How to stop a second Great Depression

Financial markets are driving the world towards another Great Depression. The authorities, particularly in Europe, have lost control of the situation. They need to regain control and they need to do so now.

Three bold steps are needed. First, the governments of the eurozone must agree in principle on a new treaty creating a common Treasury for the eurozone. In the meantime, the main banks must be put under European Central Bank direction in return for a temporary guarantee and permanent recapitalisation. The ECB would direct banks to maintain credit lines and outstanding loans, while closely monitoring risks taken for their own accounts. Third, the ECB would enable countries such as Italy and Spain to temporarily refinance themselves within limits at a very low cost. These steps would calm markets and give Europe time to develop a growth strategy, without which the debt problem cannot be solved.

The immediate task is to erect safeguards against contagion from a possible Greek default. There are two vulnerable groups – the banks and the bonds of countries such as Italy and Spain – that need to be protected. These two tasks could be accomplished as follows.This is how it would work. Since a eurozone treaty establishing a common Treasury would take a long time to conclude, in the interim the member states have to appeal to the ECB to fill the vacuum. The European financial stabilisation facility (EFSF) is still being formed but in its present form the new common Treasury is only a source of funds and how the funds are spent is left to the member states. It would require a new intergovernmental agency to enable the EFSF to co-operate with Europe’s central bank. This would have to be authorised by the Bundestag and perhaps other legislatures as well.

The EFSF would be used primarily to guarantee and recapitalise banks. Systemically important banks would have to sign an undertaking with the EFSF to abide by the instructions of the ECB as long as the guarantees were in force. Banks that refused would not be guaranteed. Europe’s central bank would then instruct the banks to maintain credit lines and loan portfolios while closely monitoring risks in their own accounts. These arrangements would stop the concentrated deleveraging that is one of the main causes of the crisis. Completing the recapitalisation would remove the incentive to deleverage.

To relieve the pressure on the government bonds of countries such as Italy, the ECB would lower its discount rate. It would then encourage countries to finance entirely by issuing Treasury bills, and banks to buy the bills. Banks could rediscount the bills with the ECB but they would not do so as long as they earned more on the bills than on the cash. This would allow Italy and other countries to refinance for about one percent a year during this emergency period. Yet the countries concerned would be subject to strict discipline because if they went beyond agreed limits the facility would be withdrawn. Neither the ECB nor the EFSF would buy any more bonds in the market.

These measures would allow Greece to default without causing a global meltdown. That does not mean that Greece would be forced into default. If it met targets, the EFSF could underwrite a “voluntary” restructuring at, say 50 cents on the euro. The EFSF would have enough money left to guarantee and recapitalise the European banks. It would be left to the International Monetary Fund to recapitalise the Greek banks. How Greece fared then would be up to the Greeks.

These steps would bring the acute phase of the crisis to an end by staunching its two main sources and reassuring markets that a longer-term solution was in sight. That solution would be more complicated because the regime imposed by the ECB would leave no room for fiscal stimulus and the debt problem could not be resolved without growth. How to create viable fiscal rules for the euro would be left to negotiations.

Many other proposals are under discussion behind closed doors. Most seek to leverage the EFSF by turning it into a bank or an insurance company or by using a special purpose vehicle. While practically any proposal is liable to bring temporary relief, disappointment could push financial markets over the brink. Markets are likely to see through inadequate proposals, especially if they violate Article 123 of the Lisbon treaty, which my proposal respects. That said, some form of leverage could be useful in recapitalising the banks.

This course of action does not require leveraging or increasing the size of the EFSF but it is more radical because it puts the banks under European control. That is liable to arouse the opposition of both the banks and the national authorities. Only public pressure can make it happen.

This article was first published by the Financial Times