Halt the Crisis: The ECB should announce that it will become Lender of Last Resort for all Eurozone Countries. If I were running the show I would lead this off with a particular show of force. A short term bond issue for which there is heavy short interest I would have the ECB buy into specifically and dramatically to drag bond yields to 1.25%, in an effort to cause the shorts to miss their margin calls and take heavy losses on the issue.

This is not because I have anything against shorts, think they are acting irresponsibly or even initiating some type of implicit attack. Instead, its because I don’t need to waste the rest of the afternoon or god-forbid the better part of a week with markets wondering whether or not I am serious. It will become abundantly clear within the first 10 mins of trading that I am quite serious and prices need to adjust, lest there be more losses of this type.

Replace Individual Sovereign Debt with Eurobonds: The ECB will pull on to its balance sheet all Sovereign Debt of Eurozone Nations are replace that debt with Eurobonds. This process can proceed over the course of weeks or months. With prices stabilized it need not be done fast.

Independent Issues of Sovereign Debt are Banned: Any Sovereign requesting additional funding must come through the ECB and be sterilized with Eurobonds. Rollover issues may be funded at the overnight rate. New issues will be initially funded at the overnight rate plus 2%.

Sliding Scale on New Issues: New Issues of debt, that expand the total stock of debt held by a member country will be funded on a sliding scale voted on by the European Commission. The sliding scale will provide for a penalty rate based on the Primary Balance of the nation in question.

Issue Holds For Violation of EC Rules: A violation of European Commission rules can result in a increase in the penalty rate for new issues or a hold on the funding on new issues.

The Single List is Replaced By Eurobonds: The ECB will accept only Eurobonds as collateral for primary funding operations.

Super-Sovereignty for Eurosystem Banks: Banks which participate in the Eurosystem and receive liquidity under primary funding operations, are no longer under the jurisdiction of member states. They are under direct jurisdiction of the European Commission, with the ECB as their regulator.


Right now, the EC is attempting to use “market discipline” to impose reforms on peripheral countries. As I pointed out from the beginning this is a dangerous game.

It only works if you are actually willing to drive the bond markets over a cliff and if you are actually willing to do this and the markets believe you then you go over the cliff automatically.

It is theoretically possible to thread the needle if you know that the peripheral countries are willing and importantly able to offer unconditional surrender. Then you can creditably halt the train from going over the cliff and everyone knows that you can and so you are safe.

Yet again, as we pointed out earlier, for this to fail all you need is incompetence, not intransigence, on the part of your counterparties. This is the problem with doomsday devices or credible commitments to be irrational, generally.

To solve this the EC should just abandon attempts at market discipline – which are unserious or in any case should not be used by serious people – and replace that with administrative discipline.

Simply require that member states come to the EC or the ECB for financing and that the financing may face a penalty or be outright refused. This means that the EC or the ECB can force a government shutdown without having to force a bond market crisis.

This is the power it really wants. It wants the power to say that Greek retirees will not get their pension checks unless Greece shapes up. It does not want the power to say Greek bondholders will not get paid. You see where that leads.

With this set up the only way a government can get out from underneath the EC’s thumb is by running a cash surplus (not simply a primary surplus) which is what the EC wants anyway.

The concern that people will raise is that this puts “tax payers on the hook” for debts in other countries. I don’t think this is in fact true, though one would have to sit down and look at the numbers.

What it does is puts Eurozone economic growth on the hook for the total debt in all member countries. Remember that now that refinancing operations are conducted only in Eurobonds they are “first at the table” in soaking up savings in the country.

Thus an excess of bonds over desired savings would imply inflation if the ECB took no action and higher interest rates generally if the ECB took action. The outstanding quantity of debt is not so high that I think you would ever need to raise taxes to finance it. The total debt is small enough that it can always be financed through crowding out.

And, since the EC effectively now has the means to force a cash surplus on member nations it can push the outstanding stock of debt down over time.

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