Thursday, November 27, 2014

Which Eurobonds?

OSLO – Any solution to the eurozone crisis must meet a short-run objective and a long-run goal. Unfortunately, the two tend to conflict.

The short-run objective is to return Greece, Portugal, and other troubled countries to a sustainable debt path (that is, a declining debt/GDP ratio). Austerity has raised debt/GDP ratios, but a debt write-down or bigger bailouts would undermine the long-term goal of minimizing the risk of similar debt crises in the future.

Long-run fiscal rectitude is the only way to accomplish that goal. But it is hard to commit today to practice fiscal rectitude tomorrow. Official debt caps, such as the Maastricht fiscal criteria and the Stability and Growth Pact (SGP), failed because they were unenforceable.

The introduction of Eurobonds – joint, aggregate eurozone liabilities – could be part of the solution, if designed properly. There is certainly demand for them in China and other major emerging countries, which are desperate for an alternative to low-yielding US government securities.

But Germany remains opposed on moral-hazard grounds: a joint guarantee of Eurozone members’ liabilities would strengthen individual national governments’ incentive to spend beyond their means. Indeed, this version of Eurobonds would fail, both economically and politically.

But a different version has begun to gain traction in Germany. The German Council of Economic Experts has proposed a European Redemption Fund (ERF). The plan would convert into de facto 25-year Eurobonds the existing sovereign debt of member countries in excess of 60% of GDP, the threshold specified by the Maastricht criteria and the SGP. Steps toward this solution to the short-term debt problem would be paired with implementation of the “fiscal compact,” German Chancellor Angela Merkel’s proposed solution to the long-term problem.

But this seems upside down. To use Eurobonds as the mechanism for eliminating the big sovereign-debt overhang jeopardizes the longer-term objective of eliminating moral hazard: it offers absolution precisely on the 60%-of-GDP margin where countries will have the most trouble resisting temptation. After all, there is little reason to believe that the fiscal compact or proposed “debt brakes” will succeed where the Maastricht criteria and the SGP failed. Rules need a credible enforcement mechanism.

Misplaced hope that the enforcement problem can be solved by enshrining the fiscal compact in member states’ constitutions might be based on a misunderstanding of the US system. To be sure, the US federal government has never bailed out a state, 49 of which (all but Vermont) have laws or constitutional provisions that limit deficit spending. But the main explanation for the absence of US moral hazard is that the right precedent was set in 1841, when the federal government let eight states and the Territory of Florida default. Eurozone leaders should have done the same with Greece a year or two ago.

Ever since 1841, the market requires that US states running up questionable levels of debt pay an interest-rate premium to compensate for the default risk. By contrast, Greece and the eurozone’s other heavy borrowers were able to borrow at interest rates that had fallen to virtually the same level as German Bunds. Had the ECB operated from the outset under a rule prohibiting it from accepting SGP-noncompliant countries’ debt as collateral, the entire eurozone sovereign-debt problem might have been avoided.

Moreover, even the most fiscally dysfunctional US states, like California, do not operate on a scale remotely near that of European national governments. When citizens began in the twentieth century to demand more from their governments – defense, entitlement spending, etc. – the expansion in the US took place at the federal level, where spending today amounts to 24% of GDP, compared to just 1.2% of GDP for the European Union budget.

The version of Eurobonds that might work as the missing long-term enforcement mechanism is almost the reverse of the Germans’ ERF proposal: the “blue bonds” proposed two years ago by Jacques Delpla and Jakob von Weizsäcker. Under this plan, only debt issued by national authorities below the 60%-of-GDP threshold could receive eurozone backing and seniority. When a country issued debt above the threshold, the resulting “red bonds” would lose this status.

The point is that the enforcement mechanism would be truly automatic: market interest rates would provide the discipline that bureaucrats in Brussels cannot. If private investors judged that the new debt had been incurred in temporary circumstances genuinely beyond the government’s control (say, a natural disaster), they would not impose a large interest-rate penalty. Otherwise, the risk-premium mechanism would operate on the red bonds, much as it does on US states.

Of course, the eurozone cannot establish a blue-bond regime without first solving the problems of debt overhang and troubled banks. Otherwise, the plan itself would be destabilizing, because almost all countries would immediately be in the red. Many countries, with debt/GDP ratios already far in excess of 60%, face high borrowing costs and austerity-deepened recessions as well. Sharing their debt burden up to 60% of GDP would be substantial assistance, but it would not necessarily restore debt sustainability.

Thus, Eurobonds are not a complete solution. In the short term, Greece may well default and leave the euro. Governments and banks in other countries will then have to be insulated from the conflagration through a combination of bailout money and strong policy conditionality.

Creating this fire break between Greece and Europe’s core would have been far easier two years ago, before debt/GDP ratios and sovereign spreads climbed so high, and before eurozone leaders’ credibility sank so low, or even one year ago. It might or might not work today.

But one thing seems clear. German taxpayers, whose longstanding suspicion of profligate Mediterranean euro members has been vindicated, will not be happy when asked to pay still more for the cause of European integration. At a minimum, they will need some credible reason to believe that 20 years of false assurances have come to an end – that this is the last bailout.

The fiscal compact alone cannot provide that reason. The blue-bonds scheme just might.

Read more from our "Are Eurobonds a Silver Bullet?" Focal Point.

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    1. CommentedGerardo Canto

      I think one of the worst case scenarios is to push debt down the road by creating more of it in the short-term accompanied with austerity measures. If public expenditure drops out at the same time as taxes increase and commercial and investment banks attempt to collect on their debt it will spell disaster--most likely destroying aggregate demand and syphoning money to international sources that are absolutely unconcerned with the long-run prospects for growth and repair. Nonetheless, banks must not be allowed to fail. The money supply needs to be steadied enough so that investment and the entire banking system do not fail. Debt needs to be restructured so that it is not simply adjusted onto the backs of debtors for down the road and problematic deleveraging to occur. At least if we hope to put the Greeks back on their feet again and allow them to make their own steps into a more healthy integrative future. Interest rates cannot sore through the rough, and there cannot be a liquidity crisis that pits the ranks of a global banking system against each other down to the last Greek citizen's foreclosure and repossession. Interbank loans must be upheld, public debt even increased, so that output rises giving us the opportunity to manage capital flows more diligently, regulating the pace of growth that can ensue. Rather than a booming upward spiral akin to the excessive leveraging and speculation which drove the United States' boom in the years prior to 2008.

    2. CommentedDave O'Carroll

      Those that cannot operate within the strict confines of monetary union need to leave it, further debt in whatever guise is still debt.

      Ejection is easy, debts when converted to host countries currencies simply get exchanged at the rates agreed at original convergence allowing tick boxes to be ticked, mark to markets marked and with lessons learnt until they are forgotten, the world can roll on debts virtually forgiven in the virtual world that fiat money operates in.

      It really isn't that difficult and as Mr Bernanke is keen to progress, money dropped from helicopters is the correct approach but only in a carpet bombing sequence rather than this painful one day at a time sweet Jesus.

    3. CommentedProcyon Mukherjee

      Gerardo Canto’s write up is brilliant and my question is that if the bail-out is reduced to re-capitalization on a large scale and if austerity measures are simultaneously enacted, it leaves a situation that wage rise and consumption would be stalled, thus dampening domestic demand, when the wherewithal to cope with a Pan-Europe competitive environment is limited. How does this help Greece to come out of the crisis?

      Procyon Mukherjee

    4. CommentedGerardo Canto

      Yes, Eurobonds have the propensity to attract further capital that may help stem any rapid burst of liquidity deposit demand that would contagiously disperse from Greece to other peripheral nations as the likelihood of isolation rattled the looming fear of an extended dissolution of the Eurozone. Discontinuing capitalization by disassembling interbank loans would lead to Greece's bankruptcy thus beginning a deleveraging process akin to the United States' centralized efforts to quell its own unraveling housing bubble, speculated upon false confidence. This, many assume, would fuel fears across countries such as Spain and Italy due to the interconnection of the central banking system ostensibly integrating national economies that remain disparate and disharmonious.

      The problem with further integrating bond markets is that it may only obscure the current plague which leaves peripheral real interest rates and currency values unadjusted to their gross domestic outputs and respective capital demands. These economies, rather than reflecting domestic conditions, are instead artificially supported by the central powerhouse Germany who nonetheless received more than its fair share of benefits. Today, Greek people are left with debt and little savings, a major inhibitor to future investment. Investment banks are leveraged on that debt, much like Lehman Brothers was. The European Central Bank holds a large proportion of government debt, as well as of these liabilities that were used to fuel these domestic loans, making the centralized corporatism hesitant to continue this now needed liquidity.

      When Greece initially stepped into the European Central Banking System it received lower interest rates because global investors were confident in its solvency, particularly due to the proponent that a developed union would hopefully not let it fail. Most scholars agree that this course started advantageously with increased investment and employment, an overall growth in economic output which also benefited other European nations who were able to buy their products at competitive prices while also profiting on the relatively more secure debt liabilities.

      Investment banks, here inclined to confidently report their balance sheets, may have then over-estimated the underlying dynamics in continuing to feed and profit from Greece's capital markets. Government spending, alongside of private investment, noticeably increased output at an evidently unsustainable pace, unsuitable in the long-term, at least from the diverted perspective of this current juncture. An increase in domestic loans leveraged commercial banks. An increase in government spending then also left more debt obligations on the asset sheets of the central banks. Similar to the United State's recession, rent-seek investment injected too much capital and caused speculation beyond the fundamental increases in wealth. But what are these underlying dynamics that discontinued improvement along this assumed trend?

      The aggregate labor market demand depleted. Greece's productivity did not align to that of the powerhouse nation. In essence, Greece's domestic currency overstepped its fundamental pace on the stilts of Germany's central bank. The disparity of output, due to Greece's all around smaller economy, caused the labor market to unravel in a fit of unemployment circular to lower rates of expenditure and subsequently sky high interest rates, thus revealing the criticality of the unionized stilts that bloated liquidity in the short-run splurge of investment. Even though bolstered in the short-term, competition was imbalanced due to the underlying levels of productivity. Wages fell back on debt-stricken people, and output slowed because the economy lost confidence and demand.

      In other words, the quick growth experienced upon their joining the Euro was due to an undeserved access to low interest rates, in essence what a badly crafted Eurobond would only exacerbate. Low interest rates can clearly increase output, leading to more expenditure and employment, which is desirable. However from the beginning Greece inherited a losing battle. Although wages went up and inflation was low in the short-term, firms soon recognized the outlasting insufficiency of export markets and the half-hearted vitality of domestic consumption wholly consequent of this expansionary phase of expenditure and were forced to lower wages rather than allow the currency to devalue itself. Zealous bankers and these their interest rates inflated the Greek economy beyond the sustainability of their capital markets limited by the firms' productivity and therein its excessive prop to wage labor. This liquid deflates in funneling backward to the source.

      But it is difficult to pay back money which is not grounded upon domestically retained wealth creation.

      I think the key to eventually leveling these currently disparate conditions must account for these underlying parameters of growth and productivity that will allow Greece to eventually pay back their debt in the long-term and become more competitive. If wages and investment did not increase so drastically due to low interest rates, there would have been a slower flow of capital and a smaller amount of leverage. Debt would have better reflected the growth in output and wages of the domestic population. Nonetheless, the Keynesian effects are notable and a necessary ingredient to a forward prescription.

      Sustainable development requires a pace reflective of domestic demands which cannot become energized by the lower interest rates otherwise in line with the stronger states simply because they depend on the same central bank. Austerity measures will not move toward this goal. Greece wants to receive more capital and to uphold government expenditures. If not, being in the Eurozone simply forces weaker national economies to compete with the productivity and size of Germany at excessive levels of sovereign debt due to the artificial advantages of being tied into a robust capital system that will ultimately lead to unraveling leverage beyond its means—in there being too accelerated.

      Also given that many of these obligations are held in the Central Bank, investors worry that the liquidity crisis will spread to the servicing of other domestic demand deposits also in precarious spirit, such as Spain or Italy.

      And rightly so. The European Central Bank and the International Monetary Fund currently have their eggs in a short-sighted basket. They fear more of the short-term loses due to this partial unraveling rather than the potential guidelines, requiring a restructuring of debt and continued capitalization, to set these nations on a long-term path of sustainable growth and subsequently then a healthy integration.

      In the end, I do not think single-currency systems work for exactly the reasons already stated. When we tried implementing the gold standard globally, interest rates were volatile and convoluted, leaving many nations likewise condemned to pervasive unemployment and dissolved investment and saving. Why: because currency values, and then following interest rates, were not able to adjust to the domestic market conditions. When the United States backed only its currency with gold we were faced with mountains of debt single-handedly in obligation to Europe's confidence which caused inflation and our eventual withdrawal. Interest rates and currency values cannot be uniform; they must be in flux to the relative conditions of the nation-state, a more accurate indicator for the floodgate managers of capital flow.

      Granted, interest rates are not determinedly uniform, however being intertwined throughout bond and capital markets distorts the domestic well size capable of containing prolific though speculative flows which further implicate the labor markets and a large scale of gross domestic product. This distortion must be regulated still by implementing Keynesian principles of expansionary monetary policy, but prudently. Banks, for example, may be required to expand capital reserves in order to limit the bolstering of interbank leverage in times of expansion. Otherwise, Spain and Italy will walk down similar paths of soaring interest rates, dissolved public benefits, and oppressive unemployment.

      That may make the Grexit a painful though responsible—with the proper monetary aid—decision for the long-term. Now, however, the Central Bank must continue to supply Greece's banks with capital, even though they hold a large quantity of uncertain government debt as it is. The left-over leverage on these smaller balance sheets also furthers the risk involved with these transfers because the de-leveraging process will obviously not be contributing to quick solvency or domestic growth. This leaves a debt restructuring, extending from the Central Bank, pivotal.

    5. CommentedProcyon Mukherjee

      The important question raised by Mr. Frankel, on behalf of the Germans, 'Is this the last bail out?', is yet to be answered.

      I would rather track the Government debt to Government Revenue ratio instead of debt to GDP ratio, to try to find the right metric that would limit moral hazard.

      Needless to point out that ratio, government debt to government revenue has been moving to the stratoshere, something that would need the polity to lay hands on immediately after the elections.

      Procyon Mukherjee