Debt crisis: What is to be done now?

I’ll sketch this in five parts. First, the banks. Then the euro. Then monetary policy. Then fiscal policy. Then growth.

But before we begin, accept this: the denial, delay-and-hope, no-creditor-shall-lose bailout strategy pursued since early 2008, as well as being immoral and destructive, has failed. Until policy-makers really embrace that point, at least to themselves, no progress can be made.

The banks

- Introduce Special Administration Regimes for banks. Now. Not tomorrow.

- Make depositors preferred creditors, overturning current bond contracts.

- If banks are insolvent but essentially going concerns, impose debt-equity swaps in special administration and provide unlimited liquidity to see off bank runs.

- If banks are insolvent, restructure or liquidate.

- Withdraw all government guarantees.

- Do not provide any further government recapitalisation funds. Especially resist the temptation to throw yet more good money after bad in the banks previously bailed out.

- Enact longer-term structural reforms – quickly.

The euro

- Accept that quick fix solutions have failed. Only a comprehensive solution can save the euro (and probably the EU) now. Understand that that comprehensive solution cannot be provided by the ECB printing money.

- Accept that this is fundamentally a political project, requiring political union to work.

- Accept that not all current members can be in the euro. Greece in particular.

- Decide who is not in. In particular, decide which of Portugal, Ireland, Finland and Slovakia is out.

- For those that remain, accept that there must be a dramatic change in the balance of expenditure and sovereign control of expenditure. Specifically, “national” Parliaments must become regional spenders, answerable for their spending and debt levels to a central Brussels authority.

- Understand that the transferunion concept, according to which Germans, for decade after decade, send tens of millions to the Italian/Spanish/whomever government to spend as it will is a complete non-starter.

- Instead, much more funds must be spent from Brussels. Members of the euro must accept that they will send currently unprecedented proportions of their budgets to Brussels, and Brussels will then decide whether it purchases the building of this railway or that hospital or funds those training programmes.

Monetary policy

- Try to retain some shred of credibility (and dignity) for your inflation targets and broader central banking policies.

- In particular, when pondering grand schemes for central banks to buy vast quantities of junk bonds, recognise that having your central bank go bust can ruin your entire day.

- Also, for goodness sake stop pretending. Set an inflation target you actually hope might be met.

- Seek to normalise interest rates. The right medium-term objective is not that they be a low as possible. The right objective is that they be at the natural rate of interest, at which investment decisions are socially efficient (not too much, not too little).

- Over the medium-term, understand that inflation targeting has intrinsic flaws that tend to generate credit cycles.  Consider alternatives such as price-level targeting.

Fiscal policy

- Look to your own ramparts. No nation should be so arrogant as to assume that it can afford to run whatever debts it likes.

- Focus deficit reduction programmes on spending cuts. Raise taxes only to the extent that that is required, politically, to deliver the spending cuts.

- In countries that have dramatically raised spending in recent years, such as the UK, cut spending as far and fast as is politically feasible. Once you have completed that, consider cut spending some more.

Growth

- The most powerful tool the government has for promoting growth is to cut spending. The worse the growth outlook gets, the stronger the argument becomes for cutting spending further and faster.

- The next most powerful tool the government has is to increase the productivity of its own spending, in particular by increasing public sector productivity growth. In the UK, if public sector productivity growth were to be only as fast as private sector productivity growth (a modest achievement, given that it fell one third behind from 1997-2007), economic growth would be 0.5 per cent higher each year.

- If the government wants more rapid public sector productivity growth, it needs to unashamedly promote markets, competition, and profit-seeking in health and education.  If it refuses to countenance competition or profit-seeking in health and education, we can confidently assert that though it may will the end of more rapid GDP growth, it does not will the means.

And once you’ve done all these things, do one more: pray.