ECB Liquidity support for Euro Banks, Italy and Spain

In my blog of October 27th. I had stated (point 4)that only the ECB had to act like a normal central bank for the Euro area (i.e. provide unlimited liquidity in times of financial crisis) if basically solvent Euro countries were to be saved from becoming insolvent.  The best way would be to change the ECB constitution to allow it to do so (in parallell with changes to impose tough fiscal rules on Euro-countries).  This may however take too long to stave of a crises in the next 12 months.  One possibility that has been suggested is the issue of Euro Bonds.  However, it is unclear whether this has any greater feasibility till the fiscal rules have been changed by treaty.  There is however, an alternative that may be worth considering.
     National Banks within the Euro area, such as the German Bundesbank still exist, but do not have the authority to undertake monetary policy (interest rates) or to create money (Euros). This authority has been ceded to the European Central Bank (ECB).  They do, however, still have the capacity to issue euro bond to raise hard cash and their debts are still implicitly or explicitly guaranteed by their National governments. Thus these would have triple A rating in countries with a similar rating.  To the best of my knowledge, there is nothing barring the ECB from buying such bonds as part of any effort to increase liquidity in the Euro zone. The money raised in this way could in turn be used by the National Banks to create bilateral funding arrangements in the IMF.  Given the triple A rating of the IMF, this would preserve the triple A chain.  The funds could then be used to provide liquidity support to fundamentally solvent (even if currently stressed) Euro governments, under a fund program that ensures that these governments undertake the policy reforms that ensure debt sustainability (point 1 of Oct 27 blog).  Non-Euro area countries with a current account and trade surplus, such as China could also contribute to the bilateral fund in the IMF if they choose to do so.

How can the World help the Euro Group Save itself

    In my blog of October 27th I outlined the four critical steps for saving the Euro and the possible role of the IMF. In this note I focus on what the rest of the World can do to help, possibly through the IMF.  The IMF, given its expertise in enforcing fiscal and monetary discipline for restoring Balance of payment sustainability, has already been involved in helping the Euro-area governments enforce policy reforms (conditionalities) on Greece and Portugal for the support they are recieving from the Euro area (2/3rd) and the IMF (1/3rd).  This has however invloved the IMF providing unprecedented level of funds (100s and 1000s of times thier normal entitlement) and extrodinary fiscal support to soveregns that markets consider insolvent.  In principle the genuine and valuable role of the IMF in enforcing conditionalities on delinquent sovereigns can be provided with much lower levels of financial support, as was done historically in Latin America, Asia and other continents!

   From a global perspective the question is, what should the Rest of the World do to ensure that the Euro crisis is contained and any potential contagion to countries outside the Euro area minimised?  To answer this question it is essential to recognise that the World is currently suffering from a severe shortage of effective demand.  Thus there are two types of countries which are playing or should play different roles in diffusing the global crisis.  On one side are the current account and trade (goods and services) deficit countries who are making a net contribution to the global demand from the rest of the world, including the countries in crises.  Without thier continuing contribution there, it is impossible for the crises and near crises countries to reduce or eliminate thier current account deficits in the next few years. 

   On the other side are the current account and trade (G&S) surplus countries who are earning foreign income and accumulating foreign assets/ reserves.  These countries have the international resources to reallocate thier foreign earnings/assets into alternative channels, including to international financial institutions, to build a loan fund/buffer for ensuring that "innocent bystanders" hit by contagion from any euro-crises are provided adequate liquidity support.  It is thier obligation and duty to do so as long as they remain in surplus. One way of doing this is to contribute to a Bilateral loan fund in the IMF.  This would be fair and evenhanded contribution by all non-euro countries to help save the rest of the World from the negative contagion effects of the Euro crises and a potential melt-down of the Euro.  To the extent that some of these contributors are middle income countries, it would be legitimate to ask non-contributing rich countries to underwrite part of the risk. The precise nature of the contribution and the manner in which it should be used would ofcourse be need to be worked out in co-operation with the potential donors to this fund.

   In between these two types of countries, are an ambiguous type, which can contribute either through an increase in thier net purchase of goods and services from the rest of the World or through bilateral provision of funds to IFIs/IMF or a combination of the two, depending on thier thier income levels and reserve currency standing.

     Another source of funds for providing global liquidity could be fresh SDR allocations.  The conversion of SDRs into hard currencies by those in need of liquidity would have to be carefully circumscribed as long as the Euro crises lasts.  This is because a Euro-meltdown will result in a credit squeeze by European banks that is likely to lead to a sudden stop/capial outflow from emerging market economies.  Thus emerging economies with Current account and trade deficits who are dependent on foreign capital will become vulnerable even if they have substantial foreign exchange reserves.  Minimisation of contagion thus requires that these countries be shielded from demads for SDR conversions into free foreign exchange.  Any substantial new issue of SDRs should ensure this risk mitigation feature!