Winning the European Confidence Game

CHICAGO – If any solution to the European crisis proposed over the next few days is to restore confidence to the sovereign-bond markets, it will have to be both economically viable and politically palatable to rescuers and rescued alike. This means paying attention not just to the plan’s technical details, but also to appearances.

There is growing consensus about any solution’s key elements. First, Italy and Spain will have to come up with credible medium-term plans that will not just restore their fiscal health, but also improve their ability to grow their way out of trouble. While any plan will involve pain for citizens, the markets must deem the pain politically tolerable, at least relative to the alternatives.

It is important that these plans be seen as domestically devised (though voters will have no illusions about the external and market pressures that have forced their governments to act). At the same time, an external agency such as the International Monetary Fund could render the plan more credible by evaluating it for consistency with the country’s goals and monitoring its implementation.

Second, some vehicle – the IMF or the European Financial Stability Facility, with either entity funded directly by countries or the European Central Bank – has to stand ready to fund borrowing by Italy, Spain, and any other potentially distressed countries over the next year or two. But there is an important caveat, which has largely been ignored in public discussions: if this funding is senior to private debt (as IMF funding typically is), it will be harder for these countries to regain access to markets. After all, the more a country borrows in the short term from official sources, the further back in line it pushes private creditors. That makes private lenders susceptible to larger haircuts if the country eventually defaults – and thus more hesitant to lend in the first place.