The Money View

Lethal Embrace? A Thought Experiment

At the heart of the Eurocrisis lies a vicious circle where once there was a virtuous one.  Over the last week or two, the FT has been reflecting on the connection between the sovereign debt crisis and the bank crisis, conjoined twins (as George Soros has put it) of the current Eurocrisis.  See here, here, here.

Historically, banks have stepped in to help sovereigns in their time of need, such as the stresses of war finance, by expanding their own balance sheets, offering bank liabilities (money) in exchange for sovereign debt that has no alternative ready market. 

Contrariwise, sovereigns have stepped in to help banks in their time of need, offering central bank liabilities (reserve money) in exchange for bank debt to allay periodic liquidity crises, and sometimes going so far as to offer sovereign Treasury liabilities in exchange for bank equity issue that has no alternative ready market.

The problem Europe now faces is that monetary union, a fait accompli, left in place the historical symbiosis between national banking systems and national sovereignties, as well as the pattern of thinking formed by generations of experience with that symbiosis.   As a consequence, when the crisis hit, national banking systems stepped in to help their national sovereigns, and national sovereigns stepped in to help their national banking systems.  

Both thought they were doing the right thing, based on past experience.  But the consequence has been to transform isolated sovereign debt crises into systemic bank crises, and to transform isolated national bank crises into systemic sovereign debt crises.  What started as a problem of the periphery (the famous PIIGS) is now threatening the very core of Europe, both sovereigns and banks.  The ongoing run on Greece et al. is now threatening to become a run on Europe, both European sovereigns and the European banking system.

The problem is that banking is no longer national, and neither is sovereignty.

Calls for “fiscal union” are calls for replacing lost national sovereignty with something new, supra-national sovereignty.  The EFSF, and then the ESM, were supposed to be steps on the road toward a common European Treasury, and a common European sovereign debt (Eurobonds and Eurobills).  Maybe it could work, from an economic point of view, but by now it looks like too big a step to be achieved in the time available, from a political point of view.  Angela Merkel is not wrong when she says we are in a race between politics and the market, and we know which one of these is the hare and which one the tortoise.

That is the background needed to understand properly the shift, in recent weeks, toward focus on “banking union” instead.  But old patterns of thinking still stand in the way.  If you think of banks and sovereigns as inherently symbiotic, then it is hard to conceive of banking union without fiscal union, and vice versa.   (See here the FT article today that finally inspired me to put my developing thoughts on the record.)

Here is the main point.  History tells us that there is nothing inevitable about such a symbiosis.  Banking, indeed even international banking, existed long before the modern nation state.  The origin of the lender of last resort function of the modern national central bank is in the operation of private bankers’ banks.  (In the US, before the Fed there was J. P. Morgan.)  There is no logical, or economic, necessity for sovereign backstop of banking.   It follows that there is no logical, or economic, necessity for fiscal or political union to precede, or even coincide with, banking union.

Of course today the balance sheets of European banks, including the ECB, are stuffed with sovereign debts of one kind or another, and that fact by itself makes it hard to think about banking union without fiscal union.  But let’s try, as a little thought experiment.  

Let us imagine a special purpose vehicle, a private vehicle without supra-national backstop, which issues its own private securities of various types and uses the proceeds to buy sovereign debts of various types.   (For those who remember fall 2007, think of it as an analogue to the super-SIV idea, except that the assets are sovereign debts rather than tranches of securitized subprime mortgages.)   In this way, sovereign debt could be removed from the banking system and replaced with cash, which (suppose) banks use to repay liabilities so shrinking their balance sheets by the size of their debt holdings.   No doubt some banks would still be in trouble, but we can imagine banking union proceeding as the Europe-wide solution to that remaining trouble.

But wait, you say, what about deposit insurance, currently national and so currently a second channel of lethal embrace?  But this is just another asset of the bank and another liability of the sovereign.   Since we are just thinking, let’s imagine that we place a market value on this asset and have the SPV buy it as well.   Note that, by making this implicit asset explicit, bank capital will be increased.  Even so, no doubt some banks would still be in trouble.

The point of this thought experiment is to enable us to think separately about the sovereign debt crisis and the banking crisis, and to conceive of the possibility of addressing each separately.  At the end of the day we will be left with a range of private banks, some insolvent, some merely illiquid, and perhaps a few that are okay.  That is one side of the problem.  And we will be left with our SPV; that is the second side of the problem.

But, most importantly, we will also have broken the lethal embrace.   Investors who are thinking about lending to private banks, or perhaps taking up a new equity issue or taking over the existing equity ownership, can form estimates of value without having to consider the fortunes of the bank separately from the fortunes of the sovereignty where that bank has its headquarters.  And investors thinking about lending to a sovereign, or perhaps taking up the securities issued by the SPV, can form estimates of value without having to consider the fortunes of the banking system that happens to be headquartered within the national boundaries of that sovereignty. 

If we think the lethal embrace of banks and sovereigns is currently taking both down together, then breaking that lethal embrace should improve the fortunes of each separately.  It’s a win-win.

Historically, the origin of the embrace between sovereigns and banks was pragmatic.  They did it because it was a win-win.  Today it looks like the win-win involves dissolving the embrace.  



I thought this was already one of the plans for europe - and it still makes just as little sense. The problem with this is a matter of simple math.

The only way you get benefit from this scheme of aggregating debts is if the statistics of the quality of debts is known but the actual distribution is not. For example, if 10% of the bonds would default in total, but they are uniformly distributed and we don't know which ones will go bad. But that is not the case for europe. In Europe the distribution is known: the southern euro bonds are effectively already defaulted and are known to be unsustainable. Thus in order to account for this risk, the interest rate on the SPV issues would have to be just as high as required to buy the bonds at present market rates. There's no way this scheme would be able to buy the existing bonds at face value. Of course, the ECB could fire up the presses and buy these bonds at any price - but in that case why not just buy the sovereigns directly? And does ECB money subordinate other buyers? And if so, who else would ever buy them?

Even if this scheme got off the ground and sold its issues, there's the possibility it blows up later, just like all those other CDOs. Except this one is a bit larger in size.

It's a shame, we already ate the "free lunch".. either ECB prints a ton of money and pays bondholders or bondholders lose a ton of money. Or Germany leaves.


I think you miss two key differences between my SPV and the EFSF/ESM.  

First, I have the SPV buy ALL sovereign debt anywhere in the Europe-wide banking system, not just peripheral debt.  the whole point is to disentangle the fortunes of states from the fortunes of state banking systems.

Second, the SPV is not backed by Germany, or Europe as a whole, so its liabilities are not Eurobills or Eurobonds.  Their value depends on the portfolio of assets, simple. 

You raise the question whether ECB would discount the bills.  Maybe yes, maybe no.  If my scheme were to work, it would be because current holders of bank debt find the SPV debt an attractive alternative.




Very interesting post. It is not an easy task to separate conjoined twins, and the risk of catastrophic consequences is big for both parts.
My questions would be: Is it likely that the SPV can fund itself to buy all European sovereign debt? And will the SPV not be assumed to have an implicit backing from the sovereigns?
The follow-up comment, in the light of Kindleberger's saying that for stability we need a stabilizer, so to stabilize the Euro-zone we need united implicit backing from all the European countries.
Maybe that is not enough and we need an outsider to strengthen the stabilizer, so would it for example be an idea making the SPV a global sovereign debt fund?



I appreciate your comments.

Remember that the SPV is holding only debt that was formerly held by the banking system, and that the banking system is currently having quite a difficult time funding itself.  I think the SPV should have an easier time if only because its exposure is more transparent and easy to value.  Remember also that the individual sovereignties stand behind the assets of the SPV already, individually, and in that limited sense implicitly stand behind the liabilities.  If there were will to jointly and severally explicitly stand behind the liabilities, then those liabilities would be Eurobills and Eurobonds.  But anxiety about that kind of guarantee is exactly what is holding up progress now, so I have explicitly designed the SPV without any such guarantee.

The capital entry in the SPV is meant to suggest the possibility of an outsider setting up the SPV, and using its own credit to enhance the quality of the SPV liabilities.  That entity could be private or public.  (MF Global comes to mind, but they failed because their funding was tied to collateral values of individual bond issues.  Perhaps we can learn from their mistake.)

On the issue of stabilization, note that I have deliberately avoided talking about the ECB.  Again, anxiety about monetization of sovereign debt has held up progress, and I have therefore imagined the SPV without any explicit access to the ECB discount window.  But I can imagine that the bills issued by the SPV might well qualify as eligible collateral, not only at ECB but also more importantly in private clearing arrangements.

It is interesting to me that both Asgeir and Anonymous focus on the sovereign debt and SPV side of the separation, as if that were the "bad bank" and there would be no problem with the remaining private "good bank".  








I'd go further and make the SPV massively and easily available for universal online retail investment. As banking sector uncertainty grows, all those tax dodgers are going to want to want somewhere clear to stash their dosh. Let's make their returns tax free!

It's too difficult to invest in European states as it is from the avg Joe perspective. Why is it so easy to take out an overdraft or create a retail bank account, but so difficult to lend to a govt., or to one in the EZ?

Seems clear to me that the only way out of this crisis really is going to be huge state spending on new infrastructure, technology, etc., without WW3 or Falklands or Iran or whatever the hotheads think might help. We clearly can't trust a dysfunctional finance sector to properly allocate resources, so let's all lend to this SPV and hope to God it becomes as a consequence powerful enough to abuse its status and throw around some political clout....


This looks like a promising idea. But recall: the SIVs ended badly (they are extinct) because they collapsed onto the balance sheets of their sponsors, unable to obtain funding in wholesale markets. Who is going to sponsor your SIV, and how are they going to provide liquidity support and credit enhancement?


There are several ways to go at this, which is why I left it open.  Not completely open, since I have included an equity tranche (which serves as a kind of credit enhancement for the tranches above it).  Also, I have in mind that current holders of bank bonds probably will prefer the SPV bonds, so you could just do a swap there.  

The liquidity support issue is mainly about the bills, so one question is whether the ECB would accept them at the discount window.  Not my call, but I would observe that a claim on a diversified portfolio is better than some of the assets they have now.  Indeed, the ECB might itself take advantage of the SPV to unload some of its current sovereign debt and replace it with SPV debt.

Lots of ways to go.  I'm just trying to indicate a few of the possibilities.


Why wouldn't we just erase the debt seeing as it is a nuisance to every country that has it. It's sort of like saying you will no longer play the game of winer and loser. If everything were based on the legitimate value within the country, not the perceived value, possibly what the country were working towards. If money were based off necessity, the mother of invention, being that each new problem that had arisen from human activity over the years of our existence were to be the necessity to be solved, each currency could be based on achieving the goal of solving that problem. So you could imagine a different currency for each different problem that needed to be solved.

The way you would determine whether or not the problem would need to be solved is whether the problem were a threat to health of any single human being, and being that it were a threat to one human being, we would determine that it would be a threat to all human beings, simply because it was a threat to one human being, because human beings are physically 99% the same.

Anyway back to the problem solving situation. A different currency for solving each problem. The human activity from trading, exchanging the currency/money from one human body to another human body would be activity working toward solving the problem. A currency for preventing cancer creation and spread (eliminate burning). A currency for no longer contributing to human created climate change/massive population decrease (eliminate burning/GHG & toxic emission). A currency traded to decrease and no longer create waste. A currency for no longer supporting oligarchy!

Debt does not help anyone. It gives human beings things they aren't supposed to have yet. It allows human beings to do meaningless things to have ability to consume. The only activity they get involved in is consuming and that is their meaningful thing in life. They have a Just Over Broke to get money so they can use that money to do the things they like (consume).

Fractional Reserve Banking is a thing of the past, we print money based on supply and demand, but the value of the paper money goes down as we print more, unless we remove the old money from the marketplace, however this has psychological value, like old coins do, even if they aren't made of valuable material. Think of Art. I know the wealthiest families printed the money, came up with fractional reserve banking, hold egregious amounts of gold and gave that money, with interest of course, to kings and governments (the sovereignty).

Having debt encourages countries to go to war against each other. Think about how Nazi Germany became. They owed numbers to France and London as well as a bunch of other countries. Putting human beings in debt creates the ruler and slave situation. You are truly a programed obedient slave if you think this is not true.


I fail to see any benefit in this action other than smoke and mirrors to extend and pretend. Lets assume this is done. Then what? Lets assume the SPV must trade in the public to get market feedback or else there is no mechanism for fiscal discipline. Well at best we have a bit of a reset as we head back into a remix. We have no structural change of lasting impact.

The issue to me at this time is that most all money is created as credit with interest due. In a infinity world this is not an issue. In a world finite in people, resource and to a great extent, GDP growth rate, it is not simply the natural cycle of terminating bad bets but a poorly designed social structure in managing the liquidity short fall driven by the interest due as a world approaches population capacity.

The choice of printing this money into banks seems to be a poor one other than perhaps as emergency measures. We are a wealthy society. More civil alternatives are due.

As an example. Perhaps when we report on our income tax filing, the interest we have earned, we are issued credits of equal value that must be spent on someone else's debt. We could randomly be provided 50 choices with some anonymous details.

We could then all (and individually) manage inflation and liquidity by our allocation of savings to stock or interest investments. We would also be able to all (and individually) impact how credit builds our future.


I think this is an excellent post. Congratulations. This may well help a lot. Keep going, keep posting, keep developing these ideas please; they are excellent.


I like the SPV idea - it's brilliant. Here's another technique that can be used by our SPV:

Assuming this SPV is there to transfer risk. It can sell insurance (Credit Default Insurance) on any sovereign government debt at fixed (non speculative) premium. The cash inflow from selling insurance can be used as the reserves or invested to earn further cash flow. We now have a fund that can produce liquidity and move it to the markets where it's needed the most. The buyer (mostly banks) of this insurance have two possible use of it: One he is speculating that the underlying issuer will default, two he is hedging his exposure to the underlying issue. In both cases, he gets a good deal in exchange for making premium payments on annual basis.

Since most CDS have to be marked-to-market and may require margin accounts, this should be an insurance contract not to make our SPV search for liquidity to settle cash every day. This contract is a pure protection that pays in the event of a downgrade or default. Is downgrade possible? Yes, but given the existence of insurance, the demand for sovereign paper will increase. This would reduce the rate the government has to pay to refinance. Less the gov't has to pay to borrow more it can use to address the structural issues in the Economy. I hope S&P would not mind leaving the rating intact if this happens. Can Defaults happen - not unless ECB continues to be there to help.

Of course, the point is that like any insurance company, our SPV can pocket the premiums if no accidents happen, if they do occur, the insurance payback to investors can cushion the German taxpayer from bailing out the government of Cyprus. So, our SPV should probably have some implicit guarantee from ECB: It would almost be a Euro Mac.

However, like everything else in the Economics, ceteris paribus - and bunch of assumptions that may never hold.

Post new comment

The content of this field is kept private and will not be shown publicly.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
  • Allowed HTML tags: <a> <blockquote> <br> <cite> <code> <dd> <div> <dl> <dt> <em> <h2> <h3> <h4> <img> <li> <ol> <p> <span> <strong> <sub> <sup> <table> <tbody> <td> <tr> <ul>
    Allowed Style properties: display, float, height, margin, margin-bottom, margin-left, margin-right, margin-top, width
  • You may insert videos using embed codes like these:
    • [video_large:KoqLu5CKx-o]
    • [popupvideo_mini:KoqLu5CKx-o right]
    • [lightboxvideo_mini:KoqLu5CKx-o]
    • [text_popupvideo:KoqLu5CKx-o nostart noicon|Click here to open the video.]
    • [text_lightboxvideo:KoqLu5CKx-o|Open this video in a lightbox.]
    To learn more, please click on the "More information..." link below.

More information about formatting options

Type the characters you see in this picture. (verify using audio)
Type the characters you see in the picture above; if you can't read them, submit the form and a new image will be generated. Not case sensitive.