Any proposed resolution to the European crisis over the next few days will have to be economically viable as well as politically palatable to both the rescuers and the rescued if it is to restore confidence to the sovereign bond markets. This means paying attention not just to the technical details but also to how it is presented.
Some institution – either the IMF or the European Financial Stability Facility with funding from countries or the European Central Bank – has to stand ready to fund borrowing by Italy, Spain, and any other potentially distressed countries over the next year or two. Crucially, if this funding is senior and therefore higher priority to private debt – as IMF funding typically is – it will be harder for these countries to regain access to markets. For the more a country borrows in the short term from official sources, the further back in line it will push private creditors, making them susceptible to larger haircuts if the country eventually does default. Therefore official funding must be have loss-bearing capacity and be treated no different from private debt.
A credible plan out of the crisis must also include a monitored pledge by the banks in the eurozone that they will not unload bonds as the official sector steps in, that they will be circumspect about bonuses until economies start growing strongly again and that they will raise capital over time instead of continuing to deleverage – if this hurts equity holders, they should think of this as burden sharing. Cries that this is not capitalism should be met with the retort: “neither are bail-outs!”. Continue reading »