Europe’s debt crisis could be contained by using the European Central Bank to make up to 5 trillion euros ($6.7 trillion) available through a euro-area rescue fund, according to a “strategy game” conducted by about 50 experts and former government officials.
The European Financial Stability Facility, the euro area’s temporary bailout fund, would be on the hook for any losses incurred by the rescue effort, according to scenarios explored during a two-day meeting in Paris earlier this month. At the same time, the EFSF could have a reserve of ECB cash to act decisively when needed.
“What Europe needs is action,” Edwin Truman, a former U.S. Treasury and Federal Reserve official who took part in the exercise, wrote in an article about the event published on the website of the Washington-based Peterson Institute for International Economics. “The unpleasant fact of life is that markets can mobilize almost unlimited financial firepower to communicate their skepticism. The European authorities must respond commensurately.”
Truman said the details of how the EU would leverage its rescue plan are secondary to a clear commitment from policy makers. The broader need is to transform the 440 billion-euro EFSF into an “overwhelming financial force” to fight the crisis.
In the strategy game, participants played the roles of countries, central banks, financial markets and voters. It was organized by the Peterson Institute and the Brussels-based Bruegel economic think tank.
“In a notable feature of the game, contrasting with some of the discussing of the first day, no concerns surfaced among the players about a possible breakup of the euro area,” the Peterson Institute wrote in a summary posted on its web site. “Lingering wariness over the economic outlook in Europe was widespread, on the other hand.”
German officials have so far rejected using the ECB to increase the power of the bailout fund, warning it could push the central bank further into the realms of fiscal policy. Bundesbank President Jens Weidmann said on Sept. 17 that he also attached “big question marks” to the idea of allowing the facility to run like a bank.
A properly designed leverage program “does not amount to monetary financing of government debt,” said Guntram Wolff, Bruegel’s deputy director and a participant in the exercise. He proposed a program in which the EFSF would buy government bonds of countries affected by the crisis and then lend the bonds to the ECB using repurchase agreements.
The ECB would sterilize the liquidity it provided by cutting back on direct lending to the banking system, Wolff said. It also would set a haircut on the repurchase agreements to limit its exposure to any solvency risk associated with the bonds. A hypothetical 10 percent haircut would allow the EFSF to leverage its resources by a factor of 10, putting the funds capacity at 3.5 trillion euros.
Wolff said the mechanism, as envisioned during the exercise, would put an end to market speculation that the euro area might not support sovereigns under stress. It would thus “buy time” for euro-area nations to put more lasting structural reforms in place.
“Market participants in the simulation reacted positively to the new mechanism when it was proposed in the simulation,” Wolff said in an article on Bruegel’s web site. “Spreads to Germany narrowed strongly and overall market stress was reduced. In addition, the ECB could stop its costly securities markets program.”
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