How to Save the Euro

Gero Breloer/AP Images
Italian Prime Minister Mario Monti and German Chancellor Angela Merkel, Berlin, January 11, 2012

My new book, Financial Turmoil in Europe and the United States,1 tries to explain and, to the extent possible, predict the outcome of the euro crisis. It follows the same pattern as my other books: it contains an updated version of my conceptual approach and the application of that approach to a particular situation, and it presents a real-time experiment to test the validity of my interpretation. Its account is not complete because the crisis is still ongoing.

We remain in the acute phase of the crisis; the prospect of a meltdown of the global financial system has not been removed. In my book, I proposed a plan that would bring immediate relief to global financial markets but it has not been adopted.

My proposal is to use the European Financial Stability Facility (EFSF), and its successor the European Stability Mechanism (ESM), to insure the European Central Bank (ECB) against the solvency risk on any newly issued Italian or Spanish treasury bills they may buy from commercial banks.2 Banks could then hold those bills as the equivalent of cash, enabling Italy and Spain to refinance their debt at close to 1 percent. Italy, for instance, would see its average cost of borrowing decline rather than increase from the current 4.3 percent. This would put their debt on a sustainable course and protect them against the threat of an impending Greek default. I call this the Padoa-Schioppa plan, in memory of my friend who helped stabilize Italy’s finances in the 1990s and who inspired the proposal. The plan is rather complicated, but it is both legally and technically sound. I describe it in detail in my book.

The European financial authorities rejected this plan in favor of the Long-Term Refinancing Operation (LTRO) of the European Central Bank, which provides unlimited amounts of liquidity to European banks—not to states themselves—for up to three years. That allows Italian and Spanish banks to buy the bonds of their own country and engage in a very profitable “carry trade”—in which one borrows at low interest to buy something that will pay higher interest—in those bonds at practically no risk because if the country defaulted the banks would be insolvent anyhow.

The difference between the two schemes is that mine would provide an instant reduction in interest costs to governments while the one actually adopted has kept the countries and their banks hovering on the edge of a potential insolvency. I am not sure whether the authorities have deliberately prolonged the crisis atmosphere in order to maintain pressure on heavily indebted countries or whether they were driven to their course of action by divergent views that they could not reconcile in any other way. As a disciple of Karl Popper, I ought to opt for the second…

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