INET Council on the Euro zone crisis vs. Mr. Draghi
July 26, 2012
This Monday (July 23), the Institute for New Economic Thinking, Council on the Euro Zone Crisis issued a noteworthy report, "Breaking the Deadlock: A Path Out of the Crisis". In it, the Council lays out with great clarity the structural causes of the Euro crisis, namely: divorcing monetary policy from fiscal policy and bank supervision, extracting money supply control from individual sovereigns, and eliminating exchange rate adjustments between members of the union.

Further, it essentially proposes two varieties of solutions. The first aims at more integration between Euro zone countries: a banking union with powers to supervise and, if necessary, dissolve banks; Euro-wide financial reform to refocus the financial system on economically beneficial activities; a "debt-restructuring regime" for countries troubled beyond rescue; and more fiscal surveillance by the European Parliament.

The second variety is familiar in that the Council essentially proposes to mimic the cooperation of the U.S. Treasury and Federal Reserve in financing government debt. Circumventing the complications associated with Eurobonds (i.e., the need for re-forging the ECB's statutes, enforcing shared responsibility for sovereign debt, etc.), they propose two alternative and complementary solutions.

First, the European Stability Mechanism (ESM) could be granted a banking license to finance itself through the ECB discount window. It would thus function as lender of last resort and be able to help troubled countries through crises -- that is, after current debt levels and capital flight is dealt with -- without requiring tedious alterations in European law.

Second, a "common risk-free asset", similar to U.S. Treasuries, could be issued by a to-be-created European agency, to cut the cord between a given sovereign and its banks.

In terms of the latter, the report falls a little bit short of explanation, referring to a 2011 paper on the subject (Brunnermeier et al., "European Safe Bonds"). The idea, in essence, is to create an agency that buys sovereign bonds (a nationaEUR(TM)s debt) up to a fixed maximum that is linked to the country's debt riskiness and the size of its economy. The agency then issues senior and junior tranche bonds of its own, using the sovereign debt as collateral. The mechanism is given value by regulators assigning these bonds zero risk weight, and the ECB insisting on them as collateral. This would cut market frenzies out of the financing process of sovereigns and provide the financial system with an opportunity to flee into a different asset class instead of the different sovereigns.

In light of this, it is rather curious that Mario Draghi, the ECBaEUR(TM)s president, would announce that the European Central Bank would do "whatever it takes" to save the Euro, only three days after the report was published. The markets, of course, rallied in a sort of knee-jerk reaction, as they usually do. But what did Draghi actually commit to? Nothing of substance. Instead he lectures about liquidity and risk aversion in the interbank lending market, which, he assures, has been "taken care of" with the ECB's Long-Term Refinancing Operations (LTRO). Draghi then goes on about the necessity of creating a European-wide deposit insurance system and supervisory authority, the establishment of which is outside of the reach of his power.

So, what was the purpose of Draghi's comments? To set the stage for the INET Council's proposals put into practice? To refocus the cause-of-the-Euro-crisis debate on things he can influence?

Only one thing is certain: with the ECB's statute prohibiting sovereign bail-out, Draghi's hands are tied.