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It isn't every month a US Treasury Secretary flies to Europe multiple times to meet with Europe's top economic policymakers. So even if the Obama administration has an obvious own-interest in lining up a potential convenient external excuse for Europe, should the American economy continue to sputter during the accelerating election campaign, it is important to realize that rarely has a US Treasury Secretary been better placed to offer Europe crucial needed advice than Tim Geithner is today.
Europe has for months been struggling to align the financial markets' demands for urgent decisive action to end the euro area debt crisis with the political constraints on elected officials. The European Financial Stability Facility (EFSF) was created in May 2010 and in July 2011 made far more flexible, yet it still is far from having the financial firepower needed to deal with Europe's crisis as it spread from Greece to Italy and the core European banking system. The European Central Bank (ECB) has repeatedly been forced to step in and make emergency support purchases in deteriorating sovereign bond markets. This is a role the ECB has made clear is merely temporary, as the independent central bank does not wish to continue taking actions with clear fiscal policy implications and put its independence and financial health at risk.
However, as acute market concerns surround Italy, and euro area leaders are incapable of increasing the size of the EFSF much above its current €440 billion without jeopardizing the French AAA-rating, the ECB is trapped. Any notion of a "complete handover" from the ECB to the EFSF later this fall, after recently decided changes to the EFSF have been ratified by national parliaments, completely lacks credibility. It is inconceivable that Europe could simply exchange the ECB bazooka with the EFSF water pistol in the midst of the current crisis. Certain disaster would ensue. The EFSF simply does not and will not independently have the capital capacity to take over from the ECB.
Enter Tim Geithner, who having been president of the Federal Reserve Bank of New York (FRBNY) early in the crisis and US Treasury secretary since January 2009, has more experience than any policymaker today in maximizing the financial firepower of a limited amount of taxpayers' money by leveraging it with the unlimited lending capacity of a central bank.
As has been discussed on this blog before, the FRBNY (initially led by Tim Geithner) and the US Treasury from September 2008 onwards engaged in an innovative collaborative rescue effort of major US financial institutions (like AIG) and dysfunctional financial markets (like the asset-backed securities lending market) by leveraging limited funds from the TARP program with lending from the FRBNY. In essence, the US Treasury offered TARP funds as "first-loss insurance" to the FRBNY, thereby protecting (to a certain extent) its balance sheet from any credit losses associated with its lending activities. In the case of the Term Asset-Backed Securities Loan Facility (TALF), for instance, $20 billion of TARP funds injected into a special purpose vehicle (TALF LLC) were leveraged in November 2008 10 times by the FRBNY's willingness to lend up to $200 billion against eligible collateral from private investors using the program. The collaboration with the FRBNY thus multiplied the financial muscle of TARP at a critical juncture of the US financial crisis in late 2008, when clearly the US Congress would under no circumstances have approved additional taxpayers' funds (beyond TARP).
Europe's situation today is in many ways similar to that of the UnitedStates in late 2008; too few taxpayers' funds are available in the EFSF to deal with any crisis related to Spain or Italy, and only the ECB's balance sheet has that capacity. Just like Tim Geithner and Hank Paulson in late 2008, Europe's leaders therefore today need to find an innovative method to join the risk capital status (e.g., potential to suffer substantial capital losses) of the limited EFSF with the risk averse but unlimited lending capacity of the ECB.
This can be done in several ways that might not require a change in the EU Treaty. Euro area leaders could essentially turn the EFSF into a bank, enabling the ECB to lend—with a haircut—against collateral provided by the EFSF. The EFSF could for example then lend €10 billion euros to the Greek government, who would then purchase €10 billion of its own bonds in the markets. The Greek government would then take the €10 billion of bonds to the ECB as collateral, and receive a €9 billion loan (e.g., here with a 10 percent haircut applied by the ECB as in TALF) with which it would purchase a further €9 billion of its own bonds. It would then again take these €9 billion of bonds to the ECB and get a €8.1 billion loan and so on. Depending on the severity of the ECB haircut, EFSF funds could in this manner be leveraged multiple times. In extremis, for example, a 10 percent ECB haircut could mean that €440 billion in EFSF funds could enable €4.4 trillion in collateralized lending by the ECB.1
Euro area leaders might also simply pledge the EFSF funds as first-loss capital to the ECB, providing it credit protection against any losses the central bank endures from its regular open market repo-transactions with impaired collateral, or from its outright purchases of sovereign bonds, from Greece for instance. It would then be up to the ECB to decide how much credit risk it would expose itself to, depending on the scale of the euro area sovereign EFSF-based first-loss guarantee. The €35 billion in credit loss protection the ECB received from the euro area on July 21st to enable it to continue to accept default-rated Greek collateral for repo-transactions, which at the time was of a scale of around €100 billion with Greek banks, again suggests the ability to multiply the financial impact the EFSF using this technique.
The precise design of the collaborative euro area effort between the EFSF and the ECB will depend on a host of different issues and European politics in particular. However, it is clear that the ECB will have to continue to provide the majority of the financial force for crisis interventions in the euro area financial markets also in the future, while the EFSF (e.g., euro area governments) will have to bear most of the risk.
No one is better placed to explain this type of setup to Europe's policymakers than Tim Geithner. Europe had better listen and learn.
Notes
1. The bank-model with collateralized lending from the ECB would furthermore have the advantage from Frankfurt's perspective that it would relieve the central bank from the decision-making responsibility of when and how to intervene in secondary bond markets. Actions with fiscal policy implications would thereby be taken by fiscal actors among the euro area governments.
