Daniel Gros Suggests a Solution to Euro Crisis

Aug 14, 2011 Comments Off on Daniel Gros Suggests a Solution to Euro Crisis by

Daniel Gros writing in the Social Europe Journal makes the case for an ECB mega bail-out of the ESFS enabled by making it a bank.  Interesting. Here are his main points….

…The bank-government-debt snare

As usual, banks are the weakest link and are subject to another domino effect.

Many banks hold large amounts of Eurozone government debt;
Their credit rating can never be above that of their own sovereign.
Anyone expecting a country’s downgrade should also sell the shares of its banks.

This, in turn, increases the cost of capital for the vulnerable banks making them more vulnerable.

Other banks – who see the falling bank share prices and widening credit-default spreads – react by refusing to provide the vulnerable banks with interbank liquidity.
This breakdown in the interbank market, in turn, leads to a breakdown of the credit circuit.

This is what lead to the “immediate recession” experienced after the Lehman bankruptcy showed.

These days it seems that the equity markets are anticipating a doomsday scenario with the economy going abruptly into recession as the interbank market breaks down under the anticipation of further public debt problems. Unfortunately this anticipation will be realized unless the breakdown of the interbank market is addressed very soon.

What needs to be done

At this point the Eurozone needs a massive infusion of liquidity. Given that the cascade structure of the EFSF is part of the problem, the solution cannot be a massive increase in its size. However, the EFSF could simply be registered as a bank and could then have access to unlimited re-financing by the ECB, which is the only institution which can provide the required liquidity quickly and in convincing quantity.

This solution would have the advantage that it leaves the management of public debt problems in the hand of the finance ministries, but it provides them with the liquidity backstop that is needed when there is a generalised breakdown of confidence and liquidity. This is exactly when a lender of last resort is most needed.

It would of course be much better if the ECB did not have to ‘bail out’ the European rescue mechanism, but in this case one has to choose between two evils. Even a massive increase in the ECB’s balance sheet (which if the US experience is any guide will not lead to inflation) constitutes a lesser evil compared to a breakdown of the Eurozone financial system.

This column was first published by Voxeu.org

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