Wednesday, December 21, 2011

The European Central Bank Considers a “Work Around” to Work Around the Rules That Forbid It From Loaning Money to European Governments

Making the Situation Worse, Not Better – That’s What Policy Makers Frequently Do

Here’s the problem:

About the only way that Europe can stave off a major economic and political and fiscal crisis is for the European Central Bank to buy the debt of nations like Italy and Spain. Private investors do not believe that those countries can pay off the debt that they currently owe, much less the debt that they will need in the future.  Failure of the ECB to act will leave Italy and Spain with interest rates so high their economies may go into severe recession, leaving them even more unable to raise money in the private markets.

The rules of the ECB forbid this. The ECB could buy the debt in the open market, and has done so in the past, but it cannot buy the debt directly and it cannot state that its policy is to support Italy and Spain’s debt no matter what.  So how does the ECB do what it has to do without violating the rules.

One solution would for the ECB to loan money to the International Monetary Fund, and the IMF would in turn use the new funds to loan to countries that cannot sell debt to anyone else.  At first glance this looks like a good idea. (and we all like that part about America not contributing).

In many ways this money-laundering would be a clever wheeze. It gets around the central bankers’ hang-ups. It provides discipline, since the fund’s conditionality would help to keep Europe’s peripheral economies on track. And it could elicit funds from others. America won’t contribute anything more to the IMF, but big emerging markets seem willing to top up the fund’s resources, provided the Europeans do so too. With Europe’s own rescue fund—the European Financial Stability Facility—floundering, the IMF may be the best route to raising real money.

So what is wrong with this plan that The Economist magazine calls “money laundering”.  Well, a couple of things.

Unfortunately, like many clever wheezes, this one is full of pitfalls, both for the Europeans and for the IMF. The fund, which already has over half of its outstanding loans in the euro zone, would become even more heavily exposed to one region.

The IMF, which for much of the world is all that stands between stability and global financial meltdown would incur a large amount of risk.  But even if it acquired the risk, it might make the situation worse rather than better.

The IMF is a preferred creditor, which means it always gets paid back first. Thus the more the fund lends to a country, the bigger the write-down for private creditors if there were ever a default.

An IMF rescue plan could spook investors rather than reassure them, particularly if parallels were drawn with Greece, Portugal and Ireland, which have already had rescue packages from the IMF and the Europeans, and show no sign of regaining access to financial markets.

So instead of resulting improving the market for sovereign debt, the ECB – IMF shell game could make things much more difficult, as the IMF moves in front of private creditors should Italy or Spain or Greece or Portugal or Ireland or who knows who else have to selectively default.

Here’s the ugly possibility

If the euro then falls apart, the IMF, the one institution that could pick up the pieces, will lack both the cash and credibility to do the job.

Everybody feel better now?  No, and its the Holiday season too.

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