Why Leveraging the EU’s Rescue Fund Won’t Work

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This quote from Wolfgang Münchau is getting a lot of attention:

We are now in the stage of the crisis where people get truly desperate. The latest crazy idea, which is being pursued by officials, is to turn the eurozone’s rescue fund into an insurance company, or worse, a collateralised debt obligation, the financial instrument of choice during the credit bubble. This is the equivalent of putting explosives into a can, before kicking it down the road.

That’s a pretty punchy quote! But I was happy to read Münchau’s full piece anyway, because I’ve been puzzled for a while over the idea of “levering up” the EU rescue fund. The basic idea is that the fund is too small: rather than its current €440 billion, it needs to be somewhere in the neighborhood of €2 trillion. But nobody wants to pony up that kind of dough, so instead there have been proposals that the €440 billion be used as the equity tranche of a gigantic security that would be sold to private investors. Voila! You have €2 trillion at your fingertips. Europe is saved!

This didn’t make much sense to me, but I vaguely figured that maybe I just didn’t understand it. Sadly, I think I understood it all too well. The whole point of a rescue fund is that it’s so rock solid that everyone breathes a sigh of relief and there’s no longer any risk of bank runs or sovereign defaults. But private investors just aren’t rock solid enough. As Münchau puts it, “When the eurozone CDO fails, there are no governments that can bail it out because the governments themselves are already the equity holders of the system. This leaves the European Central Bank as the last man standing. But the whole idea of setting up a eurozone CDO is to avoid this outcome.”

Right. One way or another, the bailout is going to come from either national governments, the central bank, or both. Or, alternatively, there’s not going to be a bailout and all hell will break loose. All the tricks in the financial rocket scientist’s toolkit can’t change this grim reality. Europe either ponies up eye-watering amounts of money for its teetering banks and teetering countries or faces financial catastrophe and the end of the eurozone. Eventually they’ll have to decide which fate is worse.

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