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Pick a Bunny Trail

10/26/2011

The good news is that national leaders in Europe have finally realized the grave condition of their financial system and are committed to saving it.  The bad news is that they don’t know how!

In July, they agreed to set up a European Financial Stability Fund (EFSF), with about 440 billion euros or $600 billion.  Now, there is general agreement that is too little but no agreement on how to increase it.

Most Europeans favor a quantitative easing approach by the European Central Bank (ECB), which would buy unlimited amounts of sovereign debt.  (Greek bonds are not included, which will get a haircut of about 60%)

The Germans favor an insurance approach, whereby the EFSF would guarantee the top 20% of most soverign debt.  This extends the power of the EFSF to almost $3 trillion  ($600 billion times five)  But, doesn’t this smell like AIG?

Another trail is to simply let the defaults occur.  Since the bondholders are mostly European banks, this would require the governments to re-capitalize the banks by injecting new taxpayer money.  Some estimates are that this will only cost about 140 billion euros, which is the cheapest scenario.  The problem is that the bondholders are not evenly dispersed across Europe.  Most are German and French, placing the burden on northern Europe and excusing the profligate southern Europe.

A new trail is to set up a Special Purpose Vehicle (SPV), whereby a separate entity would raise money by selling bonds to the EFSF, as well to the IMF and to the market.  While there are few details, the idea is that they would then use this money to leverage up enough to take the place of the ECB in quantitative easing. The thinking is that this would save the ECB.

Remembering Alan Greenspan’s prediction that the European Union will eventually fail because it has no unified fiscal policy, will this finally force that next step in European integration?  Or, is that just a bunny trail?

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