Because of my view that Germany would not capitulate to the demands of its European partners, there would be no Germanic deus ex machina to save peripheral Europe (Greece, Cyprus, Italy, Spain, Portugal, Ireland). These countries, having lost the ability to refinance sovereign debt and to maintain depositor confidence, are slowly being drained of euros such that they must quickly find an external source of finance.
If Germany will not agree to co-guarantee eurobonds, and if the Bundesbank will not allow the ECB to lend to insolvent banks and to buy government bonds, then these countries will run out of euros, default and redenominate. This would bring down the European financial system and challenge the global financial system due to the size of European exposure in the global system. Global growth would go negative.
But, I am repeatedly asked: Since this must be prevented, how can it be prevented? The underlying assumption is that the world circa 2012 is still a rational place run by reasonable men and therefore the world will not be allowed to end.
The collapse of Europe can be prevented, perhaps. It is too late now for piecemeal assistance from the EFSF/ESM to make any difference to bond investors or to depositors. Today, no one in his right mind would buy a Spanish bond or deposit funds into a Spanish bank unless they expected an intervention on the scale of which I am about to describe.
The only institution in the world with the ability and the credibility to rescue the periphery is the ECB. It alone has the ability to create an unlimited amount of euros. Just as the Fed was able to increase the dollar monetary base from $800 billion in 2007 to $2.6 trillion last year, so the ECB can do something similar--or even more.
First, the ECB must extend an immediate and blanket guarantee of all senior bank obligations in the eurozone. (One can debate whether to include senior bondholders or not; easier to include them.) Second, the ECB must commit to purchase unlimited eurozone government bonds at a reasonable rate of interest, such as 3%.
In order to immunize the ECB from the credit risk associated with these two commitments, the eurozone governments must (1) guarantee their individual banking systems; and (2) extend joint and several guarantees to the ECB for any losses sustained with respect to either banks or government bonds. (In other words, the creditworthy countries must accept as a contingent liability the risks taken by the ECB.)
The ECB must push aside, for the moment, its price stability fetish and adopt perforce a financial stability mandate. (In practice they are almost the same.)
Time is of the essence. These steps must be taken before Greece exits or any banks default. For this to occur, a treaty must be drafted, executed and approved by all eurozone parliaments. That would be extremely difficult, considering that there is at most a month to get this done. It could be possible for the ECB to take action now on the understanding that it will be subsequently indemnified by the member states. This would require, inter alia, Draghi, the Bundesbank, Merkel and the major German political parties to agree to the scheme. In other words, this can only occur if Germany capitulates. As Merkel has already indicated, there would have to be agreement to a systemwide fiscal governance structure acceptable to Germany. This is in turn highly unpalatable to the member governments, such as France.
Please remember that I was asked how Europe can be saved, not whether I consider it to be easy or probable. In essence, for Europe to be saved, not only must the eurozone states surrender their sovereignty, they must do it overnight, at least by preliminary agreement. This is why I had previously analogized the situation to accepting defeat in war. To be saved, Europe must not only accept Germany’s ultimatum as and when presented, she must do it forthwith. (This might cause abit of a shiver in certain parliaments.)
The ECB cannot take on massive credit risk without a systemwide indemnification, which requires the consent of all member states. Effectively, the eurozone would become a federation, and the rest of the EU will be left as a free-trade zone. I see no other way that the eurozone can avoid collapse. Given the statement that Merkel has made along these lines, such an agreement is likely to be under negotiation as we speak. Many heads of government will have to take quite daring steps, and soon.
Can Europe pull this off? I don’t think so. I see too many barriers (such as the German constitution, and 150 years of French history). Europe simply cannot move this fast. Maybe the ECB can step in on an emergency basis before there is a definitive agreement; that is possible. But again, even that will require German consent.
Therefore, I remain of the opinion that the world will end this year. All that stands between us (Americans) and the abyss is the FOMC, which is a floating crap game these days. Perhaps the risk of massive financial dislocation might focus their parochial minds and allow Bernanke to open the floodgates. For the US economy to weather such a storm will require QE3 of at least another trillion, if not two or three. Whatever the Fed does will require sufficient “shock and awe” to break the deflationary implications of a European financial collapse.