A Europlan that Works

Winston Churchill once remarked that "American can always be counted on to do the right thing... after they have exhausted all other possibilities." While the veracity of this statement is certainly up for debate, it seems  to apply to European policymakers in today's context.

Over the last 18 months a litany of ineffective plans have been drafted and implemented to deal with the sovereign debt crisis. Leaving various nuances aside, these plans are pretty effectively summed up by the following: (1) Provide country X with Y billion euros in loans at below-market rates, (2) force austerity on country X, (3) declare that country X is illiquid rather than insolvent and reiterate commitment to no bankruptcies in the euro area (4) on the basis of illiquidity rather than insolvency, have the ECB purchase country X's bonds. Keen minds in financial markets saw through each of these plans (Macro Man has offered a concise analysis of the failings of each plan), and the market disruptions they were designed to end always re-emerged.

The most recent bout of market instability differed from those which preceded it in that it posed an immediate existential threat to the European banking sector. This seems to have finally woken European policy makers up to the scale and severity of the problem. A series of meetings (and subsequent statements/announcements), as well as various leaks have offered observers a glimpse of the plan being negotiated. It appears to include the following:

1. A forced Greek default, with a haircut of 40-50%.
2. A commitment that no other countries will be allowed to default (this will require either a larger EFSF or more bond purchases by the ECB to be credible).
3. Bank recapitalizations. There is to be a new round of stress tests including a much harsher set of assumptions surrounding sovereign debt valuations. Where the estimated 200 billion euros necessary to get all European banks to the targeted 9% tier 1 capital under the stressed scenario will come from is to be determined, but it seems that there are enough good credits in Europe to raise the money.

The current expectation is for the final details to be ironed out by the end of the meeting of the G20 on November 3-4. Should the plan emerge as a credible version of the points above, I would consider it sufficient to contain the European sovereign (banking) crisis for a considerable period of time.

It is important to point out that the plan, in the form outlined above, would not address the longer-term structural issues I outlined in my earlier post. However, it would mitigate the more immediate threat, giving policy makers time to make the necessary adjustments to the legal structure governing the euro area (I am not particularly optimistic that the necessary changes will be made, however that is a discussion for another day).