The bold measures taken by the Eurozone countries, the IMF and the US are to be applauded only in that the plan buys time for the restructuring of the Eurozone. It provides adequate liquidity in the near-term, and from the European perspective, is unorthodox indeed. By allowing the European Central Bank to buy government bonds directly from the market or the governments themselves, they are hoping to mimic the success of the Fed’s measures to deal with the last US financial crisis.

The problem is the nature of the Eurozone crisis is quite different. It is a solvency problem if the governments of the periphery are forced into austerity measures that are unlikely to be accepted by their populations on any sustained basis, and if they remain in the Eurozone. However, it is a temporary liquidity problem if it is used to provide time for an exit strategy by these countries from the Eurozone. As I have discussed before, you cannot announce in advance that a country is leaving the Eurozone. It must be done swiftly and be done either overnight or preferably over a weekend.

I have read many commentators recently who have begun to realize the true nature of the problem. The one thing they keep missing is that such an exit doesn’t mean a government technically defaults on its debt. It has the legal right to redenominate its old debt into its new currency just as it had the right to redenominate its old currency government debt into euro-denominated debt. No one called that a default.

The real risk investors face is that if what is really needed is done and the periphery exits the zone, then investors bear an exchange rate/interest rate risk, since in the initial stages, the value of these bonds may decline compared to the euro, if history is any guide. However, depending on the time horizon, the exchange rate of some of these countries may improve significantly, especially as their external accounts turn around. Using Italy as a past indicator, we see that whenever the lira declined sharply, exports soared, imports declined, international spreads on foreign currency denominated debt usually narrowed and the economy began to grow. This made austerity more politically palatable.

If this occurs in the periphery countries and there is a modicum of austerity, not the kind of austerity which is required by the present system, then Western Europe’s exchange rates against the dollar on a trade weighted basis will improve. This is what the US needs.

US swap lines are helpful, and the US can probably get away without buying government bonds directly, because the ECB will be doing it “for them. ”It will represent a virtual increase in international reserves. The Fed probably went down this route because it doesn’t technically need Administration approval. It keeps the action less political and more below the radar screen, since only a small percent of the voting public understands the arcane nature of central banking.

Tags: Bailout Plan, ECB, eurozone, Exit Strategy, Periphery, Swap Lines