The EFSF would be used primarily to guarantee and recapitalize banks. The systemically important banks would have to sign an undertaking with the EFSF that they would abide by the instructions of the ECB as long as the guarantees were in force. Banks that refused to sign would not be guaranteed. Europe’s central bank would then instruct the banks to maintain their credit lines and loan portfolios while closely monitoring the risks they run for their own account. These arrangements would stop the concentrated deleveraging that is one of the main causesofthecrisis.Completingtherecapitalizationwouldremovetheincentivetodeleverage.Theblanketguaranteecouldthenbewithdrawn.
To relieve the pressure on the government bonds of countries such as Italy, the ECB would lower its discount rate. It would then encourage the countries concerned to finance themselves entirely by issuing treasury bills and encourage the banks to buy the bills. The banks could rediscount the bills with the ECB but they would not do so as long as they earned more on the bills than on the cash. This would allow Italy and the other countries to refinance themselves for about 1 per cent a year during this emergency period. Yet the countries concerned would be subject to strict discipline because if they went beyond agreed limits the facility would be withdrawn. Neither the ECB nor the EFSF would buy anymorebondsinthemarket,allowingthemarkettosetriskpremiums.Ifandwhenthepremiumsreturnedtomorenormallevelsthecountriesconcernedwouldstartissuinglonger-durationdebt.
These measures would allow Greece to default without causing a global meltdown. That does not mean that Greece would be forced into default. If Greece met its targets, the EFSF could underwrite a “voluntary” restructuring at, say 50 cents on the euro. The EFSF would have enough money left to guarantee and recapitalize the European banks and it would be left to the International Monetary Fund torecapitalizetheGreekbanks.HowGreecefaredunderthosecircumstanceswouldbeuptotheGreeks.