Saturday, July 28, 2012

German Left Party proposes new way to save euro

As reported by Der Spiegel, the German Left Party has put forth a proposal based on the idea of rebooting the market economy and then cushioning the fall.

Regular readers know that this is the basis for your humble blogger's blueprint for saving the financial system.

Step one in the blueprint was for the excess debt in the financial system to be written down and losses realized by the banks.

Step two was to realize that banks can continue to operate and support the real economy even with negative book capital levels.  They can do so because of deposit insurance and access to central bank funding.  The deposit insurance means that taxpayers are 'silent' equity investors in the banks while they have negative book capital levels.

Step three was to require the banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market participants could confirm the banks had absorb the losses on the excess debt and exert discipline on the banks to restrain their risk taking.

The German Left Party proposed
First and foremost, [Sahra] Wagenknecht calls for a radical debt haircut. "The EU member states should resolve that all sovereign debt above a certain level will not be paid back," she writes. 
Wagenknecht proposes using 60 percent of a country's annual gross domestic product as the cutoff -- meaning that even Germany, with its debt load worth some 80 percent of GDP, would have to partially default.
A call for recognizing losses on the excess debt in the financial system.
Such a euro-zone-wide partial default, of course, would result in the bankruptcies of several European banks and insurance companies due to the amount of European sovereign bonds they carry on their balance sheets. 
"The financial industry has seriously underestimated the risks associated with sovereign bonds," Wagenknecht writes. Banks and insurance companies, she notes, provided euro-zone member states with fresh capital to the extent that their debt loads have now become unmanageable. Her plan, she adds, merely reflects that "risk and liability are linked in a market economy."
It is important to repeat that as a result of taking the losses the banks would have negative book capital levels.  However, they would not have to be closed.

Rather, those banks that had a franchise that was capable of generating earnings could retain 100% of pre-banker bonus earnings until such time as they had restored positive book capital levels.
It is a sentence that could just as well have come from the party platform of the business-friendly Free Democrats on the center-right of the political spectrum. Indeed, the same could be said for large parts of Wagenknecht's approach to the euro crisis. 
But the Left Party politician has also included measures that would reduce the economic effects of a banking crash. 
Following a "technical moment of insolvency," her plan calls for the state to inject fresh capital into the banks so that they can continue serving those sectors that are required for the economy to function. 
In other words, they would manage customer accounts and extend loans to companies in the real economy, thereby fending off a recession.
My blueprint differs from her suggestion because the banks can continue to manage customer accounts and extend loans to companies in the real economy without being recapitalized by the state.
Much of the investment banking sector, on the other hand, would be liquidated as part of the insolvency proceedings.
In my blueprint, the proprietary trading area of the investment banking sector would be eliminated because the banks were required to provide ultra transparency.  The fact that all market participants could see what the banks were doing would make it difficult to profit from proprietary trading.
The state would also guarantee up to €1 million ($1.2 million) per person in savings and life insurance value. "Anything beyond that would be defaulted as part of the insolvency," Wagenknecht writes.
Since the state does not have to invest in recapitalizing the banks, it might set higher guarantees on savings and life insurance value. 
Under her plan, of course, it would not only be banks that became insolvent, but also countries. And when that happens, those countries are generally shut out from international financial markets for many years. 
Wagenknecht, however, believes she has found a way around that problem. 
Euro-zone states would be able to receive a certain amount of financing directly from the European Central Bank (ECB), but only up to a certain maximum -- Wagenknecht suggests capping it at 4 percent of GDP annually. 
Under her plan, the ECB would remain independent and continue to focus on controlling inflation and maintaining full control over the money supply in the euro-zone. However, most of the fresh money the bank pumped into the euro zone would no longer flow into the banks but, rather, it would directly benefit national budgets. 
"At the moment, the ECB is pouring money into the banks in the hope that they will invest a small percentage of it in sovereign bonds," she writes. "It would be much more efficient to give this small percentage directly to the states." 
Finally, she envisions having banks extend loans almost exclusively on the strength of the deposits of their customers.
The experience of Iceland suggests that countries can return to the financial markets fairly quickly.

Rather than try to stretch the ECB's mandate, it might be easier to use the IMF.  It is funded and it has a mandate to support these types of loans until a country can return to the capital markets.
Still, there are a number of positives to Wagenknecht's approach. Her model would finally let the air out of Europe's gigantic debt bubble -- one that has hung over the global economy for almost a decade now. 
As would following my blueprint.
Furthermore, the application of strict market economy principles to the banking crisis could cure them of their addiction to high-stakes gambling. 
Requiring banks to provide ultra transparency would cure them of their addiction to high-stakes gambling.
After all, the supposedly "mandatory" steps that have characterized the euro zone's response to the crisis thus far have done nothing but reward banks for their incredibly risky business models.
This is the result of having adopted the Japanese model for handling a bank solvency led financial crisis.  Banks get to continue doing what they did that led to the solvency problem in the first place.

The German Left Party is effectively endorsing the Swedish model for handling a bank solvency led financial crisis.  They are requiring the banks to recognize the losses hidden on and off their balance sheets.

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