"Pay our bills -- or -- we'll DEFAULT!"

“I bargained for salvation/And she gave me a lethal dose.”   Bob Dylan

Our ear has lately been whispered into by the Gnome, of whom we have spoken before.   Privy to the subtle ripples and eddies of quiet conversations in dimly-lit back rooms and the halls of state, the Gnome sees a consensus developing that could well guide the course of European finance for the next decade.  If successful, this strategy would solve the issues of sovereign debt bailouts, bank balance sheet shortcomings and the highly- controversial topic of European integration and federalism.

“There’s a way out,” says the Gnome, “and everybody wins.”

“What is the way out?”  we queried tremulously.

“The three Rs,” said the Gnome.

Well, hell.  Of course.  Maybe if people could read the writing on the wall and add up the numbers, we’d all be in better shape, but isn’t it a little late for that?

“No,” said the Gname.  “These are the three Rs:  Rescheduling.  Recapitalization.  Restructuring.”

Briefly:

Rescheduling:  No one wants a Greek default.  The recent noises and trial balloons about an “orderly” default are bogeymen to scare voters in the northern nations into accepting the inevitability of rescheduling Greek debt.  This would accomplish one good thing and inflict one bad thing.  Good thing:  the quarterly interest payments for Greece would decline to sustainable (read “subsidizable”) levels.  Bad thing:  many banks would take substantial hits to their balance sheets, leaving them on shaky ground.  Hence:

Recapitalizing:  European central banks would enable these banks to recapitalize at favorable terms, through low-interest lending and other devices, in exchange for hard concessions on regulation (“ring-fencing” of deposits chief among them), and another less-tangible, more subtle but very far-reaching agreement among major European banks and central banks that can loosely be termed:

Restructuring:  a major and profound distinction between the banking system in the “United States” of Europe and the United States of America lies  in the regional nature of  European major banks.  While the largest European banks have expanded significantly into new markets internationally, much of that expansion has been outside the European continent.  Deutsche, Societe General, BNP Paribas,  UBS, Credit Suisse and Barclays now do significant business in the US, Asia, Latin America and elsewhere, but their European business –especially at the retail and corporate middle market levels, remain largely centered in their home markets.  In the US, JP Morgan Chase, Citi, et. al.  have significant stakes in California, in Texas, Illinois and most of everything in between, and are therefore national in outlook.

How to do this in Europe?   It may be that a great many smaller banks, especially in the southern nations, will suddenly find their requests for assistance to their central banks met by chilly smiles and a suggestion that they should accept those phone calls they have been getting from the strange men speaking German or French (or Swedish or whatever), who have evidenced an interest in acquiring a small — say 51% — stake in their operation.  A Deutsche Bank with hundreds of thousands of Greek and Italian and Spanish depositors — and billions of euros in loans to hundreds of borrowers — is less likely to turn a deaf ear to cries of distress from these markets in the future.

The key right now is to accept the distasteful notion of letting the Greeks get away with it.  Germans were perfectly happy to giggle along with the Greeks when they joked about the taxman, but are much less amused when they find it is they who wind up paying him.  But that’s the harsh reality.  Under the structure laid out above, the Germans (and the French, and the Swedes, etc) will all get their pound of souvlaki, and without the potentially catastrophic continental purge that will likely ensue in any type of default.

More important, it addresses in a wonderfully European way the whole issue of greater political integration of Europe, which most Europeans really don’t want.  Of course, the eurocrats want it, and make strident speeches about eurobonds — perhaps the most noisome notion ever to find voice — and potential war (!).

Since the impetus for renewed calls (by eurocrats) for a federalization of European states and a stronger integrated central bank is financial, perhaps the best solution to the question is also financial — that is, a stronger actual interlinking of continental banking institutions with substantial stakes in other European nations would provide powerful incentives for greater economic cooperation without the doubtful baggage of yet more political apparatus.  For many Europeans, the only thing more distasteful than a joke parliament in Strasbourg or Brussels or wherever it happens to be meeting at the moment is a serious parliament with real power.

Will all this come to be?  The Gnome seems to think so.  And on these matters, he has been uncannily prescient in the past.  We watch with hopeful eye as the drams continues to unfold, but remain mindful that the discussions that matter are probably not being reported in the press, which has been hilariously inept at any effort to untangle the jumble thus far.  And the eurocrats?  They see their moment slipping away, which might explain the somewhat shrill nature of some of the statements issuing from their battlements.  Hardly a bad thing, from our point of view, which is admittedly jaundiced, yet still optimistic.  Europe has survived the Moors, Napoleon, Hitler and mad cow disease.  It should be able to deal with this.