Sunday, July 29, 2012

Fixing "Unsustainable" Rates in Spain/Italy: Subsidize Rates Instead of Buy Bonds

This approach has vastly lower risk, better conditionality, and conserves resources for a real emergency.

If Spain/Italy yields are "unsustainable" because they are 3% too high, then just pay the 3% from EFSF/ESM/EU as a subsidy and let them finance in the market.  
To avoid risk of having to pay very high subsidies, the EFSF/ESM/EU can backstop bond auctions at, for example, 9%. 

Vastly reduces risk: Instead of holding large credit positions,  the cost of this subsidy for €300bn of debt would be €9bn/year, but only for as long as the market misunderstands that Spain/Italy are better credits. The cost of subsidizing €2 trillion of debt is the same as the cost of EU agriculture subsidies.  
Reduces pressure on Target2 creditors since they don't have to assume this additional risk.
Conditionality works much better since Europe dispenses the benefit over time instead of up front.  
- Highlights how small are amounts that are claimed to cause unsustainability.
Eliminates subordination risk.
Retains market information, which is the first step to appreciating that information.  
---- Perspectives would have changed had it been shown that Spain could have financed the  €100bn for bank capital in the market.  The suggested approach allows this to be attempted without risk of disaster.
---- The market is often wrong, but should not be dismissed.   When the market appears wrong, it's a good exercise to try to figure out why it might not be.  Analysis of Greece would have benefited from this; same for Spain.  Destroying this information makes it impossible to consider it.

- Subsidy could be repaid as subordinated debt or ordinary debt.
- Subsidy could be repaid as GDP-linked debt
- If the auction is bought at 9% pursuant to the backstop, the subsidy is zero. 

1 comment:

  1. Hi Will,

    Interesting idea. I'm more of a central bank watcher, government finance isn't my thing. But it seems to me that this plan would surely be more politically feasible than outright bond purchases, simply because 9 billion euros/year sounds like a lot less than 600 billion. A political free lunch to say.