As time goes on without a Eurodebt solution the markets will get impatient and the options will become more stark.

Steve Barrow, Head of G10 at Standard Bank says that the Eurozone could try and just ‘soldier on’ but at the end of the day they will need to find some sort of ‘nuclear option’ to tidy the mess up. The markets didn’t think the EFSF was sufficient to deal with Greece, so Italy will be another question entirely.

Steve Barrow asks ‘Does any such explosive option exist?’ and puts forward some scenarios:

In our view there are a number of options policymakers could take if they decide that the current route of EFSF lending, Greek haircuts, deficit reductions, improved governance and bank recapitalisation is simply not sufficient. One, relatively easy, option would be for the ECB to slash rates dramatically to try to pump some life into the euro zone economy. For, until the euro zone economy turns around, the market is going to be suspicious that deficit cuts will produce results. We look for the ECB to cut rates to 0.5% early next year but we fear that even this degree of rapid easing won’t save the situation.

A second option, which goes dramatically beyond rate cuts, is a decision by the ECB to fully backstop government debt. If debt is monetised the ECB will go well beyond the sort of easing it can get from dropping rates to 0.5%. For not only would money supply increase materially but the euro would fall over time, imparting more stimulus to the economy.

This could certainly work to end the crisis—if the ECB promised to buy unlimited amounts of debt from the outset. Will it sign up to this? ECB members argue that such action is prohibited but, in our opinion, crises call for rule books to be ripped up and this is one rule that could become a casualty. However, it seems very unlikely at this sort of stage. In fact, we feel the ECB would only take this particular nuclear option if it were clear that the only other outcome was EMU collapse. The ECB might hold a nuclear button in its hand but so too do the politicians. For instance, if the problem of the euro zone is that the market is attacking national bond markets, one option is to replace national bonds by one single euro zone bond market. This issue is set to be addressed soon by the EU but those that don’t want the ECB to press its nuclear button are also opposed to this option as well. What’s more, given the poor performance of EFSF bonds recently it’s possible that traders and investors would turn their ire on euro zone bonds if the likes of BTPs, Bonos etc were replaced.

Another nuclear option for politicians is a federalist fiscal structure. This would get right to the heart of the problem but may ask a lot of the markets patience, which clearly seems to be in thin supply right now. We think this option is unlikely at this stage—certainly a lot less likely than a push on the nuclear button marked “single bond market”. Another nuclear option for the politicians is to sacrifice a country. Greece, of course, would be the most likely. But this creates a contagion risk in our view and would not really serve to end the crisis; it might actually make it far worse. Splitting EMU into a ’strong’ northern half, and letting the weaker southern countries do their own thing, might produce a better result, but also seems a long shot right now. So these are some of the options. What button(s) are policymakers likely to press? First up, they are unlikely to press any for now as they will try to soldier on under current arrangements. The next step is likely to be rapid ECB easing and, after that, the creation of a single bond market. If this does not work, leaving the whole of EMU staring over the precipice, we believe that the ECB will have to come in to backstop the bond market—and accept the weaker euro that this will create.”

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