Eurozone needs to cut out the rot before it’s too late

Allister Heath
WHEREVER one looks, the signals are bad. The S&P 500 is down 14.5 per cent from its highest point of the year. The Vix, a measure of market turbulence, rose 9.4 per cent yesterday. Bank stocks tumbled everywhere. The Swiss franc went nuts when the authorities took the dramatic step to peg it to the euro, a possibly unworkable plan aimed at preventing the destruction of Swiss exports as its currency keeps on rising as a result of safe haven buying. Even though the UK and the US economy are still just about expanding, the vibes are ominous.

There are intense worries that weak growth and the possibility of a renewed slide in US house prices could hit the financial system hard. But the greatest fear of all, of course, is the Eurozone, which is on to a hiding to nothing. Several component states are insolvent in all but name; contagion fears are rife; nobody has a credible plan to do something about it.

There is still a chance that the EU will muddle through. If it doesn’t, the authorities need a Plan B. One thing is sure: it would be a disaster were the EU authorities or individual countries to end up launching deeply unpopular Tarp style capital injections for Eurozone banks that fail as a result of the stupidity and over-borrowing of governments. Capitalism will lay discredited across the continent if this turns into a bailout bonanza, fuelling populist, fascistic or extreme-left attitudes and a war on wealth. Instead, the authorities should encourage prudent firms in France and Germany to recapitalise privately; they could also allow the good ones to temporarily suspend capital requirements. But they should stand ready to seize and unwind insolvent banks, starting with the weaker ones in Greece, as Sweden famously did in the 1990s. Equity should be wiped out; top management fired; contracts suspended; and bondholders made to take a huge hit. All bad assets should be auctioned off and sold to the highest bidder. The banks should then be recapitalised and reprivatised as soon as possible, with the aim to minimise any taxpayer losses.

The central bank should stick to liquidity support to solvent banks in the event of a sudden collapse in the interbank-lending and money markets. Our monetary and banking system is predicated on the existence of central banks as the ultimate bank for private banks. The central bank’s lender of last resort function has been largely misrepresented over the past three years. It is not tantamount to a bailout, assuming that it is properly and fairly provided, that it doesn’t discriminate against smaller banks and that it doesn’t amount to a secret subsidy.

What should happen is that the central bank must take in collateral in exchange for providing otherwise unlimited amounts of liquidity to the system; if an asset provided as collateral has suddenly become illiquid and hard to value, the central bank’s job is to assess a fair value for it. The rate charged for this service should be steep. This doctrine was laid down in 1802 by Henry Thornton in his An Enquiry into the Nature and Effects of the Paper Credit of Great Britain and by Walter Bagehot in his Lombard Street in 1873. I actually believe that this kind of policy is second-best; there is a more efficient and less risky way of doing things that relies more on the market, as argued by George Selgin of the University of Georgia, Lawrence H White of George Mason University and others. But we live in the world we live in, and the European Central Bank and others ought to be prepared to produce as much liquidity as is needed to solvent banks if the present crisis intensifies.

Tragically, the Eurozone is repeating the errors of the past. The Greek state is insolvent; because its financial system owns a lot of the debt, it too is in trouble. This is a solvency problem, not a liquidity issue (though some other, much sounder EU banks may soon be contaminated by genuine liquidity issues if the crisis continues). Rather than gradually shifting much of the debt on other, more prudent European countries, which will merely fuel terrifying political tensions, the answer must be to face reality and amputate the rotten limbs.

Popular support for capitalism will only be possible if all industries are governed by profit and loss, not just profit and bailouts. Any outcome will be painful; but unless dud institutions and unrepayable debt are written off, this crisis will never end and the ensuing recession will drag on for years, discrediting our society.
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