The starting point, of course, is the realization that the sovereign debt crisis is, at bottom, a banking crisis. The default of periphery members of the euro zone would not pose a systemic crisis were it not for the vast holdings of sovereign debt in Europe's banks.
"The main reason that the specter of an unruly default keeps policy makers up at night is its likely consequences for Europe's banks, whose balance sheets hold some 45 percent of Europe's government bonds," the WSJ editorial says.
Why do the banks hold so much sovereign debt? Mostly because Basel reserve requirements rewarded them for doing so by requiring no reserves whatsoever to be held against sovereign debt.
So what should be done? Well, if Europe is going to go down the bailout road, perhaps it should do it directly.
"The most efficient solution," [IMF Managing Director Christine] Lagarde argued Saturday, "would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary." She suggested that the EU's existing sovereign bailout fund could be used for this purpose.
In response, anonymous European mandarins have taken to the media to criticize the message, arguing that Europe's banks face liquidity issues, but not a solvency crisis.
The criticism merely shows that Ms. Lagarde understands the problem better than her former peers. For any highly leveraged financial firm, solvency is always, in part, a matter of perception, and right now the perceptions are getting worse. The official position of insisting that Europe's banks are sound hasn't worked. Banks that don't need the capital could repay it after the crisis has receded, while all of those subject to "mandatory" recapitalization would benefit from the strengthening of their balance sheets.
Forced recapitalizations are not without risks, especially in terms of moral hazard. But many of these banks are being bailed out already as their bonds come due and they're repaid by Athens, Dublin and Lisbon with funds provided by the EU and the IMF. Short of an economic miracle, others will end up being bailed out directly.
If moral hazard is the fear, better to recapitalize through the front door, a la TARP in the U.S. in 2008. This at least forces taxpayers to confront the costs directly, and to hold the bankers and politicians accountable.
Of course, TARP isn't the best solution. It would be better to distinguish between solvent and insolvent banks, and let the latter be seized and liquidated. The Journal gets this, too:
Moral hazard also could be reduced by sacking bank managers, wiping out current shareholders and giving a haircut to bank creditors, and in some cases breaking up banks that are persistent offenders...
A better model was the Resolution Trust Corporation in the U.S. during the savings and loan crisis in the early 1990s, which made a distinction between solvent and insolvent banks and seized the assets of the latter. That would require the courage to make the distinctions, which Mr. Paulson was reluctant to do three years ago and Europe's politicians are equally reluctant to do today.
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