The Politically Expedient German Scheme for Eurozone Sovereign Debt Bail-Ins

Yves here. This is an important and accessible post on another bad Eurozone idea that might be implemented, that of a scheme for the orderly restructuring of sovereign debt. While idea of having some parameters and processes in place is a good one, the program under consideration is fatally flawed. Ambrose Evans-Pritchard wrote about this topic earlier based on the stinging dissent by one of the members of the German Council of Economic Advisors. From our post on his article:

Evans-Pritchard’s story appears to have been placed by Peter Bofinger, who is apparently a lone and loud dissenter on the five-member German Council of Economic Advisers to the sovereign bail-in plan.

From the Telegraph:

A new German plan to impose “haircuts” on holders of eurozone sovereign debt risks igniting an unstoppable European bond crisis and could force Italy and Spain to restore their own currencies, a top adviser to the German government has warned….

The German Council has called for a “sovereign insolvency mechanism” even though this overturns the financial principles of the post-war order in Europe, deeming such a move necessary to restore the credibility of the “no-bailout” clause in the Maastricht Treaty….

Under the scheme, bondholders would suffer losses in any future sovereign debt crisis before there can be any rescue by the eurozone bail-out fund (ESM). “It is asking for trouble,” said Lorenzo Codogno, former chief economist for the Italian Treasury and now at LC Macro Advisors.

This sovereign “bail-in” matches the contentious “bail-in” rule for bank bondholders, which came into force in January and has contributed to the drastic sell-off in eurozone bank assets this year.

Prof Bofinger wrote a separate opinion warning that the plan could become self-fulfilling all too quickly, setting off a “bond run” as investors dump their holdings to avoid a haircut.

Italy, Portugal and Spain would be powerless to defend themselves since they no longer have their own monetary instruments. “These countries risk being hit by a dangerous confidence crisis,” he said.

Yves here. Bofinger’s warning was based on the assumption that the next move would be for countries like Italy and Portugal to introduce their own currencies pronto. But as we discussed at length (see here, here, and here for some examples), it will take years to convert to a new currency, thanks to systems requirements, most of which are not under the control of the government wanting to make the conversion. In the case of Greece, as we saw in its two-week bank holiday, the lack of access to international payments systems hit key imports – tourism, food and pharmaceuticals – hard and would have soon started affecting fuel imports. Greece is not self-sufficient in food. Italy may be, but does it have the staying power to function as an autarky for 3+ years? (Yes, IT experts who know the relevant systems estimated three years was the minimum amount of time to execute a conversion smoothly. No planning, meaning trying to manage an emergency while you are also trying to deal with the systems issues, would almost certainly be worse).

So the fact that the Eurozone is a roach motel may be why the Germans think they can push their plan through. But in tightly-coupled systems, measures to reduce risk actually wind up increasing it. And bail-ins don’t just fail to reduce risk, because they shift it from taxpayers to investors. They increase it by putting in place an automatic procedure. Now that procedure may wind up being suspended in practice. But if it is believed to operate in an automated manner, parties will move to get out of its way when it is in danger of kicking in, creating runs. In this case, unlike Bofinger, I don’t think this will cause exits. It will cause funding crises at Eurozone states and bank runs, since bank guarantees are primarily at the national level and the second-level of Eurozone-wide guarantees is thin and only in the process of being funded.

And that’s before you get to the immediate tight-coupling factor: this mechanism would lead to haircuts of sovereign debt sitting on bank balance sheets. Worse, imposing losses on banks is a feature, not a bug.

You can read more here.

By Charles Wyplosz, Professor of International Economics, Graduate Institute, Geneva. Originally published at VoxEU

The German Council of Economic Advisers has mooted an interesting proposal to deal with excessive public debts in the Eurozone (Andritzky et al. 2016a, 2016b). This is a major remaining gap in the Eurozone, which governments would prefer to keep ignoring. Although the authors should be commended for bringing it up, their proposal suffers from some inherent weaknesses.

It is obviously essential to prevent another Greek PSI, which was so long in coming that most private lenders escaped scot-free, pushing the debt into public hands and thus reducing the scope of the operation while burdening helpless taxpayers. It is also crucially important to rebuild the no-bailout clause, which requires that member states be able to restructure their debts if they cannot serve them anymore. This is why the IMF has put forward its own policy principles; so indeed, the genie is now out of the bottle.

The proposal suffers from two logical errors. Its two-step procedure – first, extend debt maturity; second, trigger a debt restructuring – is justified by the familiar distinction between illiquidity and insolvency. Like many others, the authors accept this distinction as it applied to governments. However, it has long been recognised, that insolvency does not apply to governments (Eaton et al. 1986, Bulow and Rogoff 1989). One reason is that legal rights are fuzzy. Another reason is that it is not even clear how one can compute the present value of future public spending and receipts, not to mention how to evaluate the value of public assets. In fact, governments are never insolvent. One can ask instead whether honouring public debts is economically sensible and whether it is politically feasible. But that is a value judgement, not a formal assessment. A third reason is that illiquidity and insolvency are not separate concepts in a world of multiple equilibria, which characterise debt crises. It follows that a sovereign debt crisis requires a single step.

For this step to be successful, it is highly desirable that sovereign debt instruments include a collective action clause of the kind advocated by the authors, in line with much of the literature, going back at least to Krueger (2002). The key insight here is what we now call bail-in, namely, that debt-holders be forced to accept losses. Herein lies the second logical error. As long as public debts are held largely by domestic creditors (including banks), governments will have to deal with the losses, one way or another. In particular, banks may fail and need to be bailed out, which implies that a significant chunk of forgiven debt will resurface promptly as new public debt. This is what Brunnermeier (2011) has called the ‘doom loop’ between governments and domestic banks. The proposal does not consider this lethal problem.

The proposal also suffers from several weaknesses. To start with, decisions are guided by arbitrary thresholds. This is already a major weakness of the Stability and Growth Pact (successive revisions have tried to move away from the 3% deficit ceiling and the 60% debt ceiling was obsolete by the time the euro was launched). As the authors note, rules that are not enforced undermine incentives to obey them. Arbitrary thresholds are especially problematic when the decisions are to be taken by unelected officials, which is the case of the EMS. The proposal implicitly tried to alleviate this weakness but allowing for bands instead of single targets, but the result is to worsen the situation as it gives more discretion to the EMS. The stated intention is to establish a rules-based process – which is commendable – but the rules must be both robust and economically justified – which they are not.

Two other major weaknesses concern the second stage. The depth of the restructuring is to be set by the EMS on the basis of debt sustainability analysis (DSA). The IMF has developed DSA, only to discover its arbitrariness, exemplified during the early phases of the Greek crisis. Note first that this procedure refers to sustainability, not solvency – a nod to the inadequacy of this concept, as mentioned above. Yet, DSA does not avoid the problem of assessing future incomes and receipts of a government. Present value calculations are remarkably sensitive to slight variations in assumptions concerning interest and growth rates over the long run (Wyplosz 2011). Well aware of this difficulty, the IMF increasingly presents its DSA calculations as an exploration of their relationship to the assumptions. The implication is that the EMS would have to make a decision on the basis of superficial calculations, deepening the difficulty of relying on delegating decisions to unelected officials. This is compounded by the fact that debt restructuring involves massive income transfers. This is the other weakness – only elected officials can make such decisions. Because the only elected officials that we have are governments and their parliaments, debt restructuring must be a national decision. The IMF procedure is to negotiate debt restructuring with national governments, requesting that it officially be their decisions. This may be what the authors have in mind, but then they should carefully spell out the procedure.

In the end, the proposal makes the case strongly that collective action clauses should be applied not just to the financing of deficits, but also to maturing debt refloating. Under the first approach, the volume of debts subject to the clause will be kept insufficient for far too long. Otherwise, the proposal recycles well-established ideas but imbeds them in an original setup that suffers from grave limitations. In addition, they refrain from alternative proposals (Pâris and Wyplosz 2014, Corsetti et al. 2015) that aim to deal with excessively large debts as soon as possible, rather than waiting for the next crisis. Waiting for trouble is the strategy of choice of policymakers, fiercely defended by the German government. The proposal serves to strengthen a strategy that is politically expedient but economically dangerous.

See original post for references

Print Friendly, PDF & Email

9 comments

  1. Synoia

    Charles Wyplosz

    However, it has long been recognised, that insolvency does not apply to governments (Eaton et al. 1986, Bulow and Rogoff 1989)

    …sovereign debt instruments…

    …As long as public debts are held largely by domestic creditors (including banks), governments will have to deal with the losses…

    Professor Wyplosz seems to avoid stating that the Counties in the Eurozone are not sovereign, and cannot create money. He hints at the concept but avoid addressing it directly.

    So I suggest (addressing it directly):

    1. On joining the Eurozone the procedure should be that all country debt is reissued as Eurozone debt and managed by the central Government of Europe (an anathema to the Germans.)

    2. All current Country debt be replaced by debt at the Eurozone level, and become the responsibility of the European Parliament.

    3. The European Parliament (Not the EU Commission) gain control over the ECB as other government have control over their central banks.

    Feature of Bug?

    1. Si

      Whilst I don’t disagree, I can’t help thinking that your proposal is simply an ‘extend and pretend’ strategy. You can rename and reorganise the ‘Enron’ nature of the problem but the problem still exists. It would lead to the Euro Parliament monetising debt issued by the ECB (which I think they are already by the back door) in increasing amounts.

      What I might argue with is the idea that governments have control over the Central Banks – I think it is the other way around.

  2. sunny129

    Since DEBT on DEBT has been accepted as a panacea for all the on going financial problems( private & public) in the World since 2009, more dissertations are coming out by the pundits on the variation of the same.

    A DEBT which cannot be paid, will NOT be paid, no matter what!

    The only game being played (I acknowledge grudgingly very successful, so far!) is band aid solutions, extend and pretend! No one ( who matters most) is dared to speak the truth!

    Insanity reigns and the charade continues!

  3. dk

    Tangential to the article proper (with feeble attempt to tail it back around):

    Yves, reading your references to the currency conversion discussions here at NC, flashed on this comment posted to todays Links:

    Bunk McNulty
    http://cfdtrade.info/2016/08/links-8116.html#comment-2646492

    The Chip Card Transition In The US Has Been A Disaster (Qz)
    http://qz.com/717876/the-chip-card-transition-in-the-us-has-been-a-disaster/

    “… the simple fact is that with chip-and-signature, banks created a new, less secure way to pay—when a more secure version was available.”

    While very different from a currency conversion (or is it?!?!), this is a real-world model/example of the kinds of deployment/compliance/compatibility issues that can come up in relation to payment processing.

    Note the way the various players making “this works for my needs” selections:
    – decided to implement weaker chip-and-signature instead of the more secure chip-and-PIN configuration
    – left out open-transaction cases like bar tabs, existing tipping patterns
    – fumbled on the cost/incentive ratio for smaller stores

    The transaction time is slower at least in part because of the establishment of a secure connection, to the payment processor (bypassing the vendor, see cm’s comment in the NC thread), more secure is good, but more time disincentivised vendors from using the chips during the holiday peak.

    And this strip-to-chip conversion retains the option to fall back and use the old strip, much more forgiving (gracefully degrading) than the requirements of a currency conversion would probably permit. The ‘doom loop’ mentioned in the article is the kind of unrecognised coupling/cascading that can occur under the radar of top level planners who are unfamiliar with the full scope of the conditions they want to alter. And that’s just the robustness part of “robust and economically justified”.

  4. digi_owl

    It is massively impressive how long they manage to maintain the idea that sovereign debt is a cause rather than a result.

    I just wish i could take a step sideways so that once their minds finally pop i am not caught in the blast…

  5. Jesper

    Only an economist would even consider making an universal model for calculating DSA….

    Write-off/down will be whatever is negotiated. Restructuring will happen when the debtor can’t or won’t pay.

    & yes, collective action clauses are necessary – without them there’ll be a situation like for Argentina.

    1. craazyman

      that’s the only thing holding the Eurozone together — opacity. Nobody has any idea who owes who what and when they can pay it ever back. The more studies and plans there are, the more confusing it gets. If they start using advanced math, like net present value, it becomes impossible to calculate anything. Infinity is forever. That’s the good thing. You have forever to pay off your debts but you’ll need forever to do it. That equals 1. Everything is either 1 or 0. The problem is you can’t calculate which one it is

      This whole thing is worse than untangling a fishing knot on gray November afternoon when your fingers are icy cold and too numb to even move. Actually, i’s even worse than that, cause you can just cut the knot out of the line. It’s like getting your backcast tangled in a tree 53 feet across the creek 17 feet iin the air. You just stand there thinking “Oh fuk.” That’s the good thing about fishing in the mountains by yourself, the stream is always there. So once you accept it, that you have to cut your line. You can start over. That happened to me many times.

      even if they have to take losses they’ll be back. where else will they fish? it’s the stream itself that will bring them back. because enough of them will calculate a 1 and not a 0.

Comments are closed.