Events in the last few months, and in particular the last week, have clearly revealed that Europe is riddled with insolvent sovereigns and insolvent banks. Moreover, European sovereigns and banks are tied up together in a web of debt, and the whole house of cards is subject to the political winds of fortune blowing in up to 27 different sovereign states. As recognition of insolvency propagates through the markets, unstoppable contagion spreads like a virus through this web of debt. The future breakup of the Eurozone, deemed unthinkable by the likes of Walter Münchau in April 2011, was deemed inevitable in June 2011 by the likes of George Soros.
What, if anything, can be done?
However, events have since escalated to a point that no modest proposal – however ingenious – has a realistic chance of success. Of course it is essential for the stability of the Euro that governments broadly avoid large deficits, and solving that one is a huge task in itself. However, almost all of the adverse events that the Modest Proposal was designed to prevent have by now happened or are considered inevitable.
Therefore at this stage, only draconian actions that go to the heart of the twin insolvency issue can possibly yield meaningful and lasting results. This is a harsh statement, and moreover it is much easier said than done, but recall that just about everything else has been tried already in the last 2 years, and everything else has failed to stand up to the test of the bond markets.
So it is imperative to deal decisively with the true root causes, and to move past the insolvency by accepting it and confronting it. With Europe staring at the abyss, there is no scope for modesty or decency.
And so I would like to make an Indecent Proposal.
Creditors around the world have already lost their money. Now these creditors need to accept it so the world can move past the bailouts and onto more important things – such as allowing opportunities for everyone who is willing and able to work to earn their livelihood.
First, one must deal with the deep cause of the sovereign insolvency. A major culprit here that affects all sovereigns in the same way is the straitjacket of the EMU monetary union without a fiscal union.
If it is accepted that it is politically impossible to convince the Northern European taxpayers of the benefits of a “transferunion”, then it will eventually become politically impossible to convince the Southern Europeans of the benefits of remaining in a monetary union. Hence, unless the politically impossible somehow becomes possible, the monetary union will at some point be broken.
The trillion dollar question is whether EMU can be severed in a controlled manner. I think it could, but first the inevitability of the uncontrolled breakup must be accepted so that a pre-emptive, far-reaching, organized and purposeful breakup stands a chance of being conceived, let alone attempted. I am not an expert in breaking up malfunctioning currency unions, but perhaps such an attempt could look like this:
(1) The Euro currency and its central bank should be split into two or more pieces: a Northern Euro managed by a Northern European Central Bank in Frankfurt, and a Southern Euro under a Southern European Central Bank based in [.....]?. France can try to choose either one, or can choose to return to the Franc. Each of the two European Central Banks will go its own way in terms of interest rates and quantitative easing to suit the needs of its member nations.
(2) The new Southern Euro would presumably depreciate, allowing the European periphery to regain some of its long-lost export competitiveness. With a currency that allows the economy to offset the impact of austerity, debt haircuts (sovereign defaults) can take place, and in their aftermath the nations will be able to borrow from the IMF, from other sovereigns, from domestic households and domestic businesses.
The above is nothing less than a radical redesign of the Maastricht treaty. I am unsure of the legal practicalities of implementing treaty reform at this stage. However, I disregard the legalese because, when push comes to shove, the crushing market pressures will also ignore the legalese in the baseline scenario of an uncontrolled breakup.
It must be noted that the Southern Euro could face the same attack from the markets if the economies comprising it start to diverge. One would hope that by then the lesson from this disaster would have been learnt, and corrective action taken well in advance. Such as, working diligently on agreeing supranational fiscal arrangements to accompany the common currency…
Second, one must address the widespread insolvency of the banking systems, which will doubtless worsen as periphery debt is repriced in the proposed Southern Euros. Again, as with the sovereign insolvency question, the first key step is to admit and confront the insolvency of several banks and stop pretending that all is well. But maybe I am being too harsh given the unprecendented number of data points disclosed by each bank in the latest EBA stress tests. Still, we are nowhere near the point of forcing banks to own up to their insolvency. And so the additional steps could be:
(3) Suspend the trading in, and voting right of shares in all Eurozone banks, declare a bank holiday, and make all banks temporary custodial wards of the European Central Banks. Tell the public what you are doing and why, explaining the whole truth and nothing but the truth. The public’s maturity will surprise many elites. I believe the people will understand and wait for the end result.
(4) Determine the true capital adequacy of each bank and then decide on a haircut and debt to equity conversions to be applied to bondholders. Repeat this step as needed to unwind cross contagion.
(5) Move all bad loans – private or public – to a bad bank and liquidate that by auctioning claims on the bad bank off to hedge funds.
(6) Having re-capitalized the banks to at least 20% common equity via conversion of bank bondholders’s debt to equity, allow the financial system to float once more, minus the debt overhang, minus the excess financial leverage and minus all the moral hazard.
(7) Having dealt a blow to bank bondholders and equity holders, offset this by proffering a generous upside for the new era dawning. This could be achieved by converting the European Financial Stability Fund into a European Economic Stability Fund, wielding a trillion borrowed Euros for investment into a Green New Deal that would put Europeans to work, reduce Europe’s annual fossil fuel bill, and improve her energy security.
Third, one must prevent the current nightmare from recurring. As all of this fiasco happened in the wake of two decades of unprecedented global financial liberalization, it makes sense that immunization would require the roll-back of most of the banking free-for-alls that brought the world to the brink of financial destruction:
(8) Outlaw naked credit default swaps on the simple principle that you should not be allowed to insure that which you do not own
(9) Break up the banks and outlaw speculation by banks: banks should be small, systemically unimportant, local, owner-managed, BORING low profit businesses, intermediating between savers and investors. Like most banking used to be in the United States in the good old days before the recurring crises that started from the 1980’s.
(10) Only Central Banks would be qualified and allowed to lend money to banks (no more webs of debt holding entire economies at gunpoint)
(11) Only regulated banks would be qualified and allowed to lend money to businesses and households (no more shadow banking systems creating credit-fuelled asset bubbles)
(12) Only the IMF, other sovereigns, businesses and households would be allowed to lend money to sovereigns (no more webs of debt holding banking systems at gunpoint)
As I said, I am no expert in dismantling broken currency unions, and I have not put in nearly as many hours in researching and documenting my Indecent Proposal as Yanis Varoufakis did with his Modest one. But if the ingenious Modest Proposal does not have the firepower to arrest and then reverse the spreading contagion, maybe it will be time for an Indecent Proposal to the Bond Markets: namely, we can’t beat you, and therefore we are going to join you.