Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 8 September 2015

Making the Eurozone work better: sovereign default

Given the current problems in the Eurozone, it is understandable that many non-Eurozone economists remind us that they had doubts from the beginning. That, unfortunately, is not very helpful criticism, except in so far as it tells us how these problems were originally wished away. One lesson from the Greek tragedy is that voters' faith in the Euro project can survive even under tremendous strain. [1] The Euro was always a political project, and the political reasons for it have not gone away. For the governing elite of Europe this is likely to remain the case. So going backwards is not an option.

Yet while the people and the elite both want to keep the Euro, they part company when it comes to moving to a complete fiscal and political union: a United States of Europe. As Philippe Legrain notes, ever since the French and Dutch voted No, voter attitudes to further central control have hardened - and with good reason. If what he describes as the “Monnet method” (use any crisis to increase integration) continues, and as Andrew Watt points out it is continuing in a big way, the threat to the Eurozone could become existential. European policy makers have taken far too many liberties with democracy as it is: they should not take even more. Which is why I tend to get a little impatient with economists and institutions that spend a lot of time designed schemes for further substantial integration.

So the critical issue for now is whether the way the current union is run can be improved? I see three key unresolved areas here: sovereign default, competitiveness imbalances and the ECB. I talked about how to cope better with potential competitiveness imbalances recently. This post is about default.

I agree with Philippe Legrain that we need to have more decentralised fiscal control, and less rules from the centre. As I have noted before, there now exists in the Eurozone a system that is parallel to monitoring from Brussels, based instead on national fiscal councils. Can we design a system around that which negates any need for central control?

One way of making this work would be to deny any support to any EZ government that gets into trouble with the market. When the EZ was set up, its architects worried that market discipline would be too weak for this to work, so centralised controls were also necessary (the Stability and Growth Pact). In one sense they were right: the markets started treating Greek government debt as if it was German debt. But once a crisis happened they were wrong: governments with lower deficits than the UK were regarded as riskier by the markets.

What should now be clear is that the debt of member governments of a monetary union are subject to much greater rollover risk than equivalent countries outside the union because they do not control their own currency. That problem has been dealt with (for the moment) by OMT. But you cannot have OMT without conditions. For obvious reasons OMT cannot be a blank cheque to a monetary union member to run ever higher deficits.

So OMT has to be conditional, but who should set the conditions? Who decides that a future Greece has to default, but that a future Ireland should get the OMT guarantee without the need to default? At the moment the answer is both the other Eurozone governments and the ECB decide. But Eurozone governments have shown themselves to be hopeless at this task (see actual Greece), partly because they are subject to pressure from creditors. To leave this all to the unelected, unaccountable ECB is just asking for problems, and would represent too great a strain on ECB independence.

Let’s imagine the following. The Italian government at some time in the future finds that interest rates on its debt begin to rise well above average Eurozone levels. We get into a situation where a self-fulfilling default is possible. Should the ECB supply OMT cover to end that possibility or not? What conditions should be imposed on Italy as the price for that cover?

It would be nice if we could write down some simple rules (even complex rules) that could choose between a Greece and an Ireland. Fabian Lindner discusses some possibilities here. The major problem is that a great deal depends on something that embodies a political judgement: just how large will future primary surpluses be? Italy, because of its large debt, is used to running much larger primary surpluses than other countries. How do you judge what the upper limit is?

This is why ‘leaving it to the market’ is so attractive, because you appear to be asking a huge number of people to take a bet on the answer. But that method is flawed, because with rollover risk what they are actually taking a bet on is what they think other market participants think about rollover risk. OMT removes that rollover risk.

So if the market cannot do this, and the ECB and EZ governments should not do this, who is left? Do we set up a new institution of experts to decide and set conditions? (Conditions have to be set, because actions may change after OMT is granted.)

One obvious response is that we do not need a new institution, because we already have one, and it is called the IMF. It is imperfect, with at the moment too much influence from EZ governments on its decisions, but that means reforming the IMF rather than reinventing it. This may happen as a result of the Greek debacle. Philippe Legrain suggests using the IMF in a similar role here, although as a transitional measure while a new EZ institution is set up. However it is difficult to imagine EZ governments setting up a new institution that was truly independent of political pressure from member states.

The proposal would work like this. When Italy got into difficulties, it would go to the IMF. No EZ assistance would be allowed before this. The IMF would decide what level of default (if any) was required. The IMF, and not EZ governments, would set any conditionality thought necessary to return deficits to a sustainable level. That would include a path for deficits that the country could reasonably achieve without creating unnecessary unemployment. (If the country was uncompetitive, some unemployment would be inevitable.)

If Italy agreed to those conditions, then OMT would automatically be extended by the ECB. It is quite possible that in those circumstances Italy would regain market access at reasonable rates. If it did not, the IMF (and NOT other EZ governments) should provide the finance necessary to cover transitional deficits.

I suspect this scheme would not be attractive to many Eurozone policy makers, because they would be losing influence and control. But a better way to think about it is that the Eurozone contracts out (to the IMF) the tricky business of deciding whether a government’s debt is sustainable or not. That seems to me to be a small price to pay to avoid the kind of conflict between governments that became so clear in the recent Greek ‘negotiations’.

[1] Of the countries polled here, only two had more people thinking the euro had been bad rather than good for their country: Italy and Cyprus. See also Andrew Watt here.


25 comments:

  1. I am skeptical about this. As I pointed out in the text that you also cite, default or its threat is a result of the constant roll-over risk which is in turn a result of (sometimes irrational) market psychology. So there is fundamentally no way to say that any country should default or not. The IMF only comes in after countries could not roll over their debts or only at unbearably high interest rates. So bringing the IMF in - or initializing any other default regime - always depends on the markets' whims and never on any clear criterion. That is why I think a sovereign insolvency regime will increase roll over risk and markets' maniac-depressive tendendcies. This will - I think - make the Eurozone much more unstable, not more stable. In my opinion there is just no clever way to circumvent this fundamental problem.

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    1. I cannot understand your logic here: there already is a sovereign insolvency regime. The EZ has a mechanism which is conditionality imposed by the Troika. They decide when OMT is to be applied, and how much default is necessary. And they are hopeless at it. All I am suggesting is that this job is contracted out to the IMF, with no inter-government lending allowed.

      You can never have OMT applied at the request of the country that gets into difficulties without conditions.

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    2. «default or its threat is a result of the constant roll-over risk which is in turn a result of (sometimes irrational) market psychology. So there is fundamentally no way to say that any country should default or not.»

      This is the usual confusion driven but the cleverly constructed dissembling of the "sell-side" anglo-american propagandists: that all defaults are the result of "rollover", "illiquidity", «market psychology», and that therefore: «fundamentally no way to say that any country should default»; the same applies to large fraudulent financial corporations of course.

      But most cases of government (or private) debt troubles are not because of temporary "rollover" or "illiquidity" issues, they are the result of pretty clear (and often fraudulent or negligent) insolvency. For the greek government for example Y Varoufakis as greek minister of finance has repeated many times that it is insolvent, not merely illiquid, that its insolvency is based on fraud was disclosed by the greek prime minister in the greek parliament.

      «The IMF only comes in after countries could not roll over their debts or only at unbearably high interest rates.»

      The IMF comes in usually to be the enforcer of USA government foreign policy. Thus for example lots of money to the ukrainian government and by and large letting the greek government hang in the wind like the USA government has done.

      As to suggestion to take fiscal transfers out of the hand of EU democratically elected representative and hand it to the IMG consider these points by our astute blogger and my comments:

      «But Eurozone governments have shown themselves to be hopeless at this task»

      Perhaps, and perhaps not. Anyhow that is a problem with "politics", that is with democracy itself. Democracy, a great and realistic man said, is the worst system except for all the others. If the elected representatives of the voters liable for ECB losses are "hopeless", the voters had better elect others, it is their privilege. The purpose of democracy is not good government, it is accountability of voters (voters suffer the consequences of their voting).

      «So if the market cannot do this, and the ECB and EZ governments should not do this, who is left?»

      The usual answer of the anglo-american propaganda is the one favoured by B DeLong, and it is "technocratic centrists", which actually is a clever euphemism for Davos-men who carry water for Wall Street and City interests and their sponsored representatives in the USA (and UK) governments. Indeed, unsurprisingly:

      «One obvious response is that we do not need a new institution, because we already have one, and it is called the IMF.»

      Fantastic idea to put it in charge of lording over insolvent EU governments. Which reminds me of the general line of the anglo-american attacks on the european union, as made explicit in this very similar proposal by B DeLong:

      «If Europe's political masters were intelligent right now, I think they would abandon the euro and their freedom of action in monetary and macroeconomic policy, and bind themselves to obey a joint U.S.-IMF hegemon in international finance, monetary, and macroeconomic policy affairs.»

      Amazing coincidence! :-)

      «It is imperfect, with at the moment too much influence from EZ governments on its decisions,»

      Ah really funny! The original "atlantic" governments that set up the IMF surely have too much influence, as well as too large shares of the IMF funding liability, but to omit the mention of the USA from «too much influence» shows the bias a bit too obviously.

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  2. I am really really really really really amased.
    Your recomendations on debt crisis are being implemented since the begining.
    I am really amased that you recomend what is actually being implemented.

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    1. If the EZ had followed my recommendations there would be no bailouts from EZ members, no EZ imposed conditionality. The IMF could well have imposed a much larger default on Greece in 2010, not 2012. OMT would have happened in 2010, making the degree of austerity required in Greece, Ireland and Portugal much less. Very different.

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    2. Any person or corporate debt is initially around 300%. This is also the state sustainable level debt.

      Caveat is that CBs control interest rate it's country pays while private borrowers only choose to accept or not offered interest rate.

      Now you probably do not want to accept that a CB decides interest rate a nation pays. And level of interest rate is what makes a debt sustainable not level of debt. Lets say a country goes 1000% of GDP in debt at 0 interest rate.
      Is this debt sustainable?

      Yes it is sustainable because countries only service part of interest payment while rest ofthe service is with more debt.
      0% rate means 0 of a currrency to service the debt.
      So the rollover of old debtis the problem,, as you say. But there was a rollover problem for some countries that were under 20% debt.
      The level of debt does not matter, it is politics that decide if one country gets to enjoy rollover or not, PURELY POLITICAL DECISION to rollover the debt.

      Untill this is understood there is no purpose in further talking about how your proposal is just what is being done to Greece.
      What you call market is decided by politics to cut off rollover for greece.

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  3. Wouldn't it be preferable to expend intellectual energy on designing a system which does not allow member countries to put themselves in a position where they might default and developing rules for dealing with recalcitrant countries such as making it illegal for them to go to the bond markets when predetermined measures (say debt to GDP ratios) are breached?

    Henry

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    1. Agree. New EU rules are not the answer.

      If there is one lesson to be drawn from the last 20 years of EU development, the stability and growth pact in particular, it is that EU rules will not work unless they are automatically triggered rules overseen by an externalised institution.

      The ECB is an example, but in this case it would be a parallel organisation set up on similar lines.

      Otherwise, big countries will just flout the rules and the difference between and Ireland and a Greece will be simply the status of the European political football game at that point in time. Hardly very satisfactory.

      The other way would be to introduce a much harder ban on EU bail-outs, which in effect would outsource the making of rules under the stability and growth pact to the market. Whilst this creates the risk of delegating policy to "(sometimes irrational) market psychology", it is hard to see how that differs from delegating it to the EU, except that the soi-disant irrational market participants are explicitly acting in their own self-interest rather than pretending to act in someone else's.

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    3. > ... a system which does not allow member countries to put themselves in a position where they can default

      King Canute called and wants his policy back.

      (Sorry, I couldn't resist !)

      Much better instead to allow default. Live in the real world. This requires, however, that banks be made rock solid and separate from the government finances in that state.

      That's easy enough to do, with suitable political will. Just bring back measures based on good old Glass–Steagall for example to make banks a bit safer. And perhaps ban banks in country X from holding bonds from country X. Other people, smarter than me, can work out the details.

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    4. Aaron makes two good points. First, of course we need better domestic (not EU) monitoring of governments to ensure they do not overspend/undertax, but trying to pretend the problem will never happen is foolish. Second, decoupling national banks from the risk of national default is just good risk management.

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  4. I can't edit but I should sign it, at least to this extent.
    - Patrick.

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  5. The solution to fickle markets is a credible commitment not to default, which is enabled by strong political institutions. Countries with weaker institutions should have a lower debt/GDP ratio.

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  6. The IMF is no more trustworthy in this than any European group or institution. Just look how Dominic Strauss Khan arranged the original Greek bail out to favour French banks.
    A better way would be to focus on the surplus imbalance issue and tie it to OMT (or ELA for that matter). Any surplus saved by a eurozone state should be made available to the others, like special drawing rights, by the ECB. That way T2 could morph fro being a scoreboard of contingent liabilities to a system for repatriating current account deficits. The question then is; do you send it the gov'ts direct, or bring in the EIB with a widened mandate to manage it. Unless we stop the blood pooling in the legs, the EZ will stay dizzy and a heart attack becomes ever more likely.

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    1. P.S Markets Shmarkets. There are no meaningful markets in EZ debt.

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    2. «Just look how Dominic Strauss Khan arranged the original Greek bail out to favour French banks.»

      Nahh, that was the german government that did that. The real story of the greek bailouts is pretty obvious but rarely told: in large part it was about avoiding a greek default for the sake of Greece itself, but also as a bailout of the french banking system by the german government, and the french government could not afford it.

      Thus the well justified gratitude of the french government, and the well reported coldness of F Hollande during negotiations with the greek government: the Y Varoufakis negotiating strategy was to blackmail France with a debt default, which would have been mostly paid for by the german government, but was initially mostly french, thus putting the french government in the debt of the german government even more directly.

      The french (and german, and polish, etc.) elites won't forget the greek attempt at blackmail anytime soon. Sure, every greek government has tried to scam their EU partners, and that's expected; but to *blackmail* them, and in particular to blackmail the french government, is going way too far.

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  7. The IMF was set up by 2 geniuses to take the blame for policies that countries know they need anyway. It is not set up to deal out bankruptcy haircuts to private and sovereign holders of sovereign debt. I suggest and international bankruptcy court with judges appointed directly by elected officials. Make a big deal out of the appointments and give the court just one thing to do - sovereign bankruptcy.

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  8. Regarding rollover risk: I've been wondering for a while why governments don't issue consols instead of fixed-term bonds. It seems like rollover risk was solved by the financial technology of the eighteenth century. Am I missing something?

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  9. «One way of making this work would be to deny any support to any EZ government that gets into trouble with the market.»

    That's quite far from how things have been setup and happened:

    * The EU provides support to any EZ gocvernment that has poor regions, and at 2-3% of GDP per year like for Greece it is remarkably large.

    * The EU and Eurozone treaties forbid the central institutions to do lending that is unlikely to repaid, without unanimous amendments by the signatories, which has happened. Dooing otherwise would be undemocratic, because it would be a fiscal operation without democratic review and accountability.

    «governments with lower deficits than the UK were regarded as riskier by the markets.»

    Let's wait and see on the UK :-).

    «What should now be clear is that the debt of member governments of a monetary union are subject to much greater rollover risk»

    The usual euphemism of "rollover" or "illiquidity" for insolvency, nothing new.

    «than equivalent countries outside the union because they do not control their own currency. That problem has been dealt with (for the moment) by OMT.»

    It has been dealt with in effect by having the debts of some members endorsed by the other members, plus in some cases substantial debt forgiveness plus substantial discounts on the remainder, plus substantial new funds; a very generous policy. OMT is just the expression of part of that solution, not the solution, to the problem.

    «So OMT has to be conditional, but who should set the conditions?»

    But OMT is just the provision of "liquidity" or "rollover", the issue of course is the provision of debt endorsment, cancellation, discounting and new transfers, despite the euphemism.

    As to that M Draghi has explained the details many time and it is astonishing that the ECB web site is not reachable from Oxford, a summary here to work around those "technical difficulties":

    * The ECB is a technical body created by a treaty and does what the treaty says, under the true interpretation of the treaty signatories, who are in very frequent communication with the ECB board and president, who attends treaty member meetings.

    * The ECB is a technical body and not a commercial one, and thus is not expected to make losses or profits. Treaty members are liable for any losses or risk of losses made by the ECB therefore the ECB treaties forbid it any activity that can be reasonably foreseen to produce losses.

    * The ECB treaties therefore forbid lending that is unlikely to be repaid, to any entity whatever.

    * Therefore ECB won't lend directly or indirectly to any insolvent entity, unless that lending is *endorsed* by solvent entities so that it is likely to be repaid, or by the unanimous consent of the ECB treaty members who are liable for any losses made by the ECB.

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    1. "«governments with lower deficits than the UK were regarded as riskier by the markets.»

      Let's wait and see on the UK :-)."
      The big deal is the UK issues its own currency.

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  10. Some more on some of the funnier points in the blog post to clarify how the eurozone/EU/ECB actually works.

    «Who decides that a future Greece has to default, but that a future Ireland should get the OMT guarantee without the need to default?»

    As to the OMT by the ECB, regardless of who is the beneficiary, that can only be the ECB treaty members as they are liable to cover any foreseeable losses from OMT. That's basic democracy: voter money is at risk, voter representatives decide how much to budget and how it is spent.

    In the recent past this has been demonstrated very clearly: the ECB has provided lending only when solvent governments have endorsed that lending, and stopped it when it looked like solvent governments were not endorsing that lending. Regardless of who was the beneficiary.

    That has been pretty clear, but has still been astutely misrepresented as the ECB taking sides among treaty members by many anglo-american culture attackers on the european union.

    «At the moment the answer is both the other Eurozone governments and the ECB decide.»

    The ECB does not decide anything, even if of course it is "influential" as consultants are, just like the central banks of individual countries were and still are. In the way the EU works even the council of financial ministers matters a lot less than the council of heads of government, which is where (indirect) democratic accountability happens currently.

    «However it is difficult to imagine EZ governments setting up a new institution that was truly independent of political pressure from member states.»

    No need to, there is already such an institution, ready to go: the Bundesbank! :-)

    «But a better way to think about it is that the Eurozone contracts out (to the IMF)»

    But the IMF can well decide to do that whether or not the Eurozone governments countract it out to the IMF: all the EU/eurozone members, including the greek government, are members of the IMF and have the same rights under the IMF treaties to apply for its assistance.

    «the tricky business of deciding whether a government’s debt is sustainable or not.»

    That seems to me the usual misdirection as that's not the decision that matters: the one that matters is whether to do fiscal transfers to an insolvent government with unsustainable debt, or the gray area when debt is likely to be unsustainable. There is no big decisions to take when the debt seems likely to be sustainable.

    «That seems to me to be a small price to pay to avoid the kind of conflict between governments that became so clear in the recent Greek ‘negotiations’»

    Well, the ‘negotiations’ between Greece and the USA (and the UK) clearly were based on a huge conflict, as the USA (and the UK) refused very explicitly to even discuss providing any (direct) once-only or permanent direct fiscal transfers to Greece, and have provided only very low support via the IMF, which has resulted in Greek citizens falling back to the level of abject poverty they suffered in 2001. :-)

    But as the IMF is the enforcer of USA policy, how would delegating the same ‘negotiations’ to the IMF result in less conflict? That seems very improbable.

    Contrast with the success of the eurozone negotiations: 18 government head unanimously decided on a generous policy to Greece, and despite the protests of some ECB members that the policy was too generous, they kept consistently pursuing it until reaching full agreement with the 19th treaty member, and the relevant national parliaments all endorsed it democratically. If anything the negotiations have shown that eurozone governments have a unified approach, especially unified when outraged by the exasperating behaviour of somebody.

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  11. «If it did not, the IMF (and NOT other EZ governments) should provide the finance necessary to cover transitional deficits.»

    That's a distinction without a difference: if those debts get repaid, it matters little who granted them; if they instead have to be written-off, then the EZ governments are IMF members too and must cover their share of the write-off, and many of them being large rich economies their share is pretty big.

    And then why should the taxpayers of the eurozone have to pay the IMF for losses that have been in effect the result of the decisions of the USA government? Admittedly they stand ready to do so with the IMF "donations" to the ukrainian kleptocratic government, though, so there is precedent.

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  12. As one or two of the earlier comments highlight, it seems to be very important to distinguish between government default and banking (system) default.

    In the Eurozone, like in the dollar zone (US) default by a government body should be difficult but not impossible (if it is made impossible it shifts risk from the lender to the taxpayer). That is why the motto of the original Maastricht Treaty was "No Bail-outs". CIties and other administrations have 'gone bust' from time to time and the results are usually damaging (as, arguably, they should be) but not catastrophic. So the right response to the original discovery of the Greek mess would have been to cut off further funding to the government and require it to come to an arrangement with its creditors, while holding in reserve measures that would protect fundamental services vital to citizens or to the EU generally.

    The response to bank-led crises like Ireland or Cyprus should be different. Much as we (I) hate to see bankers getting away with it, there is really no alternative to propping up the system to ensure that it does not collapse. In these circumstances the conditions and the sharing of costs between borrowers, lenders and third parties (retail customers and taxpayers) can only be political.

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    1. The US has fiscal transfer and spending at the federal level though.

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    2. "The response to bank-led crises like Ireland or Cyprus should be different. Much as we (I) hate to see bankers getting away with it, there is really no alternative to propping up the system to ensure that it does not collapse. In these circumstances the conditions and the sharing of costs between borrowers, lenders and third parties (retail customers and taxpayers) can only be political."
      Needs to be a rational bankruptcy procedure.

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