Cross-border deleveraging and the shifts in Europe’s bargaining game

While high-ranking eurozone bureaucrats are ruminating on the appropriate burden-sharing mechanisms of a future Europe, something potentially more momentous has been going at the background: European banks have been cutting back their intra-European exposures… fast!

The numbers are pretty stunning: Between December 2009 and June 2010 (the latest data available from the BIS), German banks cut their eurozone claims by $180bn (more than 5% of German GDP). French banks cut their own exposure by near $280bn (10%of French GDP), of which $130bn were claims on Italy and Spain. And Dutch banks cut their eurozone claims by $170bn (about 20% of Dutch GDP), with cuts across the board, from Spain, Ireland and Greece to Italy, Germany and Belgium. One can only assume that the cutbacks have continued in full force post-June.

This “deleveraging” has important implications for the core-periphery bargaining game and the future of the euro.

First, from the perspective of the stronger, core economies, a meaningful reduction in intra-European exposures means that the threat to the core’s financial stability from an adverse outcome at the periphery is smaller. In turn, this allows the core's governments to consider a more “sober” crisis resolution framework, ie one that is more discretionary and fundamentals-driven vs. one that is indiscriminate out of fear of a disorderly outcome.

What would “discretionary” really mean? Based on the ERM experience back in 1992/93, it could mean the following:

(a) For countries with no obvious fundamental misalignment (e.g. France): an explicit, large-scale and comprehensive liquidity backstop, aimed at killing any aspiring “self-fulfilling prophets.”

(b) For countries that are small (ie not systemic on their own) and in need of a sharp fiscal adjustment (e.g. Greece, Ireland, Portugal): the provision of short-term liquidity-support mechanisms conditional on the maximum possible fiscal effort, before the inevitable correction is forced upon them. (In the same way, many countries were forced to devalue their currencies back in 1992/93 in line with their fundamental misalignments, after Germany did not provide the liquidity support that would be necessary to stem the speculative attacks).

(c) For countries that are larger and, thus, a systemic threat (Spain and Italy): A strategy that buys time to allow the core economies’ private sector to exit before things escalate. This is exactly what has been happening (intentionally or not): By tackling the eurozone crisis in a piecemeal, reactive fashion, core economies have effectively bought time for their private sectors to unwind their positions in a stable environment—i.e. a common currency and an orderly payment process.

In the process, the systemic importance of Spain and Italy is gradually being reduced, improving the core governments’ ability to provide (if and when that time comes) liquidity support under their own terms.

This brings me to the second implication of cross-border deleveraging, which has to do with burden-sharing and the perspective of the peripheral countries themselves. With cross-border exposures cut, the burden of adjustment (be it fiscal consolidation and/or debt restructuring) has been shifting away from external creditors and towards the residents of the weaker peripheral countries.

This poses a natural question: What’s the appeal of eurozone membership for Greece, Ireland or Italy for that matter, in the absence of an acceptable degree of burden-sharing between debtors and creditors? And even more so, when it implies the long-term surrender of fiscal sovereignty to the “troika” of the IMF, the ECB and the European Commission? Instead, exit from the euro (with the inevitable default) would shift part of the burden to the core through an immediate improvement in the periphery's external competitiveness. It would also shift part of the debt burden to any external creditors are left, private and official (barring the IMF, which has preferred creditor status).

For these reasons, the ongoing cross-border deleveraging, and the resulting “thinning out” of the threads that tie the eurozone countries together, can mean either of two things for the euro: Either the governments of the core will demonstrate their will to share part of the burden of adjustment, in the form of a fiscal transfer rather than just liquidity support; or peripheral countries will find the unilateral assumption of the fiscal adjustment burden unacceptable, economically and politically… in which case they’ll opt out.

Under fresh light, Iceland may no longer feel too unhappy it's not Ireland.

Can there be such a thing as an “orderly” restructuring?

As EU and IMF officials set about to negotiate their second rescue package to a eurozone member in a year, more and more voices are calling for the “orderly restructuring” of peripheral countries’ debt as an integral component of a crisis resolution framework.

The idea is that, when the debt dynamic is unsustainable under most doable fiscal consolidation scenarios, pouring more official money into the problem amounts to “kicking the can down the road” rather than begetting a permanent solution.

A key advocate of this view has been Nouriel Roubini, who in a recent paper called for an “orderly, market-based approach to the restructuring of Eurozone sovereign debts” to deal with any insolvencies now, avoid the deferral of tough choices later and contain moral hazard.

My objective here is not to challenge the “kicking the can down the road” argument, which is of course correct. Neither am I going to discuss whether Greece , Ireland or, indeed, Italy are illiquid or insolvent. Instead, I want to examine whether it is at all possible to achieve the “orderly” restructuring that Nouriel and others propose in the specific case of the eurozone.

The focus on the eurozone matters: It is not particularly constructive, nor relevant, to evoke (as Nouriel does) the experiences of Pakistan, Ukraine, Uruguay or the Dominican Republic in order to shed light on what might happen if Greece or Ireland decided to “bail in” the private sector. These countries’ GDP is tiny, and so was the debt they restructured. To give you an idea, Pakistan restructured $608 million (with a “m”), the DR $1.5bn, Ukraine $3.3 billion and Uruguay around $5.5bn 1/. Greece ’s $420bn of public debt is far more prone to a disorderly outcome by virtue of its size and also due to Greece’s association with other fiscally vulnerable eurozone members.

Second, manageable initial debt-to-GDP ratios in those countries meant that sustainability could be achieved with only a small NPV reduction: Per the IMF, the NPV reduction was just 2% for the DR, 5% for Ukraine and 8% for Pakistan. In Uruguay, which had a comparable (though still smaller) debt-to-GDP ratio to Greece’s 133%, the NPV reduction was 13%. But I should point that Uruguay achieved fiscal surpluses of the order of 3-4% immediately, rather than 3 years into the IMF program, which is what is envisaged for Greece (IF ever feasible).

Let's also note that where the necessary NPV reduction was large (Argentina: 75%; Russia: 44%), the restructuring was not exactly an “orderly” one—and neither was it pre-emptive.

So much for the precedents. What can we say about the potential for an orderly restructuring in the eurozone today? First, let’s define what we mean by orderly, which, in my view, requires three elements:

1) Participation should be largely voluntary. A high degree of investor coercion can lead to a larger number of hold-outs that makes the process lengthier and messier. More importantly, a precedent of coercion in one eurozone member could prompt wary investors to stampede out of other vulnerable members, turning one country’s crisis into the self-fulfilling eurozone domino everyone dreads. This potential for contagion (through trade and financial linkages and/or by association) cannot be overstated when talking about eurozone members in my view.

2) The restructuring, along with the policy mix adopted by the debtor country, should restore debt sustainability under reasonable macroeconomic scenarios. It should also help achieve a prompt return to market financing.

3) The NPV reduction in the debtor country should not shift the crisis elsewhere in the eurozone (e.g. via the banking system).

Clearly these elements are usually conflicting—and more so in the eurozone. For a largely voluntary restructuring, the NPV reduction offered must be attractive compared to the alternative. In this context, Nouriel suggests that a restructuring be “market-based” (ie reflecting the going market value of the debt): after all, with Greece’s long-term bonds already trading at 50-something cents on the dollar, investors should voluntarily accept a 40-50% NPV reduction and do so in an orderly way, right?

In my view, such a “market-based” offer is not at all a guarantee for an orderly restructuring. First, because the “market value” can change swiftly once restructuring becomes a certainty (see what happened to peripheral spreads once Angela Merkel began to talk about bail-ins). Second, the threat of contagion cannot be overstated. What looks like a sustainable debt level in Spain (or Italy ) today might not be tomorrow, if the market decided to turn its attention there.

Third, many of the holders of the debt are banks that have yet to mark-to-market their sovereign debt holdings. Here, Nouriel’s proposal is an exchange offer that preserves the debt’s face value but prolongs the maturity and reduces the coupons. This would surely help these banks avoid immediate write-downs and the concomitant capital adequacy problems; but it would also “lock” their balance sheets with assets they cannot sell for years to come (unless they are ready to take the losses), preventing them from using their capital to lend to the productive sector. This might be “orderly” from a short-term financial-stability perspective, but it’s certainly suboptimal for the eurozone’s growth outlook.

So under what circumstances can we then have an “orderly” restructuring in the eurozone? In my view, a “pre-emptive” and “orderly” restructuring is only possible if the likes of Germany and France are ready to provide a credible commitment to backstop all the fiscally vulnerable eurozone members either directly (through a generous fiscal transfer that helps achieve debt sustainability) or indirectly (through an explicit capital backstop to their own financial sectors, which are the main holders of peripheral debt).

Note that I am *not* calling for a pre-emptive restructuring for Portugal, Spain or Italy here; nor am I talking about the establishment of a European Sovereign Debt Restructuring Mechanism or Credit Resolution Mechanism which, as Nouriel argues, is not necessary. I am talking about a credible and comprehensive backstop to cover the losses of any necessary debt restructuring, across the board, by the financially stronger governments.

Such a backstop might be anathema to the Germans, but the economic case for holding their nose and plunging into the “cesspool” can be compelling: German banks’ exposure to the PIGS (“I” for Ireland ) is around $500 billion (BIS data); that of French banks is around $400bn. This sets a clear ceiling as to the potential liability borne by the taxpayers if the crisis is contained to the PIGS.

In contrast, in the event of a piecemeal approach that leads to a systemic crisis, the size of their taxpayers’ burden becomes indeterminate: Not only will the likes of Italy be vulnerable (talking about “systemic”); but the negative wealth effects from a collapse of Europe’s financial markets would be extremely adverse for the growth outlook, especially as the global economy is still at a very fragile state.

Bottom line, it is wishful thinking to talk about an “orderly” debt restructuring when that involves a piecemeal, country-by-country approach that leaves the rest vulnerable to speculative attacks. It is also wishful thinking to talk about “market-based” approaches, given the flimsy nature of market values and the implications for the health of eurozone banks. An orderly restructuring is indeed achievable, provided it is backed by a credible backstop by the financially stronger governments. It is also desirable: the alternative won’t be pretty for anyone…

1/ Source: “Cross country experience with restructuring sovereign debt and restoring debt sustainability”, IMF 2006

The “E” and the “M” of the EMU

They say “do not believe anything until it’s been officially denied”. Just last Thursday, ECB President Jean-Claude Trichet categorically denied that the ECB had discussed buying government bonds of peripheral eurozone members.

A market sell-off and a hectic weekend later, it was time for a complete about-face… Per the ECB’s press release on Sunday night, “in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. […]

In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”

The significance of this move is huge, as far as killing speculators goes, but here I want to focus on a key policy dilemma that has emerged since the subprime (and now the eurozone) crisis ever began: The need for a separation between monetary and fiscal policy—what Trichet referred to as the difference between the “E” and the “M” of the EMU (or Economic and Monetary Union) at the ECB’s press conference on May 6th.

In the US for example, this separation was all but blurred by the Fed’s decisions to put its own balance sheet at stake in the bailouts of Bear Stearns, Citi and AIG and, more bluntly, by its decision to buy US Treasuries, GSE debt and mortgage-backed securities. In the event, Congress’ disgruntlement with the AIG saga, monetarists’ concerns about “debt monetization” and valid criticisms about the Fed’s decision to favor a specific sector—housing—with cheap credit, have served to raise questions about the appropriate limits of the Fed’s independence.

Does the European/ECB approach offer an alternative/better(?) route? In my view yes, notwithstanding the latest decision to purchase government bonds.

Ignoring the bond purchases for the moment, recall first that, at the height of the financial crisis, all failed banks were “dealt with” by their corresponding national governments, without any participation from the ECB. To the extent that saving insolvent banks was deemed desirable form a social or financial-stability perspective, the burden was assumed by the elected governments, with ultimate responsibility going to the taxpayers (who voted for them).

Meanwhile, the ECB did not remain idle—on the contrary: It was the first central bank to flood financial institutions with liquidity right at the onset of the crisis in August 2007; and in June 2009, it decided to provide as much funding as demanded by European financial institutions at a low, fixed rate for a 12-month maturity (longer than the Fed’s liquidity operations). In other words, the ECB demonstrated full flexibility and creativity when it came to preserving financial stability and fulfilling its LoLR functions (to illiquid but solvent institutions).

Given the faithful delineation between fiscal and monetary responsibilities, Sunday's decision to step into the government bond market may be seen as an aberration—or worse: A betrayal to the spirit of its price-stability mandate, let alone an anathema to the Germans.

I actually don’t think so. First of all, the interventions are described as—effectively—liquidity operations, to improve the functioning of monetary transmission. This is not a b.s. excuse for back-door debt monetization. Repo transactions using peripheral-economy debt as collateral have been increasingly dysfunctional, undermining the ability of some European financial institutions to fund themselves in private markets.

Now, why is that so different from the Fed’s MBS purchases, which, ultimately, were also aimed to help improve conditions in financial markets? It is different in many ways. First, unlike the MBS purchases, the ECB’s operations will be sterilized—that is, the objective is not to loosen monetary policy further but to relax financial conditions from the currently tight levels by improving funding for financial institutions (and governments).

Importantly, the Fed’s MBS purchases were unconditional: No actions were demanded on the beneficiaries of these purchases (the mortgage borrowers). In contrast, the ECB *had* to extract commitments for further fiscal consolidation from the eurozone governments, so that it could claim that (by its own judgment, rather than the now discredited rating agencies) peripheral government bonds are “safe” enough for its portfolio. We yet have to see whether such pledges will be met, but they are at least a start.

Mind you, the point goes beyond the “narrow” objective of securing the safety of the ECB’s balance sheet. It is about securing a commitment by the eurozone governments that they still see the EMU as a desirable objective and one that is worth making sacrifices for: Namely, further fiscal measures in line with the spirit of the Stability and Growth Pact, and structural reforms to restore competitiveness.

Trichet’s tough talk on May 6th aimed at highlighting exactly that—the limits of monetary policy in preserving financial and economic stability, when the political will to do so is lacking:

“We cannot substitute for the governments. The governments have their decisions to take while we have our own role as an independent central bank, and of course we expect each authority to fulfill its own responsibilities.”

What are the lessons here, including for the U.S. of A.? The first is the realization that, unfortunately, politicians are unlikely to get their act together until things are at the brink of falling apart. And even then, political will may be hard to muster in the midst of the crisis. Trichet’s “bluff”(?) worked in finally stirring bold action. Bernanke had to step in and bail out the likes of AIG with Fed money. But once the emergency is over, any fiscal burdens must be transferred from the Fed’s books to of the US Treasury.

The second is that there was, in fact, an alternative to the MBS/Treasury purchases... which was to buy none! Instead, like the ECB, Fed operations could have focused solely on securing ample liquidity to the financial system, in line with its mandate of safeguarding financial stability. Indeed, as I argued here, the effectiveness of the so-called “portfolio balance” channel over and above the positive impact of the MBS purchases on bank liquidity is dubious. Let alone the hoped-for impact on inflation… has anybody seen the recent US inflation numbers?! (OK, OK, we can’t know the counterfactual!)

The third lesson is that monetary policy cannot be oblivious to fundamental imbalances in the economy, whether these take the form of fiscal imbalances, current account imbalances or large indebtedness in the household, corporate or financial sectors. This applies even to those central bankers fixated with (product price) stability. The reason is that the resolution of such imbalances is often “non-linear”—as in, abrupt and brutal and one that will tend to undermine the very price stability that the central bank claims to defend.

The eurozone came close to its "non-linear" experience by seeing the viability of the euro falling apart. The US (along with the rest of the world) felt it first hand, in the fourth quarter of 2008 and its ugly aftermath.

Both these instances suggest that Trichet may actually be wrong: The “M” and the “E” cannot be that separate after all.

Giving reform a chance

If one is to believe the popular media, economists have finally found one issue to agree on: That Greece can only get out of its atrocious fiscal quagmire through debt restructuring.

Here, I’d like to argue for the opposite, even if that meant that, for once, I’d have to side with the politicians.

Let’s talk contagion first. In case you’ve missed it, repo markets for Spanish, Portuguese and Irish bonds are drying up, which raises flags of alarm for their respective banks and, indeed, any bank that is using them as collateral for funding. Debt restructuring by Greece would create a precedent that would be very hard for the markets to ignore when thinking about the rest of the PIGS.

Instead, avoiding a Greek restructuring (for now) gives a chance to the governments of these countries to take tougher measures to escape Greece’s fate. It also gives a chance to the European Commission and Council to prove that they have learned their lesson and can enforce fiscal discipline on a pre-emptive basis. Basically, it gives a chance to prevent a fresh round of financial instability in the eurozone, and to restore credibility in the institutions backing the entire European project.

The next line of reasoning has to do with “the point” of restructuring: Even with restructuring, the need for a drastic fiscal consolidation in Greece does not go away. Neither does the need for enforcing tax collection, downsizing an over-bloated public sector, eradicating corruption and improving competitiveness.

In addition, any haircut decision—and savings thereof—would have to be weighed against the new debt that would need to be issued to cover the losses of Greek financial institutions; and the much higher interest rates that Greece would be charged for its debt in the future (which would be higher the lower the recovery values and the higher the perceived probability of default).

Add to that the possibility of bank runs, collapse of confidence and the ensuing disruption in people’s daily routines, and you kill all incentives for reform by transforming an economic emergency into a national calamity.

Speaking of reform, it might have been easy to miss, amidst the catchy photos of rowdy anarchists parading in the middle of Athens, but.. there is actually a growing momentum for reform not only among the intellectual elite but also among the broader public—as demonstrated by the numerous self-critical op-eds and the more humble rhetoric of the Prime Minister himself.

On top of that, you have a government in its first year of a 4-year mandate and an utterly discredited opposition that leaves few political options for dissenters but the Communists, the Greens or… the Party of Greek Hunters! The IMF/EU package allows this momentum to continue by providing not only cheap(er) money but also an instrument for discipline and transparency in a country that has had none for years.

So much for the benefits. Now what are the risks of the IMF/EU approach?

Most people see the biggest risk being that Greece fails to deliver. I disagree. The biggest risk would actually be if Portugal or Spain failed to deliver more ambitious fiscal measures in the coming months. The point here being that the massive package for Greece is more about avoiding contagion to the rest of the eurozone than salvaging some 2% of EU GDP.

Then there is Greece itself. Those calling for upfront debt restructuring argue that the current package is fuelling moral hazard with the biggest “bailout” in history; and that, when the “inevitable” happens, the private sector will have to take a bigger haircut, since the official money disbursed would be senior to privately-held debt.

Not entirely. First, all the package does is cover Greece’s financing need for the next three years, including debt amortizations to the private sector—in full! So whatever haircut in the future will have to be considered together with the full repayments that debt holders will receive as a result of the package today.

When it comes to moral hazard, it is ludicrous to think at this point that the rescue package will encourage fiscal misbehavior in the rest of the eurozone or even by future Greek governments, given the painful measures that need to be adopted and the political humiliation of external monitoring.

However.. there is clearly a moral hazard issue when it comes to the holders of Greek debt, many of whom were happy to feed the Greeks with cheap money until they decided otherwise. Here, voluntary initiatives of the type allegedly discussed by German banks are a step in the right direction, even if too timid to counter the moral hazard concern.

But ultimately, the “rescue” of Greece (and of its debt holders) will have to be seen through the prism of avoiding contagion at a time too sensitive for the neighboring economies (and the IMF/EU) to bear.

Mind you, timing is critical: Provided Spain, Portugal and Ireland “behave”, a Greek debt restructuring would be much easier for the eurozone to bear a year or two from today, as the economy would be in better shape and the risk of contagion lower.

Greece may be too small (and too wayward) to bail but it’s become systemic by association. And while the rescue of an idiot who put his house on fire may be against one’s libertarian philosophy, keeping the fire from spreading elsewhere is (as we’ve painfully come to learn) sound policy

Europe’s bazooka is not enough

Back in August 2008, Hank Paulson, then US Treasury Secretary, went to Congress to request the mandate for a potential financial backstop of Fannie Mae and Freddie Mac, in the event of a loss in market confidence.

Faced with the Congress’ inherent aversion to an explicit government guarantee on the two companies, Mr. Paulson’s argument was raw, yet forceful:

"If you have a bazooka in your pocket and people know it, you probably won't have to use it."

We all know how this ended. Less than two months later, the US government was forced to put both companies into “conservatorship”, as markets decided to test Hank’s resolve to put his powerful weapon to use.

Europe’s EUR30bn financial package to Greece is the new bazooka on the block. Even the Greek Prime Minister himself, George Papandreou, seemed keen on recycling the analogy:

“The gun is now loaded” he said to a Greek newspaper, perhaps unaware of the fate of its US precedent.

As it happens, the European backstop alone does not provide a permanent solution. This is because it continues to treat the Greek crisis as a liquidity problem, when many in the markets believe it’s a solvency one. A permanent solution *has* to involve an IMF program, with a clear and feasible framework for swift debt reduction.

So what would be the elements of an effective Fund program?

The program should have two primary objectives: First, to arrest an impending liquidity crisis by restoring market confidence in Greece’s ability to service its debt; and second, to safeguard the long-term viability of the Greek economy within the context of the euro. The latter would have to involve, inter alia, substantial fiscal tightening to foster price reductions and increase competitiveness.

When it comes to the first objective, the Europe’s EUR30bn package is in theory sufficient to address a potential liquidity crisis, given that it exceeds Greece’s obligations in the short-run. However, it is not enough to restore market confidence in the country’s ability to service its debt, now and in the future. This is because, by some calculations, Greece’s debt is currently not on a sustainable path, unless its fiscal effort goes beyond what the Finance Ministry has pledged under the stability and growth program it submitted to the EU.

One reason is that the low interest rates assumed in the fiscal plan may not materialize for some time. Another reason is that, even with low interest rates, the current plan does not envisage a reduction in the debt/GDP from current levels until after 2013: Instead, the debt is forecast to rise until 2011, and then fall slowly from 2012 onward. This may be unacceptable to investors looking for tangible evidence of a prompt fiscal correction

The issue of debt sustainability is also a legal one: Under the Fund’s lending guidelines, large loans (or, in Fund jargon, “exceptional access”) can only be provided if IMF economists can offer explicit assurances to the Fund’s board that a country’s debt level is on a sustainable path.

It is unclear that Fund economists can provide such assurances at this juncture, without either of the following two routes: One involving tougher, frontloaded and visible fiscal measures that go beyond Greece's current commitments, aimed at restoring confidence in the country's ability to control its debt; or another involving upfront debt restructuring.

In my view, the latter is not a viable alternative for Greece. First, although some two thirds of Greece’s debt is held by foreigners, the institutions with the largest exposure (as a percent of total portfolio) are Greek banks. Restructuring would bring about large losses for the banks, potentially causing bank runs, financial instability and a halt of credit. The consequences of growth would be disastrous.

Second, in the context of the monetary union, the only way to restore Greece’s competitiveness is by forcing a reduction in its prices vs. its trading partners (ie a real depreciation). A tighter fiscal policy that includes wage cuts is instrumental for making this happen, and will have to be part of an IMF program—debt restructuring or not.

Importantly, a tougher fiscal adjustment might look daunting on paper but is not impossible: Greece can achieve a great deal with determined steps to fight tax avoidance, the streamlining of an overbloated and inefficient public sector and penalties to those responsible for the massive expenditure “overruns” (a politically correct term for “money in the pockets of favored individuals”). The point of these measures goes beyond fiscal discipline: They are fundamental in fostering a transparent and rules-based environment for doing business.

As Rahm Emanuel said back in February 2009, “you never want s serious crisis to go to waste.” Greece’s crisis should not go to waste; it’s a wake up call that economic growth cannot be grounded on consumption funded by (what was thought to be) free money. The IMF is a necessary partner in this phase of transition.

Merkel Places Hopes in Lysistrata Initiative

In a last-ditch attempt to get Greece to fix its public finances, German Chancellor Angela Merkel has turned to the wayward country’s cultural heritage for ideas.

In a somewhat bizarre move, the Chancellor launched yesterday the so-called “Lysistrata Initiative”, named after Aristophanes’ eponymous play, which calls on the women of Greece to withhold sexual privileges from their partners until they file their tax returns.

The call comes on the heels of a European Council report showing Germany, along with Finland, trailing far behind France, Italy, Greece and Spain (or the FIGS) in the eurozone rankings for sexual activity.

“German taxpayers cannot be asked to finance the unrestrained lives of the Greeks” said an exasperated Ms Merkel.

A senior German diplomat agreed: ”All we’re asking the Greeks is to take their strikes to a more constructive level.”

Greek women have yet to come forth with an official position on the matter. But sources inside the “Hellenic Association of Female Pensioners Under 40”, a representative group, suggest they are not entirely closed to the idea.

Reportedly, a hardline faction within the Association is pushing for a pledge to renounce all sexual pleasures, including The Lioness on The Cheese Grater (a popular sexual position with ancient roots), in the name of fiscal discipline.

The pledge would be conditional on reparations from Germany of still unspecified nature, if the strike turned out to last more than a week.

Weary that any such move would hamper productivity at a sensitive time for Greece’s debt dynamics, Greek Prime Minister George Papandreou has stepped forth with a fiery response.

He accused the Council of manipulating the statistics, with the intention of presenting the lives of the Greeks as “too lovely”.

He then moved to condemn speculators for planting rumors about a “Greek brain drain”, saying that there is “absolutely no evidence” of Greeks moving to Germany to exploit the underutilized sexual landscape.

Separately, French President Nicolas Sarkozy said his country’s top showing in the European Council report gave further support to his suggestion to include “happiness” in a country’s GDP.

He added that, by this new measure, France would overtake the United States by far in GDP per capita, compared to a shortfall of 14% currently.

The euro advanced on the news.



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Happy April Fool's!!

Bringing stability to the Stability and Growth Pact

With the financial crisis bringing formerly unglamorous professions into the spotlight (economists, accountants), a new one has come to claim its share: Statistics!

Last week, a report by the European Commission (the EU’s executive arm) on the egregious shortcomings of Greek budget statistics sent Greece’s sovereign CDS spreads to levels only below those of Dubai, Vennie and Argentina!

Without wishing to belittle statisticians, I’d like to suggest that, from a policy perspective, the focus on Greece is a convenient distraction from the much bigger problem facing the eurozone: The fact that the Stability and Growth Pact (SGP), both by its design and its implementation, has failed to bring stability to the eurozone (I’ll leave “growth” aside for now). Instead, the institutional framework underpinning the European Monetary Union (EMU)—of which the SGP is a critical component—has been responsible for the imbalances within the eurozone that are now undermining its stability.

The starting point here is that, in the absence of appropriate disciplinary mechanisms, governments have a tendency to spend beyond their means. This is not some abstract conjecture but a well-established fact, validated by empirical evidence and grounded on political economy arguments widely discussed in the academic literature (e.g. by Harvard’s Alberto Alesina).

Given this “natural” propensity, there is a need for a set of disciplinary mechanisms to work at different levels:

• Reputational/Cultural: In some countries, the “culture” of (or voters’ preference for) fiscal discipline is very strong. In that case, governments have a lot to lose (reputation and elections) by not adhering to fiscally responsible policies.
• Rules-based fiscal framework: Empirical research (e.g. by Henning Bohn or James Poterba, who examine the fiscal performance of different US states) has found stricter and better enforceable budget rules to be associated with better fiscal outcomes.
• Market discipline: In theory, markets should also help impose discipline by raising the cost (pecuniary and reputational) of unrestrained policies. (In practice, however, markets often fail to provide such discipline by reacting too late and in a non-linear fashion due to myopic behavior, benchmarking, etc).
• Discipline imposed indirectly by the monetary authority. Provided that the central bank is sufficiently independent, it could help counteract the destabilizing effects of government dissaving with a monetary policy that encourages the build-up of private saving.

Unfortunately, most eurozone members have not seen any of these applied with sufficient force. For starts, governments’/voters’ preference for fiscal conservatism is highly idiosyncratic (see Finland vs. Italy or Greece) or temporary (e.g. will to adjust in the run-up to EMU accession followed by a pause/reversal). As such, it cannot possibly be taken for granted in a monetary union of 16 members (and potentially more).

In the case of monetary policy, post-EMU interest rates were way below “optimal” for countries like Spain, Ireland or Greece. Their national inflation rates were consistently above the eurozone average, while residuals from a Taylor-like rule post-EMU have been far more negative for these countries than for Germany or France (or Finland!). This is not to say that monetary policy was necessarily inconsistent with the ECB’s mandate of price stability; I’m just highlighting here the well-known fact that this particular disciplinary mechanism does not work in a monetary union.

Market “discipline”, too, has been anything but… Eurozone members’ long-term yields “miraculously” converged towards those of Germany (spreads were uniformly around 25-35 bps!) despite vast differences in fiscal positions and track records of adjustment.

With three out of four disciplinary mechanisms out or order, the burden falls on the fiscal rules. In fact, precisely because the other mechanisms are dysfunctional, a monetary union should have extra-strict fiscal rules with extra-strict enforcement mechanisms. But that’s not what Europe got for itself.

The SGP has been lame in more than one respect. In terms of design, the 3% deficit limit, which triggers the switch from the SGP’s “preventive” (and softer) recommendations to its “corrective” (and stricter) prescriptions, misses “the” point of debt sustainability.

First, by being too weak a benchmark to promote adjustment during recoveries;
Second, by invariably creating incentives to use one-off measures, creative accounting and statistical misreporting to meet the “3%” limit;
and, third, by allowing heavily indebted members to operate under the soft, “preventive” framework when they should instead be in a permanent “corrective” phase until their debt levels decline to an acceptable benchmark (say 60% of GDP… make it 80%!).

When it comes to enforcement, well, here we are entering the ultimate territory of lameness! First, once again, the process relies heavily on the corrective arm (i.e. after countries are in trouble with high deficits) rather than the preventive arm. This means that, even when/if countries eventually adjust back to a "3%" deficit, they end up there with much higher debt levels.

On top of that, a country is not automatically deemed to be in a state of excess deficit once it crosses the 3% limit; instead, the process involves first an “opinion” by the European Commission, which is then pondered about and decided upon by the European Council of Finance Ministers! Yes, that’s the very same guys whose budgets are under scrutiny!

This sham has led to all sorts of self-serving shenanigans—like, when the Council refused to issue an early warning to Germany back in 2002, or when the Council came at loggerheads with the Commission in 2003 by refusing to adopt a decision that France and Germany were running excess deficits. (The case had to go to the European Court of Justice, which vindicated the Commission).

Against this backdrop, Greece’s case is only a symptom of a broader plague of fiscal misconduct, including by “core” economies like Germany, France or Italy. While their numbers may look less provocative than Greece’s, they are far more consequential from an institutional and macro-stability perspective.

So what should change? Here are a few proposals, either from the literature or (to my knowledge) from me:

1. Enhance the SGP definition of “corrective” trigger to include debt/GDP levels. In this context, place highly indebted members under a permanent “corrective” process of adjustment until debt to GDP declines to a more acceptable level.

2. Do away with the 3% limit on the fiscal deficit, which is subject to all sorts of creative accounting, and set instead a limit on the public sector borrowing requirement. Discrepancies between Greece’s (and not just Greece’s) deficit and its borrowing requirement (after adjusting for financing items) had been raising eyebrows for years, so it’s baffling why this “cleaner” rule has not been brought to the fore. Besides, this rule would be more direct in controlling the debt/GDP level than the deficit-based rule.

3. Adopt strict, legally binding budget rules in the national legislatures, to be monitored by non-partisan fiscal councils. Governments should be made accountable to their parliaments for missing fiscal targets, both the “preventive” ones and the “corrective” ones.

4. Establish “rainy day” funds at the national level, with a rules-based contribution system that ensures a stricter enforcement of countercyclical policies, esp. in “good” times.

5. Establish a eurozone-wide “insurance-against-crisis” scheme: There may be a case for taking explicitly into account the negative externality due to misconduct by a minority of the membership. Countries could make contributions to an insurance fund, reflecting (a) their size and (b) their riskiness (debt level in excess of, say, 60% of GDP). This would boost the incentive to bring debt down, as well as establish predictability about the orderly resolution of a crisis situation.

In sum, safeguarding the “stability” objective of the SGP (and the EMU more broadly) will take bold measures focusing on stricter and more effective rules and enforcement mechanisms, In their absence, eurozone leaders and their array of supranational institutions might as well call a summit to give the Pact a different name!

Greece should seek a precautionary standby… now!

Eurozone bond markets have for years now been operating under the assumption of a new “impossible trinity” (1/): That you can’t have a single currency, a (virtually) independent fiscal policy and a no-bailout clause all at the same time.

This assumption has continued to prevail even after the recent budgetary shenanigans in Greece (and fiscal slippages also elsewhere in the eurozone), judging from the latest pricing of Greek sovereign CDS.

While much wider than in early October, when the new government took office, Greek 5yr CDS spreads, at 200bps on Friday, still price in just a 6-8% probability of a credit event. (By comparison, Dubai Holding’s spread closed at 1870bps and Ukraine’s at 1350bps).

Markets are probably right… Most likely, Greece will deliver a series of fiscal consolidation promises to the Euro group (of eurozone finance ministers), will become subject to enhanced surveillance by the European Council under the Maastricht Treaty’s “excessive deficit procedure” (EDP) and, as such, obtain an implicit financial backstop from its eurozone fellows…

But here are the problems with this approach:

First, Greece (and some other vulnerable eurozone members) would be better off with an explicit financial backstop, not an implicit one. The EU’s backstop will always have to be implicit to avoid moral hazard and complacency by the Greeks, the Irish, etc. However, an explicit backstop would be much more effective in stabilizing the Greek bond markets and in curbing uncertainty about potential financing troubles.

Second, any EU backstop would likely come after a crisis hit, instead of being pre-emptive. That’s lousy policy, not least because, were a crisis to hit, it would raise uncertainty and possibly spread to other markets, even if the EU were quick to step in. It's also lousy because there is absolutely no excuse for not having a crisis-prevention framework into place (over and above Greece’s own policy promises, for what they’re worth): Greece’s fiscal quagmire has been known for a long while, so policymakers would not exactly be caught by surprise!

Third, the European Commission/Council have a truly hopeless track record of enforcing fiscal consolidation or structural reforms on eurozone members. This means that whatever plan is laid out for Greece, it could lack the credibility to pass the “rating agencies’ test”, let alone the “markets’ test.” Ongoing uncertainty and lack of credibility would only breed volatility, which is neither good for Greece nor for investors still recovering from the Great Panic of 2008. In addition, to the extent that the Europeans prove, once again, incapable of enforcing fiscal and structural reforms, implementation slippages by Greece would set a dangerous precedent for other eurozone members to follow.

Fourth, direct involvement by eurozone governments in Greece’s fiscal plan (and, if need be, bailout) raises issues of conflicts of interest. It could turn out, a couple of years later, that Greece cannot put its finances in order.

This is not just a thought experiment by the way: Greece’s fiscal problems are deep-rooted and structural—a symptom of endemic problems, including an over-bloated and unproductive public sector, a pervasive culture of tax evasion, and widespread corruption at every imaginable level, from politics to the judiciary to the hospitals! This has hurt not only the government’s ability to put its finances in order; it has also hurt Greece’s competitiveness as a place to do business, undermining future growth (and, in turn, the fiscal dynamics).

If fiscal consolidation measures and structural reforms fail to deliver the necessary correction, the next route to follow may have to be debt restructuring. And here, the Europeans have too much at stake: Almost 70% of Greece’s near-EUR300 billion debt is held by foreigners, with a big chunk of it by French, German, Italian and other eurozone institutions (per the BIS). It is easy to see why the Europeans would not be “neutral” negotiators, and likely force too big a burden of adjustment on the Greek side.

This may sound “fair” on the surface, yet consider that these guys have completely failed to impose even a modicum of market discipline in recent years, being lured by the appeal of Greek debt as a euro-denominated product with an easy spread!

So here is a better and cleaner way to go: Greece should seek a “precautionary standby arrangement” (SBA) from the International Monetary Fund (IMF).

Under the SBA, Greece would commit to a combination of deficit-reducing and structural policy measures over 2-3 years (frontloading the former to sharpen the “teeth” and credibility of the SBA). The arrangement would be precautionary, with no IMF resources drawn in the baseline scenario where Greece faces no financing gap. However, Greece would have immediate access to Fund resources in an adverse scenario of financing troubles due to either a Greek-related or an “exogenous” market turmoil.

The advantages of this route compared to an EU solution are enormous in my view:

1. Greece would enjoy an explicit financial backstop rather than an implicit one.

2. The backstop would help prevent any crisis from happening, instead of cleaning up the mess ex post facto.

3. Provided the SBA has “teeth”, the seal of the IMF would be a great palliative for the markets, helping impart credibility to a government that has none.

4. By laying out specific benchmarks/conditionalities, compliance with these would be easy to monitor by the markets and by the Greek public, reinforcing government accountability.

5. The Maastricht Treaty’s “no-bailout” clause would remain intact, while the ECB would be able to maintain its autonomy over monetary policy and liquidity provision decisions, which would fortify the credibility of the euro.

6. The arm’s length (or, at least, indirect) involvement of Eurozone governments to the process would avoid the conflicts of interest I mentioned above.

7. Finally, Greece could set an example for other eurozone members to follow, helping maintain stability across the eurozone.

It is easy to see why some European policymakers might balk at this idea, out of concern it would amount to an acknowledgement of failure to deal with bread-and-butter problems in their own back yard. As a matter of fact, it is! The Stability and Growth Pact needs major rethinking (more on this in a subsequent piece).

But while Europe’s economic integration goes through yet another phase of soul searching, let the necessary measures of fiscal and economic stabilization proceed in a clean and orderly way.



1/ The original “impossible trinity” in international economics is the argument that you can’t have a fixed exchange rate, an autonomous monetary policy and free international capital flows all at the same time.