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 :
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
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.
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