Fourth, a pan-European system of deposit insurance should be established, fully funded by a commitment from the European Commission. Finally, countries need to adopt balanced budget schemes, the main attribute of which should be prefunding of expenditures.
This is a radical proposal, and admittedly one that would be difficult for European nations to adopt, because it runs counter to their strong desire to preserve national identities. But the alternatives are even less attractive and dangerous for the continued survival of individual European nations, not to mention the threat that the collapse of the EMU would pose to world financial stability.
The proposed program also has many benefits. First, by nationalizing existing debt, it cleans up bank balance sheets and significantly reduces the threat to bank solvency; and it truly does put an asset on bank books with a uniform rating across the member countries. Such an asset doesn’t require pretending that all sovereign debt is riskless, regardless of what nation issues it. It would likely be priced in world financial markets at favorable rates, because it would signal a true commitment to keeping the EMU in place.
Second, it does not monetize existing debt purchases by either the European System of Central Banks or the emergency funds that are being put in place. It simply replaces existing outstanding debt, euro for euro, with a new type of debt.
Third, it should lower the overall funding costs to all member countries of that outstanding debt, since it is now backed by the taxing power of the EMU and not individual countries. This benefit would be shared by all participating nations, and would not put additional financing burdens on the more fiscally responsible EMU members.
Fourth, it gets the ECB and National Central Banks out of the business of funding individual country deficits through asset purchases and/or money creation, thereby reducing the inflation threat.
Fifth, it puts a clear dividing line between past debt issuance by EMU member countries and new debt issued to finance ongoing country operations and programs.
Sixth, unless additional fiscal operations are undertaken at the EMU level, the nationalized debt should be self-liquidating over time. Maturing issues would simply be extinguished, and debt payments would decline commensurately.
Seventh, it introduces market and fiscal discipline at the individual-country level, but does so in a way that clearly separates the costs of past policies from ongoing and future fiscal commitments and puts market prices on those programs.
Eighth, a fully funded deposit insurance fund would help dampen the current deposit insurance arbitrage, as depositors transfer funds from countries with questionable ability to live up to their deposit guarantees to banks in countries where the deposit insurance systems are more stable.
Finally, one would expect exchange rates to stabilize.
While this program may seem extreme, it is also the case that the present serial approach to resolving the problems isn’t working. Desperate times require bold solutions, and time appears to be running out, as the risks to both the EMU and the rest of the world escalate.