How Europe’s New Unstable Equilibrium Will Help Solve Its Sovereign Debt Crisisby Jacob Funk Kirkegaard | March 28th, 2011 | 02:18 pm
The euro area sovereign debt crisis is gradually turning into the best thing that has happened to European Union politics and European economies since the launch of the Single Market in the mid-1980s. The crisis has shattered the fake ten-year political and economic equilibrium between core and periphery countries that followed the initial shock of euro introduction. That sham equilibrium was based on the feel-good factor of illusory growth from real estate booms and credit financed consumption sprees. It was enabled both by incompetent financial market credit risk assessments that allowed Greece to borrow at German interest rates for a decade and also allowed European governments to believe the comforting, but erroneous signals from financial markets. After all, if Greece could borrow at German rates, who in Brussels could question it? It must have meant that the dream of European integration and economic convergence was really happening, that "Brussels" was competently steering Europe toward "ever closer union" and that all Europeans would enjoy Luxembourg’s standard of living1.
Instead the tide that was supposed to lift all European boats has gone out. Euro membership has become a kind of prison shelter, protecting country inmates from the mean streets of global financial crises, but allowing unpleasant things to happen to the weak, unless they reform before entering or prepare to do politically heavy lifting on reform once inside2.
The European political and institutional response to the latest crisis, had to navigate 27 national domestic political constituencies. Inevitably it limped behind. Yet the fact that it took only about 12 months from May of 2010 to negotiate the new permanent euro area crisis facility to be known as the European Stabilization Mechanism (ESM) is testimony to the innovative capacity of the European Union. The ESM is a permanent new EU institution built to last, and it was wise for leaders not to rush into it. The result has been a new political and economic equilibrium between the core and periphery of Europe. However unstable it is in the short run, this new equilibrium could ultimately help resolve the European sovereign debt and banking crisis.
Most financial market analysts and non-Europeans who have overlooked these accomplishments have committed two important fallacies.
The first fallacy: The European Union is not a "club" or mere free trade area that any member can easily decide to leave. There has been a tendency to forget that euro area members have given up much of their sovereignty to join.
More than half of the economically meaningful legislation passed by EU members’ national parliaments every year consists of implementing EU-based rules negotiated in Brussels. EU government cabinet members or their deputies go to Brussels each week to negotiate such legislation with their European counterparts. Indeed, they are probably in session in Brussels more days than the US Congress! The costs of leaving the euro area for both strong and weak countries are catastrophic3. Euro area membership entails significant de facto restrictions on any member state’s sovereignty, forcing each member to engage in an infinitely iterated game with its fellow members4. Accordingly, the strategies available to EU member state governments differ from those utilized by creditor and debtor governments in other sovereign debt crises. Historic or emerging market experiences are not relevant to possible internal EU and euro area crisis solutions.
Think of the issue of foreign vs. domestic debt. Inside the euro area, where sovereignty is pooled and the central bank shared, this becomes a complex multi-layered issue where Greek debt held by other euro area countries are not truly "foreign debt" in the same way that Argentinean government debt held by American banks is. The Greek government cannot simply stiff its "not quite foreign" creditors in the euro area, because France and Germany can retaliate. Unilateral declarations of sovereign default like Argentina’s in 2001 are not a winning or rational strategy. Euro area players will choose to cooperate with one another far more than sovereign nations usually do with their foreign creditors5. Just as the distinction between public and private sector debt is in a country facing a crisis becomes blurred, so too does the distinction inside the euro area between "peripheral debt" and "euro area debt."
In the current Greek crisis, Greece‘s debt terms remain unsustainable. This means that Athens and its euro area partners are more likely to continue to try to avoid a Greek default, which hurt them both — the equivalent of avoiding "mutually assured destruction." Default would clearly be an economic disaster for Greece. But it would also be disastrous for core euro area members, impairing the risk-free status of euro area sovereign debt in general, and leading the departure of many "real money" hold-to-maturity investors throughout euro area sovereign debt markets. A contagion would then spread to Spain and Italy bond markets. As a new currency, the euro would be tainted forever, increasing the cost of capital for all members and complicating the required (and ongoing) recapitalization of the European banking system.
The Second Fallacy: Euro area "Preferred Creditor Status" Does Not Equal That of the IMF
Much financial market anxiety in the euro area seems focused on the now legally entrenched preferred creditor status of the two bailout mechanisms created in the latest crisis: the European Financial Stabilization Facility and the European Stabilization Mechanism that is to succeed it, known among specialists as the EFSF/ESM6. But contrary to some conventional wisdom, these "official sector" creditor entities are not similar to the IMF. The IMF is an organization based on rules constraining its interaction with member governments and focused on ensuring that the IMF is paid back in full and ahead of other creditors7. The euro area and the EFSF/ESM are a completely different type of official sector "preferred creditor."
Euro area governments and the EFSF/ESM are not rules-bound. Nor are they (yet) constrained by "historic precedent." They are political entities, with lending conditionality dictated by their desire to avoid the "worst outcome" in the form of a sovereign default against private creditors8. All this should matter a lot for the lawyers and the International Swap and Derivatives Association (ISDA), when they decide whether or not an EFSF/ESM bailout inserting "preferred official creditors" ahead of private bondholders constitutes a "credit event." In the case of Ireland, ISDA decided that the bailout with EFSF participation was not a "restructuring credit event,"9 but since the ESM calls for "an adequate and proportionate form of private sector involvement on a case by case basis,"10 might it be different in the future? Probably not. ISDA is likely to conclude that any future subordination of private bondholders by the ESM will not be a subordination that is not in their (the bondholders’) interest, because the mechanism will provide additional "political options" for recipient governments to service their total debt.
The distinction between the IMF and euro area as "preferred creditors" was clearly illustrated on March 11, when the euro area overlooked their "preferred status" and was willing to accept a restructuring of their loan terms to Greece ahead of nominally "junior private creditors."11 Greece was granted an interest rate 100 basis points lower and with a longer maturity for its debt. In monetary net-present-value terms, that saved Athens perhaps €6 billion12. The IMF could not likely have entered into such a political deal. In return, euro area governments gained in "political capital," as Athens agreed to privatize €50 billion in state assets (just over 20 percent of projected 2010 Greek GDP of €232 billion).
The flexible lending terms of the EFSF/ESM permit the euro area to swap illiquid Greek government assets (to be privatized in the future) for highly liquid de facto fiscal transfers, lowering loan costs for Greece. In effect, Greece is securitizing the proceeds of future privatizations with the help of its euro area creditor partners. Only governments, and not private creditors, could help Greece in this way, knowing that they and the Athens government will be doing business down the road. German Chancellor Angela Merkel’s willingness to swap €6 billion in core country euro area taxpayers’ cash for a political pledge by Greece to privatize assets in the future speaks volumes about the strength of the euro area compact.
From all these developments we can see that the EFSF/ESM have the latitude to bring "political capital" to bear in their transaction, which neither the IMF, private creditors, nor governments in other sovereign debt crises can do. When euro area governments pledge "to do whatever it takes to save the euro," they have options that official sector creditors in other sovereign crises have not had. This is something that markets should not ignore.
Another factor strengthening the new unstable equilibrium lies in the governance design of the permanent ESM. It will be overseen by a Board of Governors consisting of the euro area ministers of finance.13 Such an arrangement cements the political nature of the ESM so that it will not operate like a statute-bound IMF defining itself as an "official sector preferred creditor."
Moreover, since a qualified majority of 80 percent of votes by the board will be required, based on the capital subscription of the ESM, only Germany and France will have the weight to veto ESM decisions. (In effect, France and Germany will have the blocking minority status in the ESM that the U.S. has in the IMF.14) As a consequence, Germany and France alone have been given the weight to attach national political conditionality to ESM lending decisions, though other ESM members might exercise such power by forming coalitions with each other.
As for the ESM pricing structure, the EU Council Conclusions state that a surcharge of 200 basis points will applied to the entire loan and an additional 100 basis points to loan amounts outstanding after three years. On the other hand, the ESM will only come into play in a crisis, where pragmatism is certain to dictate outcomes. The key Communiqué sentence about ESM pricing is the last one. It states that pricing policy "will be reviewed periodically." This promise provides the necessary room to adjust pricing to accommodate political goals of avoiding defaults against private bondholders. Accordingly, the credit default swap market has little to fear from the ESM in the current peripheral crisis focusing on Greece, Ireland and Portugal. Only in entirely new financial crises in the future is the involuntary "private sector participation" of private bond holders a politically realistic outcome.
A similar degree of discretion surrounds the maturity structure of ESM loans. Here the Council Conclusions state that loan terms "will depend on the nature of the imbalances and the prospects of the beneficiary Member States regaining access to financial markets within the time that ESM resources are available." Needless to say, this leaves a wide open door for maturity extensions granted at short notice. This is of crucial importance for Greece in 2012, when it is scheduled to return to financial markets.
Critics of Germany and other euro area creditor countries have charged that Greece and Ireland have had to bear unsustainably high interest rates on emergency loans. But that criticism is misguided and myopic. Looking at the EFSF/ESM interest rate solely through the lens of immediate financial sustainability misses the political nature of this crisis’ solution. Unsustainably high interest rates and the "ultima ratio" provision — i.e. the idea that the EU does not act to prevent a crisis, but provides assistance only once the crisis has hit — are politically necessary for the euro area to create political capital and act.15
By definition, the initial lending costs for access to the ESFSF/ESM must be prohibitive and unsustainably high16. Only by initially insisting on unsustainably high rates for Greece (and later Ireland) in May 2010 could Merkel have committed herself to a program that could be adjusted later (this March) in return for new political concessions from Athens. Her flexibility enabled her to extract political concessions from Athens will allow her to sell this "de facto transfer deal" at home in Germany. (it is probably not a coincidence that Greece’s €50 billion pledge to privatize state assets is actually quite close to the newspaper Bild Zeitung suggesting that Greece sell some of its islands!)
Although they do not want their citizens to see it this way, euro area countries coming to the rescue of Greece with lower and more favorable interest rates and maturities are carrying out "de facto fiscal transfers" they can justify because of political promises from the borrowers. This is a dramatic development that opens the door for a highly political conditionality — and limited fiscal federalism inside the euro area. That reality will ultimately enable the Europeans to solve their peripheral debt crisis17.
This process extends easily to Ireland, which is being pressed to harmonize its corporate tax with other countries in Europe, a purely political demand of no real economic importance. The issue of the Irish tax system was taken off the agenda at the recent summit, ostensibly to return after the results of the Irish bank stress tests, which will affect Irish interest rates. But an agreement on it is likely to occur no later than the EU Summit in June. This was clearly indicated by Irish Prime Minister Enda Kenny’s comment after the March 25 Summit that "[W]e are quite prepared once we get the clarity of the bank stress test to look at what we have to do but that does not include corporate tax rate [author's emphasis]18."
A lot of nonsense has been written recently on this issue. Ireland will supposedly be forced to raise its corporate income tax rate dramatically. But this is not on the table now or in the future. What is on the table is the longer-term EU process of trying to establishing a Common Consolidated Corporate Tax Base (CCCTB)19. The CCCTB has nothing to do with corporate tax rates. Rather it is concerned with the corporate tax base (i.e. the estimation of a corporation’s operating income). Even more important, the CCCTB is to be optional for companies. This means that any foreign company operating in Ireland could opt in to the new harmonized EU system or continue to operate under the existing Irish national tax system. The CCCTB therefore amounts to a "mutual recognition agreement" (MRA) in which EU member states maintain their own national corporate tax systems while also recognizing the new common EU system. It is similar to corporate accounting standards that allow companies to choose between U.S. FASB rules, or the international IFRS rules.
Earlier this month, Irish Prime Minister Enda Kenny visited the U.S. for Saint Patrick’s Day20 and rejected a deal on the corporate tax. But this seemed to be grandstanding. The struggling Irish government will no doubt shortly engage with their EU partners on the non-threatening CCCTB. In return, they will likely get the same interest rate reduction that Greece received last week. Like Greece, Enda Kenny will conduct a "political capital" transaction with his European partners, where Irish political acceptance of the CCCTB21 is exchanged for a "de facto fiscal transfer" in the form of lower interest rates.
Hovering over all these developments is another under-appreciated element in the mix. The errant euro area countries receiving aid from their AAA partners are in fact in less dire shape than the markets think. Much of the gloomiest commentary about Greece and Ireland has focused on their extremely high gross government debt levels. (Greece’s debt level is at least 160 percent of GDP today and Ireland is probably around 120 percent. Both would require unrealistically high growth rates to achieve stability.) But gross government debt is a flawed metric.
Actually, no one knows the real assets of the Greek and Irish governments. Greek authorities are only now working with the IMF to catalogue the scope of public corporations. In addition, no one knows the true value of the Greek government’s real estate and land holdings22. Estimates suggest the total value of these assets might approach as much as €300 billion in Greece. Similarly in Ireland, no one knows the true value of the assets taken over by the National Asset Management Agency (NAMA), Ireland’s "bad bank" created in 2009. For now, both countries should avoid fire sales of their assets in the wake their respective crises.
Moreover, euro area debtor countries have "political assets" they can utilize with euro area creditors. The deal last week between Greece and its euro area partners illustrated how €50 billion in highly illiquid still-to-be-privatized Greek government assets can be swapped if creditors are willing. Euro area governments are very patient counter-parties. They can give Greece and Ireland time to unload these assets to raise urgently needed cash.
Given these considerations, will markets respond with patience? Or will they demand more dramatic and immediate solutions?
It is imperative for markets to understand that "asset swap" transactions described above can be repeated to avoid the mutually assured destruction of a debt default against private holders of euro area sovereign debt. Greece’s estimated €300 billion in government assets provide the Athens government with a cushion.23 For creditor countries moreover, a lower "rate of return" for their emergency loans means that debtor countries will more easily manage the domestic politics of their repayment.
As a result, the ability of the EFSF/ESM to purchase government debt in the primary market becomes crucial, providing Greece (in another iteration of the political game) with a backstop if financial markets remain closed in 2012 in return for more political concessions.
Whether Greece can return to financial markets will hinge on "confidence" in its solvency. Here it is crucial for financial markets to understand the political constraints under which the euro area operates. There are political limits to what both Prime Minister George Papandreou of Greece, Chancellor Merkel and President Nicolas Sarkozy of France can get away with politically. Papandreou cannot announce that the Greek government will privatize €250 billion worth of assets in one step, for example. Merkel, for her part, cannot grant Greece an additional €50 billion loan, cut interest rates to zero and extend the maturity to 30 years in one single leap. The euro area cannot realistically solve its sovereign debt crisis in one fell swoop. Markets clamoring for such a thing are politically naive.
Instead, politically inspired transactions need to be much smaller in scale, and carried out in a drip-drip-drip manner. Given financial markets’ impatience, we should consequently not expect Greek or Irish bond spreads to converge dramatically right away. Over time, however, this process can succeed.
The Sovereign Debt and Banking Crisis End-Game
If these solutions hold, the euro area can buy time during which to solve its sovereign debt crisis and finally address the rottenness at the core of the European banking system as well.
Alas, that time is not yet upon us. The anemic methodology of the second European stress test provides testimony to that24, though they may provide some beneficial additional transparency25 in the EU banking sector and perhaps in isolated instances lead to government capital injections into some banks. But the tests will not force the core euro area banking system to become well capitalized, despite all the happy talk of EU officialdom. As an independent "euro area crisis solution tool," the second set of banking stress is thus likely to be disappointing.
The stress tests were weak in part because they did not require holdings to be marked to market and they did not rely on pure straight equity capital, effectively a regulatory forbearance strategy for the banks. But that, too, is relevant to the iterated "political capital games" being played with core-Europe’s leading banks, its smaller banks, and of course its governments, which would have to inject capital into the banks if they were deemed undercapitalized. Everyone benefits politically from this game of pretend-and-extend for the banks and their debtors. Just like in the case of a peripheral debt default, both sides of the bargain have an interest in avoiding the "mutually worst outcome".
At some point, however, core European banks will built up sufficient reserves against their bad loans to avoid an earnings hit, when writing down the value of their peripheral bond portfolio to levels sustainable for the peripheral debtor economies.26 At that point in time, euro area governments will lean on the banks and encourage "voluntary exchanges" into new securities a’la "Brady Bonds" to reduce the outstanding debt burden of peripheral euro area members. The goal will be to restructure outstanding privately held peripheral debt, without forcing haircuts on any non-complicit private bondholders. The risk-free status of euro area sovereign debt thus would remain intact. Such future "voluntary exchange" transactions between peripheral governments and core euro area banks would allow further European politicians to claim (with some justification) that "private sector participation" has helped to solve the euro area debt crisis.
Just as Brady Bond exchanges marked the end of the Latin American debt crisis after 6-7 years of regulatory forbearance for U.S. and Western banks, these swaps of debt would signal an end to the current euro area sovereign debt crisis.
Jean Monnet famously declared 27 that modern Europe was forged in crisis. This crisis too will leave a lasting institutional imprint on the EU, though it is too early to say whether all these steps will make the euro area a more coherent and stable entity.
Creation of the permanent ESM will likely be the most consequential new institutional development. All euro area governments now know what happens in a euro area fiscal crisis and that they must contribute large amounts of sovereign guarantees and capital to the ESM if such a new crisis were ever to emerge in the future. This knowledge could affect their behavior before any emergency occurs.
The ESM will thus formalize "self-interested peer pressure" inside the euro area as each country has its own financial interest in getting other euro area countries to put their houses in order. By aligning incentives among EU peers, the ESM potentially increases the traditionally overrated "political effect" of EU peer pressure.
In the past, "political collusion" among Europeans led to the destruction of the original Stability and Growth Pact (SGP) as large member states on the EU Council gave a free pass to others. The new arrangements give euro area less of an incentive to make that mistake. The ESM should reduce the ability of a large laggard country attempting to assemble a blocking minority against potential sanctions. The ESM might even make the SGP relevant again and is certain to amplify the effects of the new Euro Plus Pact in which euro area leaders can look over the shoulders of each other in any policy area.
The Euro Plus Pact is unique in EU institutional terms because it has none of the traditional legal distinctions between policy areas at the EU-level and at the level of member states. Hence if euro area leaders want to discuss traditional "member state only" subjects like taxes, health care, pension systems or labor markets, they now can do so. The de facto reduction in member states’ policy sovereignty and economic governance stemming from this stealth de jure change should not be underestimated.
Another area where the existence of the ESM might prove of lasting and widespread relevance concerns the effects that ESM interest rates will have on the range of interest rate spreads in the trading of long-term euro area sovereign debt. The euro area leaders clearly want to avoid haircuts or an outright default against private bondholders in the short run. But it is also clear from the introduction of Collective Action Clauses on all euro area debt after 2013 that euro area leaders are also determined to avoid a reemergence of "excessive interest rate convergence" between euro area countries,28 which might give some countries an incentive to misbehave. How large should we expect the spreads on euro area debt to be?
As this post has argued, despite the fact that EU leaders have now given themselves the right to eventually potentially reduce ESM interest rates all the way if needed down to roughly the rates charged by the IMF, we should not necessarily expect future ESM interest rates to be set that low immediately. The pricing structure for the ESM makes that clear. Eventually, however, peripheral euro area long-term debt should trade at around the level of rates charged in an IMF’s Extended Fund Facility (EFF)29, as this is the "in extremis" interest rates at which peripheral countries can obtain both IMF and EFSF/ESM financial assistance.
Another way to think of this issue is that the ultimate cost of ESM/IMF emergency financing marks the rate of interest above which a rolling "private-to-public debt restructuring" will occur in a crisis30. Ever since the May 2010 bailout package for Greece, Greek government debt held by the private sector has continued to be retired, rolled-over or converted into debt held by the official sector. There has been no default against private sector bondholders. But as the official sector loans made available to Greece since May have – even if they initially were made available to Greece by the EU at unsustainable rates – come at rates below those available in the private financial markets, an ongoing restructuring of Greek debt began already in May 2010 at net present value terms. Given the euro area’s overarching imperative of avoiding a default on sovereign debt, only when Greece (and others) are able to refinance itself at the ESM’s ultimate ratio cost of capital again in the private capital markets does the opportunity for this type of rolling "private-to-public" debt restructuring disappear.
Therefore, when euro area leaders politically determine the ultimate costs of ESM crisis assistance, they also implicitly determine the interest rate – i.e. risk level – at which euro area members must convince private markets to purchase their debt.
The ESM in its own way thus ensures that in the euro area, what counts for ultimate sovereign debt sustainability is politically determined. Angela Merkel is getting it her way with "what we call the primacy of politics31".
But make no mistake, nothing in these developments will constrain Germany, which as the continent’s biggest surplus country has the most leverage in any (consequently asymmetric) solution to Europe’s sovereign debt crisis . Resolving the current crisis may sow the seeds of future ones elsewhere, but this is as good a solution as Europe can produce today.
1. To get an idea of the "see no evil" pre-crisis Brussels mood, one need not read anything else than the self-congratulatory European Commission "EMU@10" publication from 2008, with its in hindsight fascinating one-liner: "Ten years after its launch, the euro is a resounding success. It is a symbol of European integration and has helped us run sound public finances and macroeconomic policies which have contributed to greater job creation". See http://ec.europa.eu/economy_finance/emu10/reports_en.htm.
2. It is abundantly clear from the recent Estonian and Latvian experiences and the general reluctance among Eastern European members to join the euro until their macro-economic fundamentals are in place by the middle of the decade that this lesson has been learned. The contrast with the mad political vanity rush among Southern peripheral countries (and in Greece a few years later) to become a "founding member of euro" by hook and crook, but limited real economic reform, in the mid-1990s could not be clearer.
4. Note that unlike mortal individuals, nations can be assumed to have an infinite time horizon.
5. In game theoretical terms, "chicken" is a game in which while both contestants’ best individual outcome is not to cooperate, the worst possible outcome occurs when both players do not cooperate. The name "chicken" comes from the game in which two drivers drive towards each other on a collision course: one must swerve, or both may die in the crash, but if one driver swerves and the other does not, the one who swerved will be called a cowardly "chicken", while the one that did not will be the winner.
7. The IMF does alter programs and the implied terms and conditionality faced by member states, but as a rule "never loses money".
8. Bestowing upon the EFSF/ESM "preferred creditor status" was largely dictated by the German government’s legal requirements vs. its Constitutional Court. It further has the benefit of, combined with Collective Action Clauses to be introduced in 2013, of helping cement bond market spreads between different euro area government bonds.
9. See ISDA Ruling of March 15th, 2011 at http://www.isda.org/dc/view.asp?issuenum=2011031101.
10. See ESM Term Sheet in the EU Council Conclusions of Mrch 25th 2011 at http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/120296.pdf.
11. The March 11th restructuring
13. The Commissioner for Economic and Monetary Affairs and the president of the ECB will have observer status. See EU Council Conclusion at http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/120296.pdf.
14. We should probably expect Franco-German criticism of the U.S IMF position to recede somewhat now that they have carved out an identical position in the European "IMF-like structure".
15. It is thus totally wrong to criticize the EU for "not following the IMF lead" in offering member states preemptive standby facilities etc. to avoid getting into a crisis in the first place. This is certainly an appropriate policy tool for the IMF to create and suggests a helpful division of labor between the IMF and EU, but completely misses the point that euro area leaders have to deal with solving the current crisis, rather than preventing the next at the moment.
16. This has the additional effect of acting as a check on moral hazard by making the initial application for aid from the ESM a politically one. It is not a coincident that Portuguese politicians are all currently trying to avoid taking the political responsibility for approaching the EFSF/ESM.
17. This was clearly illustrated after the euro area meeting on March 11, when German parliamentarians who had previously backed a non-binding resolution trying to tie hands of the Angela Merkel ahead of the EU Summit, backed down and declared themselves satisfied with the result. See http://www.bloomberg.com/news/2011-03-23/merkel-ally-barthle-says-german-lawmakers-satisfied-on-euro-backstop-deal.html
21. It is important to understand that viewed in the longer-term timeframe, the CCCTB represents something far more significant for the EU than an MRA on corporate tax systems. The CCCTB will be the first time tax policy – hitherto an exclusively national level policy topic – is written at the EU level, a move that has always until now been vetoed by Ireland (and the UK).
22. This issue is discussed in the latest Third IMF Review of the Greek Stand-By Arrangement Program, pages 13ff. Available at http://www.imf.org/external/pubs/ft/scr/2011/cr1168.pdf.
23. In the case of Greece, where public ownership of any potentially productive asset can be expected to mean mismanaged assets, large-scale privatizations of public assets alone should moreover lead to very substantial long-term increases in productivity. Given the abysmal track record of the Greek government to date, productivity increases similarly to those seen in Eastern Europe after privatizations in the early 1990s seem plausible.
25. At least the EBA pledge that the stress tests "will be accompanied by full disclosure of all relevant sovereign holdings". See http://eba.europa.eu/News–Communications/Year/2011/The-EBA-publishes-details-of-its-stress-test-scena.aspx.
26. I’m indebted to my colleague Ted Truman for pointing out to me this crucial timing point with respect to when – several years after the crisis began in 1982-83 – Brady Bond transactions were initiated between Western banks and Latin American debtors in the late 1980s.
28. Such future "excessive interest rate convergence" would arise if in a return to pre-crisis conditions, purely financial market effects, like the liquidity effects of normal ECB operations, short-term convergence trades and renewed plain irrationality in the market, swamp the "real economy fundamentals" differences among euro area members. A convergence trade means that financial market participants design a trading position that will increase in value if the prices of two assets converge in the future. This was an incredibly successful trade just prior to the introduction of the euro.
30. I am indebted to my colleague Ted Truman for emphasizing this important point to me.
32. A reminder of just how powerful Germany and Angela Merkel is in these negotiations was seen in the final deliberations concerning the timeframe in which the €80bn in paid-up capital for the ESM had to be made. Initially on March 11th, the Germany finance minister agreed to do it in three tranches starting with a total of €40bn in 2013. However, as this would have meant that Angela Merkel’s government would be without any chance of potentially providing a tax break before the next German elections in October 2013 (a key demand of the small coalition partner, the FDP), Angela Merkel demanded that the deal be reopened. In the final deal struck at the Summit on March 25th, the €80bn in paid-up capital is instead scheduled to come in five tranches starting in 2013, a change that preserves the possibility of Angela Merkel granting pre-election tax-breaks in 2013.