Sunday, 25 September 2011

EFSF leveraging - a miserable accounting trick

The Euro rescue fund, known as EFSF, could be made bigger at no extra cost to the tax payer - or so leading Eurocrats seem to suggest. To me, this looks like a bad accounting trick. Currently scheduled to top out at a lowly €440 bn, the fund could be allowed to leverage itself by borrowing from the ECB. In that way, it could, say, get 5€ for each € of capital, and really get going on ... buying Italian, Spanish, and Greek sovereign bonds. Overall, the EFSF's firepower could amount to a cool 1.5-2 trillion €. Surely, that would be enough to banish the default genie back into its bottle?

I have no view on whether 2 trillion would do the trick. Eventually, once almost all public debt of Southern Euro member states is owned by either the EFSF or the ECB, politicians can safely ignore what the markets say. A couple of trillion help, but they won't last for more than a year or two. Leveraging the EFSF reminds me of one of Private Baldrick's cunning plans (link here), of Captain Blackadder fame. The reason is simple -- the leveraging is simply a silly accounting stunt. If the EFSF buys a euro of government debt, and it goes bad, who pays? The EU taxpayer. If it leverages that investment, by borrowing from the ECB 5 euros, and the investment goes bad, who pays? Exactly. Either the Euro taxpayer (by underwriting the leveraged loss of the EFSF) or the Euro taxpayer (by having to recapitalize the ECB after it loses a ton of money). If politicians feel they cannot, in good conscience, explain more than €440 bn in rescue funds to their voters, then they cannot justify the idea of leveraging.

Of course, the idea of going for broke shows just how fundamentally flawed and unworkable the system of ever-greater rescue packages really is. The alternative? Let the Greeks default. Nationalize and recapitalize the banks that lose their shirts - and use this as a golden opportunity to cut the banks down to size, by selling the nationalized banks in sizes that are 1/10 of their size today. That way, we also reduce the risk of a major financial meltdown every time a bank gets into trouble.

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