EFSF Leverage Euro Zone's Most Dangerous Delusion

By GEOFFREY T. SMITH

Last weekend's meetings of the International Monetary Fund and G-20 were punctuated by panicked calls for an increase in the size of Europe's rescue funds, most of them aimed, predictably, at Germany.

German Finance Minister Wolfgang Schäuble must have lost count long ago of all the wonderful schemes the French have devised for spending Germany's money, whether from Paris itself, or from the EU and IMF, where the French genius has always exercised an influence far beyond the country's political clout. He will also be long used to U.S. calls for Germany to boost its domestic demand and reduce its current account surpluses, a call that has never faltered despite the evidence of the 1990s, when a series of German current-account deficits did nothing to stop the U.S.'s long-term decline in international competitiveness.

But whereas the interventions of Treasury Secretary Tim Geithner and IMF head Christine Lagarde fit into a largely familiar, if not predictable, pattern, Mr. Schaüble must have realized things had taken on a more serious dimension when the mild-mannered and respectful Canadians, Finance Minister Jim Flaherty and central bank Governor Mark Carney, started screaming "DO SOMETHING!!" as well.

There are only two problems with such calls. First, they address just symptoms of the crisis, not its roots; one could even argue that they not only perpetuate but intensify the causes of the crisis, making even worse chaos inevitable a little farther down the road. Second, there is no conceivable political solution under which they would have the necessary democratic legitimacy.

The most recent nonsense making the rounds is that the euro zone should allow the European Financial Stability Facility to borrow, increasing its available resources and using taxpayers' pledged €440 billion ($597 billion) as a sort of capital base. The notion is that this would ensure bailout facilities have sufficient "firepower" to "shock and awe" the doomsayers into a more sanguine state of mind. I use the quotation marks because such phrases are just shorthand for pumping up moral hazard. Acting on this plan would lead to the mutualization of hundreds of billions of Italian and Spanish debt within weeks, without any further adjustment of policy by the governments in question to defend their own credit. No one appears to have given a moment's thought to whose money would be put at risk.

Such a fix does nothing other than gain a few more years for a bankrupt model of governance in much of continental Europe, while spooking those countries that have governed themselves better with the threat of massive debt transfer. If Europe goes down this route, it will only have to face a far larger sovereign insolvency crisis in a few years. When it comes, it will involve sharing the debts of a larger number of debtors among a smaller number of creditors.

In the meantime, it will sustain unsustainable models in southern Europe at the expense of viable ones north of the Alps. Frightened businesses hoard. Only secure or confident ones invest. The only thing to be achieved by spreading insecurity across the whole of northern Europe will be the destruction of the euro zone's only significant source of growth.

As Axel Weber, the prophet not recognized in his own house, spelled out with typical force and clarity in a lecture at the weekend, the most dismaying aspect of the levered EFSF proposal is that it shows Europe's politicians have learned nothing from 2008. Leverage gives only the short-term illusion of firepower, at the cost of a huge increase in risk. Making taxpayers fund a "first loss" tranche of financing for Europe's bailout vehicle massively increases the chance of their funds being wiped out.

The best argument that can be made for levering the EFSF is that it would smooth the process of deleveraging Europe's banks, allowing them to get rid of excessive sovereign-debt holdings more quickly, within a reasonably well-defined legal framework. One positive side-effect would be a massive increase in EFSF paper in circulation. The creation of a new and highly liquid, high-quality collateral could over time help to break the vicious circle created by the mutual dependence of national governments on national banking systems.

However, as the problems created by the current lack of faith in Europe's banks are essentially liquidity-related rather than capital-related, it would be better for the ECB to take charge of the process, offering secure long-term funding in return for gradual balance-sheet adjustment over a mutually agreed period. The resources of the EFSF would be better used—as already foreseen in the July 21 agreement—to inject capital into insecure banks, and not just the dozen or so that failed or nearly failed this year's stress test. Quite apart from being more effective, it would even be legal. Between an EFSF-funded bank recapitalization and unlimited, conditional medium-term funding from the ECB, the euro zone has all the tools it needs in the short term.

But the real answers to this crisis lie in a different dimension: longer working lives, more-efficient public administration, open professions, completion of the internal market for services (where all net job creation takes place) and the stabilization of long-term demographic trends by higher fertility rates. All except the last are manifestly possible. They require only political will and honesty. Trying to duck those challenges with ever more arcane, ever more leveraged financial vehicles on ever-shakier legal ground is a recipe for a far bigger disaster than those prophesied in Washington.

Write to Geoffrey T. Smith at geoffrey.smith@dowjones.com