The solvency solution for Europe: time to do the unthinkable

By Mark Dow
September 6, 2011

By Mark Dow
The opinions expressed are his own.

It is finally game on in Europe. The starter’s pistol fired long ago, yet only now does it seem that the EU and ECB are getting out of the gate. There is no more time to dwell on misdiagnoses, missed opportunities and policy slippage. Extend and pretend is no longer an option.

I am not by nature an alarmist. But the cancer is metastasizing at an ever-accelerating rate. Italy, Spain and even France are now genuinely at risk. Failure to stem the tide now could well undermine faith in the modern global capitalist system — a system already stretched by political polarization and income inequality — with potentially massive social implications. In short: It’s go time.

Concretely, Europe has to leapfrog the phase of thinking the unthinkable and start doing the unthinkable. It begins with those on the inside admitting that the EU, as currently conceived, failed. It is not a liquidity crisis. It is not a leadership crisis (this is the smarter-than-thou throw-away line of those with a superficial understanding). It is a failure of design.

Why now? Two important things accelerated the process. One, in June, when German Finance Minister Schäuble first started speaking openly about debt restructuring for Greece, it triggered a change in market psychology, despite the fact many in the markets were already expecting a restructuring. Market psychology is a fickle beast; it is not always linear, rational or right. But he who has the gold makes the rules, and many market participants decided that the prudent response would be to wait on the sidelines until debt restructuring(s) played out. This undermined the ongoing bank recapitalization process as well as the rollover of sovereign debts. In a world of multiple equilibria, confidence and psychology are king.

Two, growth. Since July, we have experienced a precipitous slowdown in economic activity across the globe, most acutely in the US and Europe. Careful observers knew this slowdown was coming even before the Japanese earthquake/nuclear incident, but this nonetheless left the two main global economic blocks brittle and exposed when the confidence shocks came from the US debt ceiling hostage situation, the consequent downgrade, and the Summer round of Greek financial programing rocked the system. This is centrally important because with growth nearly all debt sustainability equations clear; without it, almost none of them do — absent deep debt restructuring. And it is next to impossible to envisage equation-clearing growth in the near-to-medium term in Europe with its heavy debt burden and a fixed exchange rate vis-à-vis main trading partners.

If there is good news, it is that these messages may finally be starting to get through. The refreshingly candid speech by IMF Managing Director Christine Lagarde in Jackson Hole represented the first shot of sodium pentathol in the arms of attending European officials. The annual Ambrosetti forum in Cernobbio this weekend, against the backdrop of a seemingly irretrievably off track Greek program, served to further drive home the true gravity of the situation to a broader group of largely European thought leaders.

Proactive Beats Reactive

The failing program in Greece should be the definitive signal to the EU that liquidity solutions won’t work (and the meager haircut envisaged in current Greek PSI restructuring is still really a liquidity solution). Attention is shifting from the fantasy of expansionary austerity toward the need for growth. The IMF, with the support of the US and China, needs to leverage the collapse of the Greek program into engaging the EU and ECB in a true, multi-country solvency solution. Greece, Portugal and probably Ireland are too late to save from a deep restructuring and exit from the single currency.

The plan, therefore, must be designed with a view to saving Spain, Italy and probably France so that they can be given enough time to give growth a legitimate shot. Only a solvency solution mindset can provide shelter for those three countries from serious economic contraction and an unsustainable probability of default. National politics and procedures will not accord the EU leaders the time to erect the fiscal union solution. Going down that path will only postpone a solvency solution. Eurobond emissions — even if politically feasible — would not work either until after the cancer has been excised. By then they may not be desirable.

Here are the three main elements any plan needs to embrace:

1. Recapitalize the banks so as to short-circuit the contagion propagation mechanism as much as possible. EU policymakers need to understand what seems to have so far escaped them: this is more about winning the psychological war of confidence than it is the actual recapitalization of the banking system. It is useless to insist that markets don’t understand. It is pointless to repeat that recapitalization needs are small. It is not credible to blame speculators. And it would be counterproductive to try to resuscitate the stress tests in any way. Markets have concluded that they are not convincing. Shock and awe — tired though this cliché has become — needs to be the overarching inspiration.

2. Second, deep haircuts and exit from the single currency for Greece and Portugal and likely Ireland. Only Ireland has a reasonable chance of generating sufficient growth within the context of the euro, but if Ireland is to be spared, the plan to protect it must not fail, lest it undermine the credibility of the broader operation. The technical issues surrounding this are daunting, but not impossible. Moreover, there is no viable alternative left.

3. Nothing will scare those betting against Europe more than unleashing the unlimited balance sheet. Only the ECB fits this bill. The ECB needs to turn the fire hose in support of the sovereigns on the firing line. They have already been pinning Spanish and Italian debt at around a 5% yield. They may soon need to support France. But rather than being stealthy about it, they need to commit to it up front. Worrying about undermining reform resolve in Italy and Spain, while understandable, is, at this point, a second order issue. There are other ways to scare the passenger without threatening to drive your own car over the cliff. The ECB should either state or heavily imply that until further notice they are willing to subjugate their single mandate to this objective. Those worried about inflation should take comfort from the experiences of Japan and the US. And, lastly, of course there must be continued liquidity support for the banking sector even after the recapitalization. This will be a hard, but necessary sell.

There are no good choices left. But if an agenda along these lines doesn’t materialize soon the risk of defection — and both end of the creditor continuum, Greece and Germany, are rapidly losing patience — the odds the EU will lose control over the process will jump parabolically. Orderly beats disorderly. Plan beats no plan. Proactive beats reactive. The time for the quantum leap in mindset is now.

Photo: Mayor Luca Sellari displays Filettino’s own bank currency, the “Fiorito”, at his office in Filettino, 100 km east of Rome, August 29, 2011. Filettino, a small town in central Italy, is trying to go independent and mint its own money in protest against government austerity cuts. The town is rebelling against a proposal to merge the governments of towns with fewer than 1,000 inhabitants to save money.  REUTERS/Alessia Pierdomenico

22 comments

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Insolvency, debt, contagion and so forth are not the disease, they are the symptoms of the underlying cause. Decades of sloppy lazy governnance are taking their toll on enitre nations. No matter what currency they adopt, so long as nations cover their foolish overspending with borrowed money they will screw up ANY currency they adopt. Prior to joining the Euro, the Italian lira, Portuguse escudo and Greek drachma were all “joke” currencies while the Deutschemark was gold. Ever wonder why? Old habits die hard, especially in countries with lots of sun and too much wine.

Posted by Anthonykovic | Report as abusive

Hey, I knew a long time ago that I could not run my business on borrowed money. I was working for the banks and when the business slowed down they still wanted their money. The banks cannot own property, businesses or countries. Is there anyone out there?

Posted by fred5407 | Report as abusive

All solutions are temporary, unless each state in the EU can be taken to central court that can set reasonable terms for
dept according to a single law. and a single army and police to enforce the terms.

Each of the states of the US are subject to that. The terms will never be totally break the citizens of that state or let state off the hook.

Do you see most Europeans going for it? Are they one people to have one currency and government?

Posted by SamuelReich | Report as abusive

Serious question: I am with fred5407-How can policies about growth be determined by economic institutions such as banks whose sole focus is how to maintain institutional profit?

I am honestly confused. Every argument for the EU and US economies seems to center around currency as a major tool for stability. It is as if ‘Economy’ is no longer about buying and selling but its about how much money is available.

Posted by ex-fungi | Report as abusive

Here is a complete lack of reality as to the underlying problem. Dow foolishly believes that Greece can be Germany “if only the proper fiscal/monetary strategy were followed.”
I also love how he claims that “they just need to grow” as if they weren’t already trying to do this. Dow has succumbed to the arrogance that big money/big govt can solve everything, when Obama/Bernanke have already proved they can solve nothing.

Posted by NoCarbon | Report as abusive

This failure of design should be fact enough to dismantle the EU. Let the countries that don’t demonstrate financial leadership fail. Let the banks fail. Let the US fail. This will be a lesson long remembered by all.

Posted by 24dogs1cat | Report as abusive

Before the Eurozone the ‘joke’ currencies only created national problems. Trying to tie countries to a single currency whilst their economies are entirely out of step has proved unworkable and will remain so – whatever fixes are attempted. Globally a similar problem exists, but one created by today’s global market. Currencies have a nationally uncontrolled value – witness yesterday’s action by the Swiss, which pundits are already saying may not work and will not work without printing a lot of extra Swiss francs. Karl Marx might have been right about capitalism – certainly on today’s complex global scale.

Posted by mumjum | Report as abusive

We all agree that Europe and the Euro are in serious trouble and, which way to go is finally chosen (probably ‘chosen’ by not choosing) it’s going to cost everybody a hell of a lot. Seeing that Greece and – of course – Italy are still essentially refusing to act with any sense of responsibility (let alone, honesty) towards its Euro-partners, why not cut your losses and take the loss in money but cut out the aggravation by kicking the bums out? Voting taxpayers are more and more going to react along these lines anyway.

Posted by Lambick | Report as abusive

Most of Spain and Portugal’s Local Councils have debts of bankruptcy proportions, and where I live in Portugal most of my German neighbours are fed up with bankrolling their idiotic, head in the sand, spend as you go European Partners.(Merkel is unlikely to get voted in again). Because of Higher taxes in Portugal the Black Economy is booming and the same in Spain. The Greek Government appears to have no idea what to do, other than deny reports they have engaged an American team of lawyers to investigate withdrawing from the Euro.
If economies are to grow they have to buy and sell, but sell more than they buy, that is how you create employment. To many Government employees means higher taxes and more borrowing. Quantative easing by the US and UK governments is pointless as it just shows desperation and most of the money never gets to where it is intended.
The banks created the current economic crisis three years ago and it is likely to run for at least another three years before things get better. In the meantime the Portuguese continue to hide their money under their mattresses.

Posted by AlgarvianMan | Report as abusive

As far as I see, Europe should not do anything. If US hedge funds want Greece or Italy or any other country to default – so be it! When it happens EU will recapitalize ECB and nationalize and send to bankruptcy banks. That’s it. Sure it means a new recession but to contaminate balance sheets further because “hedge funds are not convinced” would simply be stupid.

Posted by tk2 | Report as abusive

Honesty in EURO partners? Germany borrows at 3% and lends Greece at 6% (above IMF rates). Also Germany at the same time that asks austerity measures, asks Greece to buy useless submarines and weapons of multibillion euros… I dont think that weapons contribute to the GDP.

The sun and wine are not responsible for the problems of the South dear Anthonykovic (ask again this question just before the end of your life and tell me again). The problems come from a mixture of reasons, including past history (for instance Greece was at war until 1952 and then from 1967 to 1974 was under dictatorship) and present mismanagement. Yes, the people are part of the problem not of the solution, so people have to change, i definitely believe so.

Lira, drachma and escudo were joke currencies? Well define this. In the 60′s Greece had almost zero debt, was drachma (a 3000 year old currency) a joke? Italy has a great industrial machine. Was lira a joke? Then what is the USD?

Posted by reuterskostas | Report as abusive

Portugal has one quick way to drive growth, namely to exploit its Mediterranean climate. In Central Portugal there are at least 300,000 derelict or abandoned properties. These sell from between £17,000 to say £70,000. A unified national planning system should be imposed so that Northern Europeans are encouraged to buy then renovate and locals should be fiscally discouraged from letting property go to ruin. Many retired people do this as the building costs are low, cost of living is very low, people speak English or French, Portugal is driving distance to the Milan, Frankfurt & London triangle and lastly the Portuguese are a warm and open people. If this idea were marketed within a total package (including forced planning changes) some £15 billion growth could be injected into the Portuguese economy. This gentrification happened in France between 1960 to 1990, when the countryside lost millions of workers to the cities. The inflow of Northern European money into rural France was huge! You can’t now find a ruin in Provence but you can find an isolated farmhouse with 3000 metres of land in Central Portugal.

Posted by robinson99 | Report as abusive

Forcing banks to hold “reserves” is an exercise in futility. All they are doing is holding paper that becomes more worthless by the hour.

Instead, start requiring banks and eventually governments to hold a basket of precious metals, rare earths, etc. in a set ratio to their capital structure. Make sure they hold the real thing in their vaults with regular inspections and watch the entire financial system change from wild currency fluctuations and printing presses running day and night to a much more orderly environment.

Posted by stanrich | Report as abusive

This is a serious think-piece and accordingly should be given thoughtful consideration.

Let’s look at the policy issues arising from liquidity vs. solvency contagion and anglo-american market sentiments (politically) against Euro:

The outcome in Brussles will end up isolating UK (including its City banking sector) from further involvement in Euro-17 policy decision-making.

It will include Sweden and Denmark and other’s who don’t subscribe to Euro regime.

Bottom line: emergence of two-speed Europe Project in which may be 11 countries are only involved at the centre in policy decision-making on way forward.

Fiscal (Transfer) Union or not; it’s now on the planning board of even major CDU (German) politicians now.

Posted by hariknaidu | Report as abusive

[...] It is finally game on in Europe. The starter’s pistol fired long ago, yet only now does it seem that the EU and ECB are getting out of the gate. Extend and pretend is no longer an option.  ary [...]

Great solution stanrich. Fiat money is rapidly becoming a farse many places in the world. You can’t put dollars in your gas tank to get to work, or digits on a computer screen in your stomach. I’ve been doing my best to transfer my wealth from bank accounts into hard assets like real estate.

Posted by calvinbama | Report as abusive

[...] It is finally game on in Europe. The starter’s pistol fired long ago, yet only now does it seem that the EU and ECB are getting out of the gate. Extend and pretend is no longer an option.  ary [...]

So let me get this straight Dow: Your first step is to hand additional money to the banks (“Recapitalize the banks”), which of course is printed by the central banks, to make them feel better (“winning the psychological war of confidence”)? Even while you acknowledge that recapitalization is not technically necessary? (“…more about winning the psychological war of confidence than it is the actual recapitalization of the banking system…” and “pointless to repeat that recapitalization needs are small.”)

So perhaps this puts me among those with “superficial understanding,” but your point is, in my humble opinion, complete and utter nonsense. You must believe that the only people who are reading your piece are monetary managers and hedge fund managers, such as yourself, and no one else. Certainly, you consider no one else.

That “recapitalization” idiocy you would prescribe creates no employment, creates no production, creates nothing but “profits.” You (correctly) point out that liquidity solutions are untenable, and your first step is nothing other than a liquidity transfer — from the pockets of the irresponsible public you appear to despise to the capital accounts of the banks you thrive upon.

Your head is so far up in the ether (or elsewhere) that you have no capacity to see that your program does nothing but preserve the same dysfunctional structure that has led our society to this point in the first place. You need to get your feet on the ground, and quit clicking your heels together.

Posted by BowMtnSpirit | Report as abusive

[...] It is finally game on in Europe. The starter’s pistol fired long ago, yet only now does it seem that the EU and ECB are getting out of the gate. Extend and pretend is no longer an option.  ary [...]

Deleveraging was bound to hurt, but while we go through the japanised rigours that come with the job, why worry? We were going to whack the banks anyway, that’s what we do after a crash, but is it really such a problem to lend them some money, whether to recapitalise or to keep them funded? TARP is coming back to the government with appropriate profits for the taxpayer, isn’t it? There is the risk that the banks go under anyway and that would be painful, but as things stand now we just need banks, no way around it. Restoring faith in the economy, not only in banks, is going to take a while. In the meantime Europeans better watch out not to get fleeced by the Greek and Italians (with the man who screwed a country).

And for CarlOmunificent a Brazilian comment on inequality: O sol nasce para todos, sombra há para poucos.

Posted by Lambick | Report as abusive

[...] It is finally game on in Europe. The starter’s pistol fired long ago, yet only now does it seem that the EU and ECB are getting out of the gate. Extend and pretend is no longer an option.  ary [...]

The more radical option to start with is to remove this instrument call the credit default swap from being traded across all markets.
Secondly, remove the complex derivatives, follow by stop listening to the bankers and do something real for the economy like Switzerland.

Posted by About-Face | Report as abusive

[...] politics, one thing is certain: we won’t get the best solution, as dreamed up by technocrats. Mark Dow, for instance, a former Treasury and IMF technocrat turned hedge-fund manager, has a solution to [...]

It doesn’t seem to be realized that the IMF, ECB etc are NOT bailing out Greece and other COUNTRIES; they are bailing out the BANKS that made ill-advised loans.

The citizens of Greece etc are now being ‘taken to the cleaners’ to get the banks out of trouble. It should be the banks that are left to fail or recapitalize.

Posted by Puerto | Report as abusive

[...] verder op Reuters Posted by mrwonkish at 14:24 Tagged with: ECB, Economie, Europa, Griekenland, IMF, Italie, [...]

If the PIIG’s leave EZ, there will be default, which will be disruptive to financial markets. In addition, a flight to safety of the stronger Euro (similar to the Swiss Frac) would weaken German exports significantly. That would hurt global growth big time. I think the only realistic solution is accepting higher inflation expectations, expanding the balance sheet, ECB telegraphing intent to buy bonds without limit and backing that with action. EZ will need to adopt seigniorage (printing money), higher taxes and fiscal cuts throughout Europe once deleveraging starts. Strong EZ members will have to share in the pain of weak EZ members while they pursue fiscal & political integration. Approach has to be a federal – with “United States of Europe” helping the weaker states through a rough patch and sharing in the pain across both strong and weak EZ. And then the bill would be paid through fiscal austerity, inflation (reducing the real value of debt), higher taxes and growth over the next one to two decades. Slow growth over this period has to be accepted, global growth will be helped if China allows the Yuan to strengthen and expands its domestic economy through increased consumption with lower savings and investment (would probably keep a lid on speculative premiums in commodity prices).

Won’t be politically paletable unless people understand that an orderly exit would be a worse outcome for strong EZ and a disorderly exit would be far worse. If it cant be sold, the outcome will likely be disintegration.

Posted by Shiv139 | Report as abusive

[...] 4. Good analysis of how the second Greek bailout relates to the first, cynical piece.  Here is an intelligent piece on doing the unthinkable for Europe. [...]

[...] knuckle ride for Treeko & Merko intensifying… Greek 1 Year Bond Yield: 111.7% | ZeroHedge The solvency solution for Europe: time to do the unthinkable | The Great Debate "The Irish market is showing a phenomenal performance in terms of output & prices [...]

[...] Reuters blogger Mark Dow believes the EU has failed but offers these three policies to help prevent complete collapse: [...]

Another bank-centric solution to the world’s economic problems. If we just keeping throwing free money at the bankers everything will be OK. Of course that has worked out well in the US where the bankers have continued to loot their own institutions while refusing to extend credit to qualified borrowers, the real unemployment rate is 16%, growth is stagnant, millions remain underwater on their mortgages and the Tea Party blames unions and the poor for the greed and failure of our financial elites.

Posted by chris9059 | Report as abusive

I’m afraid the horse has already bolted, the greed killed the hope and War is next

Posted by Parki | Report as abusive

[...] Italian Bond Edition (WSJ) see also The solvency solution for Europe: time to do the unthinkable (Reuters) and Germany May be Ready to Surrender Over Greece (Bloomberg) • Eveillard: Expect a Mania in [...]

[...] some cohesion coming out of Europe in the wake of the Geithner meeting; but none materialized. The grands lignes of what could be a plan are there, but the political hurdles in Germany seem still too [...]

[...] Can (And Eventually Will) Avert CollapseSeeking AlphaEurope Signals Global GloomWall Street JournalReuters Blogs (blog) -The National -Business Spectatorall 906 news [...]

[...] Can (And Eventually Will) Avert CollapseSeeking AlphaEurope Signals Global GloomWall Street JournalReuters Blogs (blog) -The National -Business Spectatorall 906 news [...]