There are several steps the European Central Bank can take to save Europe. I also give some preliminary thoughts on how to shield the US.

Scenario One

My favored approach would be to simply be to cap the 2 year bond yield from any Eurozone Sovereign at 100 basis points over German bonds. The ECB would do this simply by announcing its intention to purchase bonds through its Structural Operation Facility until the rates target rates are hit.

Such a commitment is akin to saying the ECB will print all the money necessary to hold rates down. After the announcement rates will collapse immediately rates and end the contagion.

At the end of the day here the ECB still holds all the cards. Its only holding down short rates and only conditional upon countries making progress towards primary balance. If a country refuses then the ECB can remove the hold and let that country’s bonds go higher.

More over the long bond markets would still send price signals based on how likely it was that the country in question was going to stick to the ECBs demands.

The “downside” of this scenario is that it allows for rising inflation expectations. Of course, I don’t see this as a downside because I believe the ECB is far to tight as it is.

 

Scenario Two

The ECB suspends its weekly financing operations.

The ECB then moves the interest rate on the deposit facility to zero.  It moves the interest rate on the marginal lending facility to 25 basis points.

The ECB then “encourages” the creation a Single Charter Bank in Belgium (SCB) owned by the EU or some other suitable international organization. This bank has only the authority to issue 30 year bonds of two series A and B. It only has the authority to buy Sovereign debt. SCB-A bonds are then placed on the Single List.

The ECB then initiates fine tuning operations through open market purchases of SCB-B bonds, until the SCB heavily liquid.

The SCB then sells SCB-A bonds on the open market and purchases Sovereign debt with the proceeds. It does this so long as it is profitable to do so, which is to say until the yield on short term Sovereign debt converges towards the marginal lending facility rate.

The A, B bond distinction is this. In the even of a default A-bond holders have priority over B-bond holders in taking recovery.

Because the SCB is highly liquid SCB-A holders will have no trouble making recovery. While of course SCB-B holders – the ECB – may be left holding the bag.

The point of this entire exercise is to remove risk from holding sovereign bonds without creating any inflation.

Shutting down the ECB weekly financing operations ensures that the rapid expansion of List Bonds will not disrupt the normal flow of business. It is not strictly necessary but gives me more confidence that I could swell the size of the SCB balance sheet without have any direct monetary effects.

The creation of the SCB and the issuance of thirty year bonds does several things.

1) Its sterilizes liquidity injections from the ECB

2) It staggers out any potential losses – though it not clear there will be any – over a period of time in which seigniorage alone could keep SCB liquid.

3) The EU or owner of SCB still has a stick. It can always sell its holdings of Sovereign Debt and push a country back into default territory.

 

The upside of this proposal is that inflation risk is neutralized. The downside is that you lose any market signals what so ever.

 

 

These are steps the ECB could take to end the crisis right now. Will they? I doubt it. Which is why this afternoon I will thinking of steps the Fed can take to ensure that the collapse of Europe does not bring down the United States.

This is a more complex problem as I do know the exact nature of US Exposure to Europe either directly or through counter-parties. Nonetheless, I am highly confident that it could be done especially if the process is started NOW.

Starting the process of sealing the US banking system now allows you to use current asset prices for collateral rather than dealing with the problem of shoring up institutions in the wake of falling asset prices.

 

I also do know but will try to look up the steps the Federal Reserve can take to intervene in the Forex market. It is my strong sense that the Federal Reserve should consider this.

Normally of course this would be the last thing from my mind but the tidal wave of money that may be headed for the United States is highly disruptive and unless something can be done to unlock construction and mortgage refinance it could be highly destructive to the US economy.

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