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Proposal for a European Fiscal Authority (EFA), a Debt Reduction Fund and European Treasury Bills

By George Soros (People's Daily Online)

09:14, June 27, 2012

In retrospect it is now clear that the member states entered the monetary union that was incomplete in its construction. The main source of trouble is that the member states surrendered their right to print money to the ECB without fully realizing what that entails- and neither did the European authorities. When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank discounted all government bonds on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker countries to earn a few extra basis points. That is what caused interest rates to converge. The large fall in the cost of credit helped fuel housing and consumption booms, which went unchecked. At the same time, Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. This led to a wide divergence in economic performance.

Then came the crash of 2008 which created conditions far removed from those prescribed by the Maastricht Treaty. Governments had to bail out their banks and some of them found themselves in the position of a third world country that had become heavily indebted in a currency that they did not control. Due to the divergence in economic performance Europe became divided into creditors and debtors countries.

When financial markets discovered that supposedly riskless government bonds may actually be forced into default they raised risk premiums dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. That gave rise to an adverse feedback loop between the solvency of the banks problems of the banks and the risk premium on sovereign debt.

The Eurozone is now replicating how the global financial system dealt such crises in 1982 and again in 1997. Then the international authorities inflicted hardship on the periphery in order to protect the center; now Germany is unintentionally playing the same role. The details differ but the idea is the same: the creditors are shifting all the burden of adjustment onto the debtors and the “center” avoids its own responsibility for the imbalances. Interestingly, the terms “center” and “periphery” have crept into usage almost unnoticed. Yet in the euro crisis the responsibility of “the center” is even greater than it was in 1982 or 1997: they were the architects of a flawed currency system and failed to correct its defects. In the 1980’s Latin America suffered a lost decade; a similar fate now awaits Europe.

At the onset of the crisis a breakup of the euro was inconceivable: the assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reordered along national lines. This trend has gathered momentum in recent months. The LTRO enabled Spanish and Italian banks to buy the bonds of their own countries and earn a large spread. Simultaneously banks are giving preference to shedding assets outside their national borders and risk managers are trying to match assets and liabilities within national borders rather than within the eurozone as a whole.

If this continued for a few years a break-up of the euro would become possible without a meltdown but even then the creditor countries would be left with large claims against the debtor countries which would be difficult, if not impossible, to collect. In addition to all the rescue packages and ECB interventions the central banks have large claims against the central banks of the debtor countries within the Target2 clearing system. The Bundesbank had claims of 644 billion on April 30th and the amount is rapidly growing due to capital flight.

The creditor countries led by Germany are always willing to do what is necessary to avoid a cataclysm. But that is not enough to resolve the crisis so it continues growing. Tensions in financial markets have risen to new highs. Most telling is that Britain, which retained control of its currency, enjoys the lowest yields on government bonds in its history while the risk premium on Spanish sovereign debt is at a new high despite Spain’s deficit and debt to GDP ratio being lower than those of the UK. The real economy of the Eurozone as a whole is declining while Germany is still booming. This means that the divergence between debtors and creditors is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed.

What is needed is a set of bold initiatives that are convincing enough to persuade both the public and the financial markets that the authorities have both the will and the resources to make the euro work. These initiatives have to conform with the existing Treaties yet they have to be bold enough to bring conditions back closer to those that were prescribed by Treaties. The Treaties could then be revised in a calmer atmosphere so that the current excesses will not recur.

It is difficult but not impossible to construct a set of initiatives that will meet these tough requirements. They would have to simultaneously tackle the banking and the sovereign debt problems without neglecting to reduce divergences in competitiveness. There are various ways to provide it but they all need the active support of Germany as the largest creditor country.

At the Rome meeting on Thursday June 22 the four heads of state agreed on steps towards a banking union and a modest stimulus package to complement the fiscal compact but Chancellor Merkel resisted all proposals to provide relief to Spain and Italy from the excessive risk premiums prevailing in the market. This threatens to turn the June summit into another fiasco which may well prove fatal because it will not provide a strong enough firewall to protect the rest of the eurozone against the possibility of a Greek exit. Even if a fatal accident can be avoided the divisions between creditor and debtor countries will be reinforced and the “periphery” countries will have no chance of regaining competitiveness because the playing field is tilted against them. This may serve Germany’s narrow self-interest but it will create a Europe that is very different from the open society that fired people’s imagination. That is not what Chancellor Merkel or the overwhelming majority of Germans stand for.

Chancellor Merkel argues that it is against the rules to use the ECB to solve the fiscal problems of member countries and she’s right. President Draghi of the ECB has said much the same. There is a missing element in the current plans and this proposal is designed to provide it.

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