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The German constitutional court has agreed that there is no legal barrier to the establishment of the ESM, as long as Germany’s obligations do not exceed EUR190 billion. This has been taken as a landmark decision and a green light for the consummation of the next round of measures to finally solve the problems of the euro: the double-déclenchement of the ESM and Le Plan Draghi.

The attempt to cap Germany’s drawing of gaming chips from the ECB casino at EUR190 billion is quite funny because the country is already “all in” for a figure well in excess of that:

  • Joint & several guarantor of the funds injected into the European Financial Stabilisation Mechanism – EUR60 billion
  • Capital exposure on the European Investment Bank – EUR38 billion
  • Capital exposure on the European Central Bank – EUR3 billion
  • Capital exposure on the European Financial Stability Facility – EUR211 billion
  • Bundesbank surplus in the TARGET system being re-lent to the Euro periphery central banks – EUR700+ billion

There is also a potentially colossal exposure caused by the fact that any losses of the European Central Bank get allocated to its Eurozone shareholders – meaning losses on any eurozone sovereign bonds that have to be re-sold at a loss or on which there is a haircut.

The ECB shareholders are also the entities through which it conducts most of its operations. The Banque de France has a capital key of 14.22% in the ECB, and acts as its agent to conduct many types of operation – but at the risk of the ECB.

If the operation goes wrong, the Banque de France can allocate the loss along to the ECB, but then the ECB in turn can call upon the Banque de France to pay in 14.22% of the ECB’s losses. The ECB in turn is only creditworthy because it counts amongst its assets the currency and bullion reserves of its shareholders.

Because the central banking system behind the Euro is so splintered and opaque, it allows these enormous ambiguities between the legal framework and what is happening day-to-day: the Eurosystem (i.e. the ECB and its shareholders) are propping up Europe’s banking system by advancing face value to commercial banks against security of eurozone sovereign bonds, whether the bonds’ resale value would cover the loan or not.

The Eurosystem is also building up its own portfolio of eurozone sovereign bonds under Le Plan Draghi, again at the risk of its shareholders according to their capital key.

This is all in addition to the main game, which is being disguised in the day-to-day operation of the ECB’s money transfer system. Normally the participants should disposition their accounts to zero at end-of-day.

However, currently the Bundesbank is owed over EUR700 billion through the overnight imbalances in the TARGET payment system run by the European Central Bank. Those imbalances are the result of capital flight into Germany, which the Bundesbank is then enabling the Euro-periphery national central banks to permit by funding it: otherwise they would have to reintroduce exchange control.

These EUR700+ billion will show up on the Bundesbank’s own balance sheet as an asset, so maybe they do not count as an “obligation” in the sense of the limitation imposed by the German Constitutional Court, an obligation being a commitment to pay in. When you have already paid in, it ceases to be an obligation but a fact.

These imbalances sit in a grey area between bailout funds and normal central banking, reflecting the inadequacy of the ECB’s current mandate: such important things as these cannot remain grey.

There is still substantial uncertainty around the amounts on the public debt, the day-to-day funding of requirements now, who is back-stopping whom, and the future capacity to backstop as well as the legal mandate to backstop.

Activating the ESM may resolve some of the ambiguities between the EFSM and the EFSF (at least there won’t be two mechanisms) but it will not add greatly to the available firepower (considering the TARGET imbalances), nor will it clarify the total size of the problem.

Sorting out the euro once and for all requires a proper central bank. The eurozone National Central Banks should be merged into the European Central Bank, with the eurozone Member States as the ECB’s direct shareholders, and joint and several guarantors. Currency and bullion reserves would become directly owned and controlled by the ECB. Non-eurozone Member States should drop out of the ECB structure – until they join the euro.

This would give the ECB more firepower and autonomy, and it should carry out real banking: public ministries and public-sector entities would hold their bank accounts at the ECB, allowing a central overview on public sector payments.

To compliment that move, the public sector debts of eurozone countries need to be recorded and published using a consistent methodology. For example in Spain this would result in a single register of the debts of the Kingdom, of state entities (like Renfe), of the autonomous regions (like Catalonia), of the municipalities, and of the many limited liability companies whose shares are owned by other public sector entities, but whose figures are not consolidated into them. These could be motorway companies or water supply companies, whose debt service has to be drawn from the same well as that of the Kingdom, municipalities, regions and so on.

The existence of such a register would reassure investors that accounting was being done in a consistent and transparent manner, and could be audited by the ECB against the obligor’s bank statement.

That would shore up the currency and give it a proper foundation: stability. How to create growth is another matter. It means eliminating the gap between aspiration and economic performance. For 20 years, rising public debt has supported the gap – very tough to turn the tide on that habit with President Hollande paddling in the opposite direction entirely.

PDF of ‘How do we sort out the Euro and will the ESM make a difference?’ article, InterContinental Finance,26th October 2012