Debate on the euro area crisis – or the Greek crisis, as it is usually and misleadingly called – has recently centred on the participation of private-sector creditors in the so-called bail-out. This then becomes a so-called bail-in, a nonsensical expression if ever there was one.
The basic idea of involving private sector creditors in a situation in which a debtor is deemed to be unable to pay its debts makes perfectly good sense. In principle. Borrowers make a mistake in borrowing too much, but so do creditors in lending excessive amounts. Awareness of possible losses is the only way to ensure sensible lending practices in the future.
But what makes sense in principle need not do so in every case in practice. I have previously argued that in the case of Greek sovereign debt insisting that the private sector participate does not make sense. At its most succinct the argument is that, first, such participation is not necessary: in economic terms the sums are just too small relative to the size of the euro area, and the required finances can be raised easily and cheaply and simply lent on. Second, it is not desirable: talk about private sector participation is what is pushing up spreads and ‘spooking markets’, creating a self-fulfilling prophecy, the short-term risk of financial-sector contagion if losses are imposed on creditors is incalculable, and there will be a needless long-term cost in terms of dearer financing of government debt. And third, it is hard: it presupposes agreement between uncoordinated actors each of which is seeking to maximize its returns, a classic collective action problem. The whole debate, then, reflects what is seen as a political necessity: to convince taxpayer-voters, who have been misled about the nature of the so-called ‘bail-out’, that ‘the banks’ are playing their part via a bail-in.
All the turbulent events of recent days and weeks only serve to confirm me in this view. The negotiations and brinkmanship of the actors involved increasingly have the air of political theatre. The key reason is that a compromise between mutually incompatible aims is needed, but is in all probability impossible.
- Governments are attempting to put together a package which appears to show that the bankers and speculators, whom voters perceive as ungrateful (given their own recent bail-outs) and nasty, are taking a substantial hit.
- The bankers and speculators – who don’t do nasty and ungrateful, nor for that matter caring and sharing – want to minimise any losses and, indeed, maximize their returns on the holdings they still have.
- The ECB is frightened that any enforced losses on creditors will shake an already weakened financial sector to the core and that it itself will have to realise losses on the substantial amount of Greek bonds (and other paper that might be negatively affected) that it has on its balance sheet.
- The rating agencies, meanwhile, like any upstanding citizen, are primarily concerned with their unblemished reputation. The technically sophisticated systems by which they rate government bonds and other paper would look a trifle silly if they were to turn a blind eye and refuse to call a default a default (or, in the jargon, a ‘credit event’). Such a downgrade, though, would lead to firesales, put the ECB in an impossible situation, and likely precipitate the very contagion and panic that policy is seeking to avoid.
- Last and very much least, the Greek people, and with them a rather small number of commentators and economists with an awareness of the integrated nature of the European economy, seek a solution in which the indebted peripheral economies are able to grow their economy and their incomes and so pay off their debts.
Now put yourself in the shoes of a notional ‘policymaker’, and it is fairly easy to see what, apparently, has to be done. Obviously the first step is to eliminate the last-mentioned group from consideration. They have no veto power and little influence, and so their opinions and interests can be safely ignored, simplifying the conundrum at no political cost. The second step is harder, as it involves reconciling an apparently dichotomous demand: a large financial-sector contribution to placate voters and satisfy governments (to different extents in different countries), or a small (zero) one to satisfy the financial sector and the ECB, and keep the ratings agencies onside in order to minimize contagion.
The answer is clearly to propose solutions that can be presented to different audiences in different ways, while allowing for two factors: their degree of financial sophistication and their veto-wielding power. This is in the case of voters low and high respectively. The other actors are clearly financially sophisticated. Their ability to derail the process is also apparently high, implying veto power, but they are constrained by the threat of that power being curtailed if they arouse the ire of elected governments and/or if the system comes crashing down. The ECB, for instance, appears strong, given the dependence of the Greek banking sector on ECB lending: but that strength is a mirage. Withholding the lending would bring the Greek economy to its knees and very likely the implosion of the euro area and thus spell the death sentence of, err, the European Central Bank. A threat (by a rational actor) to commit suicide does not constitute a credible veto.
Once this is understood, the events of recent weeks become easy to understand. The German government initially pushed for a substantial private sector bail-out (reflecting a high voter mobilisation, given popular sentiment in the country, the current electoral weakness of the government and the imminence of a succession of regional elections). This initially led to a stand-off with, in particular, the ECB and some other national governments (notably France, whose banks have the largest exposure to Greek sovereign debt) who refused to countenance a forced haircut. Germany was forced to back down (please note: free registration on FT website is required to view this and some of the following links) and the subsequent debate centred on ‘voluntary’ restructuring. German banks came up with a purely symbolic gesture: a voluntary roll-over of the order of EUR 2 billion; that would not have worried the rating agencies or the ECB, its only drawback was that it would not have changed Greece’s debt situation one iota.
Then, voila!, French financial institutions presented a plan that appeared to come up with the goods. Its great strength was that it was so fiendishly complex that it could be sold to different stakeholders with different arguments. It offered a large-sounding (EUR 30 bn), public-pleasing roll-over in exchange for detailed, hard-to-fathom provisions that ensured that private-sector losses would be minimized and Greece would be forced to pay high rates of interest for years to come. Tres bien! But once the details were fathomed out by the media and other actors, there was considerable outcry. Does anybody expect turkeys to vote for Christmas? The Greek banks, not to be outdone, also wanted to make a gesture: unfortunately their dire financial situation meant that they were simply too hard up to be able to make any difference at all.
Meanwhile the rating agencies and ECB were threatening dire consequences: any plan involving coercion of bondholders would be declared a credit event: S+P talked about a possible ‘selective default’. Governments began brow-beating both institutions. In a tragi-comic twist the ECB was pressured into declaring that it would continue to accept Greek bonds as collateral provided at least one of the three leading rating agencies did not downgrade the bonds to junk. The rating agencies – who do not want to lose credibility by failing to call a spade a spade but also also don’t want to be seen to be the executioner of the political project that is monetary union – blustered and then suddenly shifted their focus to Portugal: Moody’s downgraded its sovereign bonds a full four notches to junk status. This led to angry warnings from governments and the European Commission that, finally, something would have to be done about the intolerable situation that what elected governments construct with great difficulty, obscure profit-maximising agencies can destroy seemingly at a whim.
Really, you couldn’t make it up! If the actual, and particularly the potential, consequence were not so severe it might be considered a highly entertaining tragi-comedy. As it is, it represents a catastrophic failure of the European political elite and its institutions. While this charade has been played out, the suffering of the population in Greece and elsewhere intensifies, the debt situation of peripheral countries worsens. Capital flight continues and the financial sector grows weaker.
The myopic nationalists, the moralistic bail-inners and the simplistic bank-bashers are (at best) misguided. As I have repeatedly argued in past months, the EU and its Member States must collectively guarantee the public debt of the peripheral countries in full, charging an interest rate at or only scarcely higher than their own, currently very low, borrowing costs. The precise form in which this is done is a secondary concern (see for example here). Indebted countries must in return commit to a sensible program of medium-run consolidation based on a return to economic growth and investment, where necessary, regaining competitiveness via a social pact. (See here for a six-point blueprint.)
This is the only credible path out of the crisis. Yes, it has a number of disadvantages, not least rewarding speculative investors that have bought up distressed bonds at a huge discount. This is regrettable but necessary (some attempt should be made to recoup a proportion of these funds via taxation). It does raise moral hazard issues: but this is a longer-term problem that need to be resolved through greater economic policy coordination. The issue of private sector involvement that currently obsesses policymakers across Europe is and always was, at the very best, a political side show. It is increasingly evident that it is playing with fire. Europe cannot afford this. It should be dropped immediately in favour of a medium-term plan, on the above lines.