Dear Friends and Colleagues, 

George Soros has written two Op-Eds which were published in the last few days discussing his ideas on how to save the euro. The first, "Three steps to resolving the eurozone crisis", was published in the Financial Times this morning, and the second piece, "Germany must defend the euro", was published last week. 

All best, 

Michael Vachon


Three steps to resolving the eurozone crisis

Financial Times 

August 14, 2011 

A comprehensive solution to the euro crisis must have three major components: reform and recapitalisation of the banking system; a eurobond regime; and an exit mechanism. 

First, the banking system. The European Union’s Maastricht treaty was designed to deal only with imbalances in the public sector; but excesses in the banking sector have been far worse. The euro’s introduction led to housing booms in countries such as Spain and Ireland. Eurozone banks became among the world’s most over-leveraged, and they remain in need of protection from counterparty risks. 

The first step was taken by authorising the European financial stability facility to rescue banks. Now banks’ equity capital levels need to be greatly increased. If an agency is to guarantee banks’ solvency, it must oversee them too. A powerful European banking agency could end the incestuous relationship between banks and regulators, while interfering much less with nations’ sovereignty than dictating their fiscal policies. 

Second, Europe needs eurobonds. The introduction of the euro was supposed to reinforce convergence; in fact it created divergences, with widely differing levels of indebtedness and competitiveness. If heavily indebted countries have to pay heavy risk premiums, their debt becomes unsustainable. That is now happening. The solution is obvious: deficit countries must be allowed to refinance their debt on the same terms as surplus countries. 

This is best accomplished through eurobonds, which would be jointly guaranteed by all the member states. While the principle is clear, the details will require a lot of work. Which agency would be in charge of issuing, and what rules would it follow? Presumably the eurobonds would be under eurozone finance ministers’ control. The board would constitute the fiscal counterpart of the European Central Bank; it would also be the European counterpart of the International Monetary Fund. 

Debate will therefore revolve around voting rights. The ECB operates on the principle of one vote per country; the IMF assigns rights according to capital contributions. Which should prevail? The former could give carte blanche to debtors to run up deficits; the latter might perpetuate a two-speed Europe. Compromise will be necessary. 

Because the fate of Europe depends on Germany, and because eurobonds will put Germany’s credit standing at risk, any compromise must put Germany in the driver’s seat. Sadly, Germany has unsound ideas about macroeconomic policy, and it wants Europe to follow its example. But what works for Germany cannot work for the rest of Europe: no country can run a chronic trade surplus without others running deficits. Germany must agree to rules by which others can also abide. 

These rules must provide for a gradual reduction in indebtedness. They must also allow countries with high unemployment, such as Spain, to run budget deficits. Rules involving targets for cyclically adjusted deficits can accomplish both goals. Importantly, they must remain open to review and improvement. 

Bruegel, the Brussels-based think-tank, has proposed that eurobonds constitute 60 per cent of eurozone members’ outstanding external debt. But given the high risk premiums prevailing in Europe, this percentage is too low for a level playing field. In my view, new issues should be entirely in eurobonds, up to a limit set by the board. The higher the volume of eurobonds a country seeks to issue, the more severe the conditions the board would impose. The board should be able to impose its will, because denying the right to issue additional eurobonds ought to be a powerful deterrent. 

This leads directly to the third unsolved problem: what happens if a country is unwilling or unable to keep within agreed conditions? Inability to issue eurobonds could then result in a disorderly default or devaluation. In the absence of an exit mechanism, this could be catastrophic. A deterrent that is too dangerous to invoke lacks credibility. 

Greece constitutes a cautionary example, and much depends on how its crisis plays out. It might be possible to devise an orderly exit for a small country like Greece that would not be applicable to a large one like Italy. In the absence of an orderly exit, the regime would have to carry sanctions from which there is no escape – something like a European finance ministry that has political as well as financial legitimacy. That could emerge only from a profound rethinking of the euro that is so badly needed (particularly in Germany). 

Financial markets might not offer the respite necessary to put the new arrangements in place. Under continued market pressure, the European Council might have to find a stopgap arrangement to avoid a calamity. It could authorise the ECB to lend to governments that cannot borrow until a eurobond regime is introduced. But only one thing is certain: these three problems must be resolved if the euro is to be a viable currency. 

Germany must defend the euro

August 12, 2011 

Financial markets abhor uncertainty; that is why they are now in crisis mode. The governments of the eurozone have taken some significant steps in the right direction to resolve the euro crisis but, obviously, they did not go far enough to reassure the markets. 

At their meeting on July 21, the European authorities enacted a set of half-measures. They established the principle that their new fiscal agency, the European Financial Stability Fund (EFSF), should be responsible for solvency problems, but they failed to increase the EFSF’s size. This stopped short of establishing a credible fiscal authority for the eurozone. And the new mechanism will not be operative until September at the earliest. In the meantime, liquidity provision by the European Central Bank is the only way to prevent a collapse in the price of bonds issued by several European countries. 

Likewise, Eurozone leaders extended the EFSF’s competence to deal with banks’ solvency, but stopped short of transferring banking supervision from national agencies to a European body. And they offered an extended aid package to Greece without building a convincing case that the rescue can succeed: they arranged for the participation of bondholders in the Greek rescue package, but the arrangement benefited the banks more than Greece. 

Perhaps most worryingly, Europe finally recognized the principle – long followed by the IMF – that countries in bailout programs should not be penalized on interest rates, but the same principle was not extended to countries that are not yet in bailout programs. As a result, Spain and Italy have had to pay much more on their own borrowing than they receive from Greece. This gives them the right to opt out of the Greek rescue, raising the prospect that the package may unravel. Financial markets, recognizing this possibility, raised the risk premium on Spanish and Italian bonds to unsustainable levels. ECB intervention helped, but it did not cure the problem. 

The situation is becoming intolerable. The authorities are trying to buy time, but time is running out. The crisis is rapidly reaching a climax. 

Germany and the other eurozone members with AAA ratings will have to decide whether they are willing to risk their own credit to permit Spain and Italy to refinance their bonds at reasonable interest rates. Alternatively, Spain and Italy will be driven inexorably into bailout programs. In short, Germany and the other countries with AAA bond ratings must agree to a eurobond regime of one kind or another. Otherwise, the euro will break down. 

It should be recognized that a disorderly default or exit from the eurozone, even by a small country like Greece, would precipitate a banking crisis comparable to the one that caused the Great Depression. It is no longer a question whether it is worthwhile to have a common currency. The euro exists, and its collapse would cause incalculable losses to the banking system. So the choice that Germany faces is more apparent than real – and it is a choice whose cost will rise the longer Germany delays making it. 

The euro crisis had its origin in German Chancellor Angela Merkel’s decision, taken in the aftermath of Lehman Brothers’ default in September 2008, that the guarantee against further defaults should come not from the European Union, but from each country separately. And it was German procrastination that aggravated the Greek crisis and caused the contagion that turned it into an existential crisis for Europe. 

Only Germany can reverse the dynamic of disintegration in Europe. That will not come easily: Merkel, after all, read the German public’s mood correctly when she made her fateful decision, and the domestic political atmosphere has since become even more inhospitable to extending credit to the rest of Europe. 

Merkel can overcome political resistance only in a crisis atmosphere, and only in small steps. The next step will likely be to enlarge the EFSF; but, by the time that step is taken, France’s AAA rating may be endangered. Indeed, by the time Germany agrees to a eurobond regime, its own AAA standing may be at risk. 

The only way that Europe can escape from this trap is by acting in anticipation of financial markets’ reactions, rather than yielding to their pressure after the fact. This would require intense debate and soul-searching, particularly in Germany, which, as the EU’s largest and best-rated economy, has been thrust into the position of deciding the future of Europe. 

That is a role that Germany has been eager to avoid and remains unwilling to accept. But Germany has no real choice. A breakdown of the euro would precipitate a banking crisis that would be beyond the global financial authorities’ ability to control. The longer Germany takes to recognize this, the higher the price it will have to pay.

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