Sunday, February 14, 2010

How to bailout the PIGS

Here is some unsolicited advice for the EU with respect to dealing with fiscal crises. Right now, there is no mechanism at the EU or Eurozone level to finance fiscal deficits at member states, meaning that the only support that can be provided would either be bilateral or via an as-yet created entity. If in fact the EU does decide that it should offer fiscal assistance (bailouts) to member states--which would be a big stretch--this is how I think such an entity should work:

The EU (not the eurozone) establishes an entity called something like the Federal Solidarity Fund. The FSF would be capitalized by the member states with government bonds and callable capital using a formula based on GDP (like other international financial institutions). 

The capitalization would be sufficient to get the FSF a bond rating of AAA from the three agencies, which have established standards for rating such institutions.

The FSF would then issue debt to fund its loan book. Such bonds would be eligible for purchase or rediscount at the ECB. Borrowers would have to submit to IMF-style conditionality, including an amortization schedule. Conditionality should be sufficiently onerous that accessing such funding would be a last resort. 

There is no reason why the ECB should not be a big purchaser of  FSF bonds. The ECB has an EUR1.7 trillion balance sheet, with plenty of marketable assets that could be sold to offset FSF funding. 

The critical constraint is sufficient capital to maintain the AAA rating while having sufficient funding to meet the needs of needy states. 

Of course, the challenge for Europe is not whether it has the resources to establish and finance such a mechanism. The challenges are instead: (1) convincing all the major German political parties that it is in their interest to establish a bailout fund for the PIGS; and (2) convincing the Greeks that the alternative to strict conditionality--essentially financial conservatorship--is default, which would be much much worse. 

I am skeptical that there is any way to reconcile the thrifty German public and the Marxist labor unions in Greece. But if it does prove to be possible, this is how I think it should be done. And it will have to be done very rapidly because the Greeks need EUR30 billion right now.

No comments: