George Kerevan: Redemption fund can be saviour of the eurozone

IT IS difficult to imagine how Greece can stay in the eurozone. Like the Asia tiger economies that defaulted in the 1990s, ordinary Greeks face the terrible prospect of having a competitive Drachma, solid economic growth of 5-10 per cent per annum, and the chance to raise a glass of Retsina to the misfortunes of their north European neighbours. (Unless, of course, the comic incompetence of Greek politicians leads to another shabby dictatorship.)

But what of the rest of us? Just how do we stop the Greek crisis turning into a financial tsunami that implodes the entire European banking system, including ours?

The key word is contagion. If Greece exits the eurozone, the financial markets will be unwilling to lend to other highly indebted economies, particularly Spain, Portugal and Italy. The EU and IMF simply don’t have the cash to make up the leeway. Result: the eurozone will plunge into a deeper recession, taking the UK with it.

Second, wary European banks will stop lending to each other. That will return them to the brink of insolvency unless the European Central Bank (ECB) provides emergency liquidity on a truly massive scale – something the German central bank, the Bundesbank, has long vetoed on the grounds it would be inflationary.

It is worth reminding ourselves why we are in this crisis, because it explains the solution. Faith in the pound is guaranteed by the Bank of England, which in the last resort will print currency to buy back government debt from the private market, thus putting a floor on its price. But the euro was created deliberately without this failsafe mechanism. Legally, the ECB can’t guarantee Greek government debt, or that of any other eurozone member.

The only way to stop a Greek exit leading to contagion in the bond markets is to collectivise eurozone sovereign debts. In other words, to issue eurobonds in the name of all the members, including Germany, which would pacify the financial markets. Plus give the ECB powers to buy these bonds in emergency.

There’s one wee barrier: the Germany constitution. According to the German Constitutional Court, the German parliament “is prohibited from establishing permanent mechanisms under the law of international agreements which result in an assumption of liability for other states’ voluntary decisions, especially if they have consequences whose impact is difficult to calculate.” Translation: no collective eurobonds.

Getting Germany to change its constitution would be mammoth task, even if her politicians were willing to do so to bail out Greece. Yet there may be a “fix” which gets round the problem. It’s called a redemption fund and has been put forward by the independent German Council of Economic Experts.

In this plan, individual eurozone countries still get to manage their own national debt up to a reasonable 60 per cent of GDP. Anything above – the excessive bit – is paid off immediately by a common redemption fund. This fund is financed cheaply through new, collectively guaranteed eurobonds underwritten by the ECB.

The big debtor countries would have to agree to strict rules on borrowing and spending before getting help from the fund. But freed of crippling interest payments, their economies should quickly get back to growth. From the proceeds of this growth the redemption fund is paid off over 25 years.

The redemption fund gets round the German constitutional rules, as you can calculate the liabilities, and because technically it does not assume the debt of other countries, but creates a new debt instead. Best of all, it is the big bazooka that could stabilise the markets following a Greek exit. But only if the eurozone acts fast. I’m doubtful it will.

That leaves another problem. We need the ECB to provide fresh liquidity while the banking system calms down. But Greece leaving the euro could torpedo the European Central Bank. This has to do with the so-called Target2 mechanism that lets European commercial banks settle payments between each other.

Suppose somebody signs a cheque in Athens to buy a BMW made in Munich. The money has to find its way from Greece to Germany. It does so via national central banks debiting their electronic accounts at the European Central Bank. All this is done automatically, in a trice, on the big computers at the ECB.

Because Germany is Europe’s biggest exporter, and because Greece exports very little, the reality is that vastly more money is going from the Greek banks to German banks. When the two payment streams are netted out at the ECB, Germany is owed euros. The ECB pays these euros instantly to Germany’s central bank (the Bundesbank) by creating them ‘electronically’ at its Frankfurt HQ.

The ECB is now “owed” by the Greek central bank. In accounting terms, that’s an asset – the very asset that allowed the ECB to invent the euros (liability) it gave to the German Bundesbank. Because it’s an asset, any accumulated Greek debt can sit on the ECB’s books, as cash flows wax and wane. But what happens if Greece quits the eurozone?

Probably, the ECB would be technically insolvent as the Bank of Greece would repudiate its Target2 debts, in turn forcing Germany and the remaining eurozone members to re-capitalise the ECB, at great cost to their taxpayers.

It is also a moot point whether the Bundesbank itself would be affected. Some commentators are worried the German central bank could become insolvent. When I was at the Bundesbank in March, any such suggestion was greeted with rigor mortis smiles. Personally, I think the possibility is remote because the ECB would just print more euros to meet its obligations to the Bundesbank.

Of course, that’s inflationary and the Bundesbank hates inflation. On the other hand, the solvency of the Bundesbank is not guaranteed by the German government, in order to protect the bank’s independence. So the ECB might get the upper hand, allowing it to bail out all of Europe’s banks. Keep your fingers crossed.