Eurozone solution: Save banks, not nations
The eurozone needs an enforcer who can tell lawmakers what they don't want to hear: They have to let some eurozone nations fail and make sure eurozone banks don't.
What Europe needs now is a good "heavy," a bad hombre who talks tough enough to scare the politicians and citizens into doing the right things – and who will make them face the consequences if they don't.Skip to next paragraph
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An enforcer seems to be the only way to shove Europe's debt-laden nations toward fiscal sustainability and keep the eurozone from blowing up. The problem is: The obvious candidates for the post aren't up to the job.
A European fiscal union could swing the job. For Germany to agree on any union in which it and other strong members would guarantee Eurobonds that bail out weaker nations, it would demand the kind of stringent rules and accountability that are sorely needed. While this fiscal union may be gradually taking shape, it remains patchy at best and lacks a defined process to rescue struggling nations.
So European policymakers need to embrace the only enforcer they currently have: the bond market itself. As Greece, Ireland, and Portugal have already found out, the bond market is a particularly unforgiving taskmaster that cares not one whit for diplomatic niceties or political sensitivities. When it speaks, it tells uncomfortable truths.
The first truth the eurozone needs to understand is particularly uncomfortable: Member nations may default. Government defaults are nothing new. However, the eurozone should take great care that a default does not lead to an implosion of its financial system, as it would cripple the real economy.
That leads to the second uncomfortable truth: If the eurozone is to survive, policymakers will have to stop trying to save European nations and save European banks instead.
Banks have one major advantage over nations. While nations must go into the market to fund themselves, banks can use their central bank. Banks employ a business model that uses substantial leverage. While the leverage makes banks vulnerable, central banks can keep even a technically insolvent banking system afloat.
Importantly, any capital injection can support a high multiple of debt. That's why the US Treasury injected money into the banking system in the fall of 2008 as part of the infamous Troubled Asset Relief Program (TARP) program rather than purchasing toxic assets outright. Europeans had their own bank bailouts at the time. As politicians worldwide weigh the cost of acting versus the cost of inaction, they are aware that further bailouts may amount to political suicide.
Still, in Europe, the focus must be on making eurozone banks strong enough to stomach sovereign defaults. Bank runs need to be avoided, thus making the sovereign default more digestible for the economy as a whole. You can't avoid losses, but you can avoid a financial meltdown.
The good news is that high borrowing costs provide indebted governments the "encouragement" to reduce spending; indeed, the language of the bond market may be the only language that forces policymakers into action.
This is a global financial crisis. Simply put, there is no such thing anymore as a safe asset. Investors may want to take a diversified approach to something as mundane as cash. Just as China diversifies its reserves into a basket of currencies, individuals may want to consider doing the same.