There is no Such Thing as Free

‘Free insurance’ option has no stigma – FT.com.

Let us look at this idea from the above-referenced article and see if it holds up to scrutiny:

By guaranteeing for example the first-loss tranche of, say, 30 per cent, risk-return profiles of government bonds are considerably improved, risk premiums should at least be halved. Investors, not least banks, would be incentivised to buy such bonds.

The author of this article is Michael Heise, an executive at Allianz. He believes that bond insurance for stricken Eur0-zone countries will give these countries enough time for reforms to do their magic. On its face, this is a reasonable idea, but let’s do the math and take this thing to where it inevitably leads us.

First, in order to stop flight from all Spanish and Italian debt and not just create a class of new preferred debt we have to make the 30% insurance program available on all issues. This means that the EFSF/ESM needs to come up with 840bn EUR. That’s way more than is available. Furthermore, we know that Italy and Spain are responsible for putting up about 30% of this figure, 242bn EUR. Where is this money coming from? I’m not being snarky; it’s just that the reason we have this bond insurance is because these countries can’t borrow money. Now, they are expected to borrow money to give back to themselves to insure their bonds.

Second, if two countries have preferred debt, their rates will fall just as the author says; however, some of this finance will come at the expense of other Eurozone countries. Their rates will rise, and they will ask to be included in the bond insurance program, too. That means we have to add Ireland’s, Portugal’s and Greece’s debt to the bond insurance program. Where is this money coming from?

In the end, there is no free lunch. What the Euros have to do is bite the bullet. A massive reform program to free each country’s economy so that it could eventually become competitive in combination with a large currency devaluation, whether it be the Euro, Peseta, Lire, Escudo, Drachma or Quatloo.

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