With Italy's 10-year debt stuck at a painfully high yield north of 7%, chatter has quieted that the European Central Bank's easy money for banks has done much more than provide a brief respite "” and rightly so.
Capital Hill has previously argued that the ECB's cheap three-year loans to banks amount to a bulldozer, not a bazooka.
While banks might plow the financing into very short-term sovereign debt, borrowing needs for fiscally challenged euro-area nations could quickly pile up into an immovable mountain as far too much matures within the three-year life of the ECB program.
From the perspective of investors in sovereign debt, a better analogy might be a game of hot potato in which the potato starts off lukewarm but predictably gets hotter and hotter.
Even investors in short-term debt shouldn't presume that they'll be able to hand off their risk because, in a game in which the odds of getting scorched are ever increasing, people may drop out long before risk becomes elevated.
In other words, the temperature "” and short-term yields "” might spike a whole lot earlier than anticipated.
In response to the troubling outcome of Italy's most recent auction for long-term debt, Prime Minister Mario Monti called for boosting the firepower of the euro zone bailout fund known as the European Financial Stability Facility.
But a politically viable approach for bolstering EFSF resources has eluded Europe's leaders because every idea for doing so relies to an improbable extent on nations with less-than-stellar credit helping to bail each other out by pledging to issue more debt.
Others have called for sovereign credit needs to be filled by eurobonds for which the bloc members would share liability "” a major step toward a true fiscal union.
But Germany, which would become the co-signer of loans to nations with less-secure credit, has made clear that eurobonds are an idea whose time has not yet come. Its refusal to take responsibility for other nations' bloated debts has been hardened both by the survival instincts of politicians and a conservative mindset that believes such a backstop would create moral hazard, undermining the commitments to make tough fiscal choices.
Before Germany agrees to more substantive steps toward a fiscal union, it wants its euro partners to yield sovereign control over their purse strings in a way that France has signaled it can't stomach.
What is needed to defuse the current crisis and move the euro area toward a more workable union is a lifeline for sovereigns that comes with credible, automatic sticks to keep nations on a straight and narrow path to fiscal sustainability.
True, Europe's leaders have discussed new fiscal rules "” far stronger than those broadly ignored for a decade "” and fines for nations that stray. But such an approach has limited usefulness for the present crisis.
For one, any rules operating within the political sphere lack sufficient credibility because they can always be softened.
Second, the stringency of rules that might clear a multitude of political hurdles and parliaments is likely to only match the degree to which Germany is willing to backstop its neighbors. This correlation explains the lowest-common-denominator agreement at the high-stakes euro summit in December.
And so, as austerity, renewed recession and bailouts threaten to drag down even euro nations with relatively solid credit, the ECB stands, in the words of Fitch Ratings, as "the only truly credible "?firewall' against liquidity and even solvency crisis in Europe."
Yet, treaty and a conservative philosophy bind the ECB from intervening more forcefully and directly to alleviate the sovereign credit crisis for fear of acting as an enabler of fiscal laxity.
The key question, then, is what kind of automatic sticks operating outside the political sphere might be attached to a sovereign credit lifeline to reinforce fiscal discipline, rather than enabling deficits "“ and to provide assurance to even dyed-in-the-wool skeptics.
The answer can be found in a new type of credit instrument called "Safeguard" bonds designed specifically to help address the euro area's unique political challenges at this perilous stage for the monetary union.
"Safeguard" reflects the intent of the bonds "” to safeguard the future of the euro area "“ and also serves as an acronym for their critical features: Sovereign Aprovable (meaning that issuance is restricted both by amount and fiscal qualifications) First-loss EFSF-Guaranteed (second loss goes to the ECB) Upfront Automatically Recallable Debt.
Safeguard bonds would be issued with the EFSF (or its successor, the European Stability Mechanism) in the first-loss position and the ECB providing a backstop beyond some portion of the EFSF's capacity.
This guaranteed debt, however, would come with built-in triggers to automatically recall incremental portions of the issuance (perhaps 10% per year) as long as the issuing country violates certain deficit parameters that would be set in advance by the EFSF in consultation with the IMF and ECB.
The automatic recall would trigger repayment to bondholders and force the borrower to issue new debt at presumably much higher rates. This provision would allow Germany to retain a degree of leverage that it has sought over the budgets of nations in need of extraordinary support "” but without encroaching on sovereignty in a way that France has rejected.
This automatic trigger resulting in immediate consequences for recidivists is a key difference between a lifeline designed to avoid the need for future ECB support and a credit line that central bankers fear might make future support even more essential.
Indeed, by ending a sovereign debt spiral with guarantees of a limited amount of long-term debt, the ECB might regain control of monetary policy, rather than being pressured to run its printing press as the buyer of last resort.
Meanwhile, Safeguard bonds would finally attract the international capital that International Monetary Fund Managing Director Christine Lagarde has said is necessary to stem the crisis.
The guaranteed debt would be issued upfront, enabling countries to immediately retire pricier debt. The new debt would be limited (perhaps 30% of a country's GDP) and would be available only to countries on track to achieve specific, uniform budget targets within a certain time frame. Failing that, some restructuring would have to come first to put that target within reach.
In the case of Italy, with debt-to-GDP of 120%, replacing one-fourth of that with long-term debt could have a similar market effect as reducing debt to 90% of GDP.
Holders of the other three-fourths of Italian debt wouldn't have to compete with Safeguard bondholders for repayment, making Italian debt much more attractive "” and less expensive to issue.
Meanwhile, Italy and other nations benefiting from lower interest costs could implement economic and fiscal fixes without going too far overboard on austerity. Yet market discipline would remain in force because countries would still have to go through financial markets for ongoing borrowing needs. Any sign that a nation might violate terms of the issuance would push up the cost of rolling over existing debt as investors price in a bigger effective float (to replace the recalled long-term debt) and less market certainty.
Hence, the automatic recall would be a penalty nations would try to avoid at all costs. On the other hand, the seriousness of the penalty also means that policymakers will need to set the triggers tied to Safeguard bonds with the utmost care.
The policy hurdle is significant, but surely surmountable. Those of conservative ideology might push for more exacting thresholds than either European banks or nations lining up to issue Safeguard bonds to ensure the ECB guarantee never comes into play.
However, debate over appropriate parameters would be a major step forward as policymakers move beyond the question of whether to provide a true lifeline to euro nations in crisis and start figuring out exactly how to provide one.
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