EFSF plan can help leaders finally get a step ahead of the markets

ECONOMICS:" WE HAVE entered a dangerous new phase of the crisis. Weak growth and weak balance sheets are feeding negatively on each other, fuelling a crisis of confidence and holding back demand, investment and job creation. This vicious cycle is gaining momentum and, frankly, it has been exacerbated by policy indecision and political dysfunction. This is no time for retreat, for half measures, or for muddling through." Christine Lagarde, IMF managing director

“We spoke about the financial markets and the fact that politicians should have the power to make policy for the people, and not be driven by the markets.”

Angela Merkel on her recent discussions with the Pope

These quotes by the two leading ladies of the crisis highlight both the existential nature of the crisis and the policy chasm that exists. The future of the euro hangs on which of them prevails.

First, we should acknowledge how far Europe has come. The no-bailout principle in the Lisbon Treaty is a fading memory. Vast amounts of money have been pledged for Greece, Ireland and Portugal and the terms attaching have been eased dramatically.

The gain to Ireland from the lower interest rates announced in July is about €10 billion, sufficient to lower the debt-GDP ratio by 7 per cent and we are now funding at rates well below Italy and Spain.

Then there is the ECB. The weekend newspapers are full of anti-ECB rhetoric. This is understandable given the deplorable way it treated Ireland last autumn, but suggestions that the ECB should waive Irish debt or, indeed, single-handedly solve all the euro’s problems are, as Michael Noonan said, “deranged”. The ECB, too, has come a long way. Its early support for euro zone banks compares favourably with other central banks and its bond-purchase programmes push the boat out a long way given its more limited mandate and exclusive focus on price stability. It is the only EU institution that has increased its credibility.

It has also made huge mistakes. Interest rate hikes in 2008 and again this year were major blunders. Moreover, its attempts to force Irish banks to deleverage in a three-month period are indicative of an organisation that knows the theory but is lacking in practical experience and devoid of common sense. It is worrying that the troika takes its banking advice from the ECB.

Despite the progress made, Europe still has major problems. Solutions such as eurobonds, whereby funding would be done centrally, with joint and several liability, are clearly long term. Effectively, Germany and the other AAA countries would give the benefit of their credit rating to the rest and would carry the can if others defaulted.

There is little prospect of this without much closer political and fiscal union. How far this would go remains to be seen; at a minimum, budgets and debt levels would be determined centrally.

Though not strictly necessary, France might insist on greater harmonisation of tax rates. Referendums would be necessary in most countries, including Germany and Ireland.

For Ireland, the effective choice would be whether or not to exit the euro. Perhaps it is time we began to face up to this reality.

The emergency measures announced in July are more radical than is generally recognised. The Greek market funding required to 2020, €450 billion, was slashed by 90 per cent and the net, as distinct from the gross, debt ratio was pared significantly.

Those who say that Greece is insolvent rarely do the calculations. Only two weeks ago, William Cline of the Peterson Institute, calculated that Greece was solvent with net debt falling from 120 per cent of GDP now to 69 per cent by 2020. This is disputed but at least it is an informed view.

The prospects for other peripheral countries are better – the extent to which Ireland is singled out for praise abroad these days is almost embarrassing – but the markets have attacked Spain and Italy because the size of the bailout fund is not sufficient to buy all their maturing debt.

To break the current cycle, EU leaders need to get ahead of the markets once and for all. Hence, the proposal to increase the effective size of the European Financial Stability Facility (EFSF) to several trillion euro.

Initially, EFSF borrowings for lending on to programme states were backed by guarantees from the 16 euro countries with Ireland on the hook for €7 billion (see table). In June, the maximum guaranteed commitments were increased to €780 billion ( €726 billion when Greece, Ireland and Portugal are excluded). To keep the rating agencies happy, the fund is to be over-guaranteed by a factor of 65 per cent – ie its effective size will be €440 billion which was the original intention.

In July, further amendments to allow the EFSF to fund governments to enable them to recapitalise their banks, to directly buy government bonds on secondary markets and to provide second bailouts if necessary, were tabled. These proposals are being ratified by the national parliaments.

Germany and others are opposed to further increasing the EFSF. There is a danger that such moves would endanger their AAA ratings and make the whole thing unworkable.

Solutions to this impasse involve increasing EFSF firepower by leveraging it. Leveraging is what Seán Quinn did to Anglo – you cough up €200 million to buy €2 billion worth of shares.

The EFSF would purchase, say, €100 billion of Greek government bonds (at 50p in the pound), swap them with the ECB for 90 per cent of the purchase price, using the cash to buy more bonds and repeating the exercise ad nauseum. In this example, the potential firepower is €4.4 trillion.

Modelled on the US equivalent of the EFSF and proposed at a recent Bruegel-Peterson Institute seminar, this notion was espoused by US treasury secretary Timothy Geithner and was canvassed widely at the recent IMF annual meetings. There are other variants but that is the basic idea.

It is only a stop gap because it does not guarantee that recipients such as Italy would be fiscally responsible – that is why a more permanent long-term solution is also needed.

There are, moreover, serious obstacles. The ECB is against it and the German president has described it as legally questionable. With no alternative in sight, it’s time to put on the hard hats.