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When EU leaders provided a bailout for Greece last May, they no doubt "did the right thing." But in the process, their temporary response not only broke at least the spirit of the EU Treaty, but also set themselves up for the future challenge of reining in moral hazard on a permanent basis in what some now deride as Europe's "Bailout Union."1
The tough conditions attached to the IMF's rescue were clearly bitter medicine for Athens, but they are nonetheless not sufficient to prevent future political opportunism from undermining them. Future versions of Andreas Papandreou, the Greek Socialist leader who dominated the country's politics in the 1980s and 1990s, may emerge not only in Greece but in other parts of Europe, run their countries into the ditch and then resign and move to Monaco, leaving it to the European Union, IMF, and future generations to pick up the pieces. The European Union therefore needs more forceful "ex ante checks" (prevention) on moral hazard in addition to ex post conditionality (treatment).
This issue is particularly critical as political resistance to bailouts will rise exponentially with each new request for aid. (Political rule number one regarding bailouts is that you never ask taxpayers to pay for a rescue twice. Regretfully the fact that the eurozone has multiple potential candidates makes this a difficult rule to adhere to.) Slovakia resisted participation in the Greek bailout, after (correctly) labeling it a case of "reverse Robin Hood," in which countries poorer than Greece were being asked to bail it out. If countries richer than Greece (Ireland, for example, which has 120 percent of the eurozone average GDP per capita in 2010) request another bailout, the politics might make it impossible. Or at least, the scale of the crisis required to once again force EU politicians' hands would be of such a magnitude that it alone would dwarf the economic or political costs of putting ex ante checks on moral hazard today. Only such measures will be able to "ease the political pain" of agreeing to another EU bailout, thereby making it possible.
—Adam Smith, Wealth of Nations, Book V, Chapter III
Moreover, there is the issue looming in Germany as the Constitutional Court reviews the German government's approval of the European Financial Stability Facility (EFSF). That pending judgment, too, is likely to be affected by whether the facility has set up tough disciplinary measures for countries seeking future bailouts.2
Jean Monnet, the father of the postwar European economic union, is alleged to have said that "Europe will be forged in crises, and will be the sum of the solutions adopted for those crises." That remains true today. Europe only progresses through measures taken at times where crisis necessitates the abandonment of traditional political resistance to novel measures to prevent future crises.
Accordingly, though some (like the European Central Bank, or ECB) say Europe's precarious situation dictates doing nothing to upset the financial markets and cause spreads for peripheral debt from rising, now is the time to discuss future preventive measures to ensure that the current crises will not recur. Only now, when the effects of the previous crisis are still fresh on the minds of policymakers, can Europe hope to adapt credible solutions to prevent history from repeating itself and the next European financial crisis from spinning out of control.
Certainly, the ECB is in a difficult situation right now. Volatility in the financial markets makes it more difficult for the bank to withdraw its aid and raise interest rates. The central bank may also have to make larger purchases of assets through its Securities Market Program (SMP) than would otherwise be the case. Maintaining consensus on its Governing Board may become harder,3 but EU politicians should look to their long-term interests.
The European Union faces a couple options. Its leaders could have bolstered the Stability and Growth Pact (SGP) against deficits with automatic financial fines—imposed based on technocratic European Commission recommendations—which could have provided checks on moral hazard. A functionally similar proposal would strip fiscally errant member states' of voting rights in the EU Council.
The former was the preferred option of the ECB and many others, but the EU Council led by France and Germany rejected it in late October. The proposal to impose "political fines" (loss of voting rights) is part of EU Council President Herman van Rompuy's mandate to consider for the next EU Council meeting in December. In fact, however, neither is likely to be adopted. Even the Germans have had a change of heart. The idea that bureaucrats in Brussels could recommend automatic sanctions against elected EU governments has proved to be a nonstarter.
How then to enforce "moral hazard" preventing future bailouts? The main option left is of ex ante "market-based surveillance"—in effect a promise to enforce haircuts on private creditors in any future bailout. By making bond holders share the cost of a fiscal collapse, the eurozone avoids the situation from the late 1990s to September 2008 in which its sovereigns faced the same cost of capital and the same risk perception on their bonds, despite their diverse and indeed diverging economic fundamentals.
As the precedent for sovereign bailouts in the EU has been set, financial markets must be made to realize that they cannot rationally bet (as has so far been the case with Greece) that they will be fully protected by other EU countries' taxpayers in future crises. With this knowledge enshrined and the "risk free label" shattered, investors will then rationally proceed to charge higher risk premia on the debt of the weakest eurozone members—currently Greece, Portugal, and Ireland.4
This is a timely and welcome proposal, and German leaders deserve credit for it, even though they accommodated France's demands for watering down the SGP reform at Deauville on October 18 . A permanent European crisis resolution mechanism (ECRM) imposing substantial losses on private sector creditors in the future is a potentially effective check on moral hazard for several reasons.
First, the time for policymakers to act is now. With many private bank assets already transferred to government "bad banks" (especially in Germany) and eurozone monetary stimulus already at record levels (benefitting banks greatly), the powerful financial lobby is not in a position to lobby as effectively against haircuts through an ECRM. Moreover, the temporary EFSF is expiring in May 2013 and peripheral eurozone members are therefore at risk of finding themselves inside a monetary union they cannot feasibly leave without a "financial safety net." Consequently, they will have no choice but to support an ECRM right now, even if it means higher interest rates for them in the short term. A serious EU split over this issue would be even worse for peripheral bond spreads, so they need a deal with Germany more than ever.
Second, a resolution mechanism will address a common difficulty in sovereign debt restructurings by shifting the costs of the bailouts onto "shareholders," in this case residents and taxpayers of the country being bailed out. Generally, in government bank bailouts, shareholders are hit with the first losses, leaving (at least senior) bond holders intact, to prevent moral hazard.5
But reversing the "shareholders first" tradition will actually achieve the same result of focusing the minds of governments. With a resolution mechanism hanging over them, the citizens of Ireland and Portugal face an effective "first default" on the promises made to them as their governments embark on more austerity and structural reforms to bring down deficits and raise potential growth rates. The mechanism thus implicitly transfers the future costs of European bailouts from taxpayers in Germany, France, and the rest of the eurozone core that would pay for them through a Eurobond-financed EFSF to the residents of peripheral countries on the receiving end.
Third, recall the concern that sank the IMF's 2002 post-Argentina proposal for a global sovereign default restructuring mechanism (SDRM). It was that countries were unwilling to cede sovereignty to a supranational entity. But these concerns are of less importance in Europe, where sovereignty is already "pooled" by the EU Treaty and constrained to an extent far beyond any other international forum. Simply put, being a member of the European Union means that a country is no longer fully sovereign, but instead becomes the subject of supranational justice meted out by the European Court of Justice (ECJ), on which each member state is represented by one judge.
The ECJ supersedes the jurisdiction of national supreme courts in all matters related to EU legislation—perhaps as much as half of all new legislation in the European Union today.6 The court's experience suggests that the European Union will be able to put together a credible legal arbitrator to preside over a sovereign default, as well as a possible special EU bankruptcy court staffed by independent legal scholars and sector experts. Establishing entirely new legal institutions would not be required.
Because of the role of the euro, moreover, the traditional differentiation in emerging-market sovereign defaults between foreign and national currency debt is irrelevant. As discussed by Gianviti, Krueger, Pisani-Ferry, Sapir, and von Hagen , eurozone members have no problem in issuing debt in their national, but shared, currency and most of it is held by other eurozone country residents. While the euro is their national currency, individual eurozone members have next to no control over it with monetary policy exclusively in the hands of the independent ECB. Today, more than 10 years after the introduction of the euro, establishing a supranational ECRM would therefore be a natural evolution of the eurozone institutionalization.
The recent proposals by Germany's Finance Minister, Wolfgang Schäuble, outlining a two-stage process for a potential future ECRM are a useful guide to how it might work.
In the first stage, the maturity and term structure of a crisis-stricken eurozone sovereign's debt would be extended. Such a step would presumably—as has been the case in Greece's three-year program—be carried out through the intervention of the official sector and thus ultimately be guaranteed by the commitment of eurozone taxpayers' money.7 Accordingly, eurozone members facing a mere "liquidity crisis" would be bailed out by relying on public money without private sector participation. The terms would likely be close to what Greece received in the spring of this year—about 5 percent and with standard IMF conditionality attached.
In the second stage, to take effect if the first stage proves insufficient, private sector creditors would take a haircut on their holdings of the crisis-stricken sovereign's debt, sharing the cost with EU taxpayers. In principle "private sector participation" would only occur in this stage for eurozone members facing a "solvency crisis" rather than a "liquidity crisis." Upon agreeing to discount the value of their debt holdings by a certain amount, private creditors would get a guarantee for the remainder of the value.
Only new debt issued after the EU Council agrees to the ECRM would be subject to these provisions, an arrangement designed to avoid the inevitable legal battles surrounding a change in the contracts for existing debts. Presumably the required "collective action clause" (CAC) debt covenants can be attached "voluntarily" to all eurozone sovereign bonds without the need for referenda on changes to the Lisbon Treaty. However, to provide legal certainty and from the perspective of satisfying the German Constitutional Court, a simplified Article 48 Treaty change procedure not requiring national referenda would be preferable.
On top of these stages, Schäuble foresees a major role in the administration of such an ECRM for the IMF.
This is a broad starting framework that could sensibly be implemented along the following operational details:
Individual crisis-stricken member states would presumably "voluntarily" initiate the process by requesting a bailout from the now permanent EFSF-like de facto "crisis-only Eurobond financed" fund and thereby enter stage one. Were the member state to face only a "liquidity crisis," the official sector assistance and the associated reform conditions would solve the problem on their own.
At the same time, an ad hoc "ECJ bankruptcy court" would have to be organized and prepared to rule in the instance that stage one had failed and stage two was necessary. A multistage proposal cannot be based merely on a "contractual approach," where collective action clauses alone facilitate the negotiated agreement between the sovereign and creditors. At some point, a "statutory approach" with a legal arbitrator must become involved.
Fixed time constraints should be set for the court's ruling to avoid legal gridlock and deny credit speculators and vultures the opportunity to profit from delays. A first ruling should be sought on whether or not stage two is required before the expiration of a stage one "IMF conditional program," possibly at regular intervals until both the member state and a certain majority of creditors agree to tougher steps. The track record of the ECJ's "Urgent Rulings Procedure"—with a proceedings duration average of 2.5 months in 2008 and 2009—suggests that it will be possible to establish expeditious court procedures for a bankruptcy court. The ECJ bankruptcy court would hear from creditors, the member state, and other entities, including the IMF, the European Commission, the ECB, and other nations. Such legal depositions should sensibly be conducted in confidentiality to avoid market speculation and secure honesty before the court.
The IMF could collect, register, and rank creditor claims with the right to be represented before the court and thereby join the "Luxembourg Club" for eurozone sovereign debt restructurings. Explicitly ranking all outstanding creditors avoids the vulture-fund incentive to seek only the most difficult-to-restructure debt, such as very short maturities.
The ECJ bankruptcy court would also determine the size of the private sector participation. In other words, there would be no rigid rules written ahead of time and no return to the failed one-rule-fits-all approach of the SGP. Instead, the size of the required private sector haircut would be determined case by case, depending on the difficulty of returning to a sustainable debt profile. The more unsustainable the total debt burden, the larger the required haircut by private sector creditors.
These steps would align incentives between creditors and the debtor nation. First, private creditors would know that the more unsustainable the loans, the larger their potential future haircut would be. This would reduce overall possible sovereign debt levels by increasing the yield demanded by creditors as total debt levels rise. And second, debtor nations would have an incentive to reform their economies, so as to sustain the highest possible amount of debt and the least possible potential future haircut, ceteris paribus lowering their cost of capital.
Timely price discovery of the ultimate worth of "sovereign debt" declared unsustainable by an ECJ bankruptcy court would enhance transparency for both creditors and debtors. In today's mark-to-market based financial sector, asset values are surely better preserved even in the short term by reducing the uncertainty about the timing and level of ultimate recovery values, lowering the risk of herd-like selling.
Or put in another way, financial markets keen to avoid excessively large drops in secondary debt market values and associated large mark-to-market losses should welcome an ECRM because a guaranteed, but negotiated, haircut would actually provide some security for the remaining value of the asset. Solomonic "middle of the road" solutions would be the likely outcome. The implied drop in volatility may not please day-trading vulture funds, but it should appeal greatly to most large participants in government debt markets.
Note that the same logic applies to the financial market volatility associated with the uncertainty about the details of an ECRM until it is approved by EU leaders. Lacking information, financial markets are likely to prepare for the worst and drive up interest rates also for nonperipheral countries like Spain ahead of the actual EU Council decision. Once that decision is made, though, and ECRM guidelines for a case-by-case approach to the size of haircuts are spelled out, financial markets are likely to calm down again.
As a corollary to avoid derivatives-based speculation from the volatile Credit Default Swap-market spilling over in the bond market and or affecting the proceedings of the ECJ bankruptcy court, the trading of at least naked default swaps on eurozone government bonds subject to an ECRM may have to be banned.
It should also be noted how Wolfgang Schäuble's two-stage permanent crisis resolution mechanism (PCRM) proposal raises several questions about a future extension of the existing three-year Greek program. On the one hand, it could be argued that Greece is already in stage one and that a required future program extension (i.e., default on existing commitments to the official sector8) would push it into stage two, with associated private sector participation. The shift could occur as early as 2011. On the other hand, of course, it looks unlikely that an ECRM could be operational as early as that. Thus no Greek debt (or debts of other eurozone countries) would be eligible for haircuts (nor would other eurozone countries if they were to go to the EFSF) early in 2011. Most likely therefore, even with an expeditious agreement for a PCRM with private sector participation, Greek creditors would not be subject to future haircuts arising from an ECRM.
Hopefully, the current political situation in the European Union, with agreement between France and Germany about an ECRM, and the inability of immediately affected peripheral eurozone countries to resist, will lead to a decision at the December 2010 EU Council.
An operational supranational European SDRM-like institution along the lines of Germany's proposal for an ECRM—as a Phoenix from the ashes of the failed Stability and Growth Pact— would in a global and historical perspective amount to another important instance of EU interstate institutional innovation. It would not only serve to check moral hazard in the European Union, but also mitigate the ex post costs of debt crises and defaults by facilitating collective action along transparent guidelines and with legal certainty. Eurozone sovereign debt and financial markets more broadly would operate more efficiently with an ECRM in place.
An ECRM would, some temporary volatility notwithstanding, ensure that Europe today, as envisioned by Jean Monnet at the beginning, has forged a constructive, long-term response to its current crisis.
Notes
1. See Policy Brief 10-25: Will It Be Brussels, Berlin, or Financial Markets that Check Moral Hazard in Europe's Bailout Union? Most Likely the Latter! (Kirkegaard 2010) for a detailed discussion.
2. The Karlsruhe court will probably be more likely to approve an EFSF if "ex ante disciplinary measures" against moral hazard are in place to limit the chance of future bailouts (i.e., breaches of the letter of the Treaty).
3. Ironically, the effects of the German government's recent proposals will most seriously upset the German members of the ECB Governing Board.
4. Given the rapidly rising sovereign debts across the industrialized world in recent years, the acknowledgement that such sovereign debt is not after all "risk free" would seem a sensible disciplining factor also globally. As discussed by Gianviti, Krueger, Pisani-Ferry, Sapir, and von Hagen , this would have large implications for how banks hold capital against (no longer) "risk-free debt."
5. In previous eras, creditor claims on foreign sovereigns were often enforced through more coercive means via guns boats or marine corps expeditionary forces. This is obviously not an option in today's world. Moreover, modern legal substitutes, where creditors try to seize the assets of foreign governments in a given country through court orders there, is also unsatisfactory. They take too long, cost too much in lawyers' fees, and yield too few assets for creditors to be effective.
6. The true scope of EU legislation today is a contested issue. A recent UK government estimate suggests that "around 50 percent of UK legislation with a significant economic impact originates from EU legislation."
7. A "debt rescheduling," which entails postponing debt repayments without changing the present value of the debt, will—if successful—not necessarily cost the official sector any money. However, especially at the time of tight government budgets, even such a debt rescheduling will impose short-term opportunity costs on governments in the form of foregone spending opportunities and, as illustrated with Greece, entail very large political costs.
8. Merely rescheduling Greece's debt without reducing its net present value would not be credible.
