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In this op-ed, Guntram Wolff comments on Tim Geithner's encouragement to eurozone leaders to collaborate in order to avoid a financial melt-down and his proposal to use EFSF guarantees and capital more efficiently by leveraging it with ECB money.

In his visit to Poland, Tim Geithner has urged eurozone leaders to collaborate and avoid a financial melt-down. He urged to use EFSF guarantees and capital more efficiently by leveraging it with ECB money, thereby increasing the firing power of the EFSF for buying government bonds. This mechanism would immediately ease the crisis and may even be cheaper than all the other options currently followed. It also does not amount to a monetary financing of government debt. Here is how and why.

The mechanism would essentially give the EFSF access to ECB liquidity[1]. The ECB would immediately stop its bond purchasing program and transfer this task to the EFSF. This will help increase ECB independence and separate clearly monetary policy from fiscal policy. The EFSF would start buying government bonds of countries with significant spreads and would repo the bonds with the ECB. The ECB would not increase its overall liquidity provisioning as it would fully sterilize the liquidity provided by providing less liquidity to the banking system directly. The ECB would set a haircut that is in line the fundamental solvency risk of the country. By doing so, the solvency risk would remain with the EFSF. A ten percent haircut would allow the EFSF to leverage its resources by a factor of ten. Its firing power could thereby increase to up to 3500 billion euros.

In the face of such a large fund, markets would immediately stop speculating against the euro area sovereigns under stress. Indeed, investors that were speculating against peripheral bonds would quickly lose a lot of money. This outcome was recently confirmed in a simulation with real market participants organized by Bruegel and the Peterson Institute (download event summary). In fact, market participants in the simulation reacted positively to the new mechanism when it was proposed in the simulation. Spreads to Germany narrowed strongly and overall market stress was reduced. In addition, the ECB could stop its costly securities markets program.

In the discussions among participants after the simulation, market participants agreed that the new mechanism would immediately ease problems. It was argued that the mechanism would probably not be tested for quite some time. However, many players warned that even while the short-term financing and budget problems of Greece were eased, all the debtor countries needed to continue on a path of fiscal consolidation and structural reform in the years ahead. The new mechanism would leave unresolved the issue of how structural reforms could be fostered and conditionality imposed. Ultimately, it would therefore risk being tested again by the market. The proposed mechanism should therefore be seen as a way of buying time only. But the mechanism is more compatible with incentives for reform than the current mechanism that relies on the ECB stepping-in to avoid a financial meltdown. Since it relies on the EFSF where every government has a veto right, its introduction would increase the incentives for structural reforms as the countries participating in the EFSF could at any stage decide to discontinue their support in case of severe misbehavior of a country. At the same time, given the size of the fund, market speculation could be ended thereby giving the time to move forward with a new economic governance framework that would allow much stronger control of public budgets and structural reform progress.

[1] This proposal was already made by Gros and Meyer (2011).