Disciplining the euro area
What’s at stake: The crisis in the euro zone continues, as European nations, EU institutions, world markets, and other players (among them the IMF) play an elaborate and dangerous game of financial chicken. The potential for a damaging default and significant stresses on the single currency is real, but as yet, no widely acceptable solution […]
What’s at stake: The crisis in the euro zone continues, as European nations, EU institutions, world markets, and other players (among them the IMF) play an elaborate and dangerous game of financial chicken. The potential for a damaging default and significant stresses on the single currency is real, but as yet, no widely acceptable solution has come to the fore. The lack of consensus is particularly unfortunate given that many saw the possibility of this sort of crisis long ago, at the very inception of the euro area. In this week’s print edition, The Economist published a guest Economics focus by Daniel Gros of the Centre for European Policy Studies and Thomas Mayer of Deutsche Bank. They give their interpretation of the challenges posed by the current situation and offer a novel solution which would reduce the moral hazard problem.
Daniel Gros and Thomas Mayer propose that Europe builds a European Monetary Fund (EMF) to address today’s moral-hazard problem. The EMF would be financed by its weakest members, would be stricter than the IMF in its policy conditionality, and would have a pre-positioned resolution mechanism to address sovereign default. Only countries in breach of set limits on governments’ debt stocks and annual deficits would have to contribute, giving them an incentive to keep their finances in order. For the euro area not to remain hostage to any country that is unwilling to adjust and threatens a systemic crisis, the EMF would also allow for orderly sovereign defaults within the euro area. Based on the successful experience of Brady bonds used in Latin America in the 1980s, the EMF would step in if a euro-area country loses access to market financing offering all holders of debt issued by the defaulting country an exchange against new bonds – taking a uniform haircut – issued by the EMF. Having acquired bondholders’ claims against the defaulting country, the EMF would allow the country to receive additional funds only for specific purposes that the EMF approved. The new institution would provide a framework for sovereign bankruptcy comparable to the Chapter 11 procedure for bankrupt companies in America.
Edwin Truman argues that the Gros-Mayer proposal is an economic, financial, and political non-starter. Gros and Mayer propose that Europe do a better job in getting the balance right between financing and adjustment than the IMF would. Just as the Japanese proposal in 1997 for an Asian Monetary Fund (AMF) was supposed to redress the IMF’s balance from adjustment and toward financing, the proposed EMF would tilt the balance in the opposite direction. But if the EMF were tougher than the IMF is on average then euro area countries would prefer to go to the IMF for assistance. Gros and Mayer also propose that the financing come from fines on the members who have failed to adhere to the Maastricht entry criteria but these fines would not be more politically acceptable than the fines anticipated for excessive deficit within the Stability and Growth Pact framework. Last, Gros and Mayer complain that the IMF lacks resolution mechanism to address sovereign default. But in 2001, Anne Krueger, then first deputy MD of the IMF, proposed a more limited Sovereign Debt Restructuring Mechanism (SDRM) which was subsequently watered down, as it was judged to be unacceptable, including to Europeans.
Carmen Reinhart argues that it is difficult to make the case for an EMF or any other regional IMF on broad-based macroeconomic grounds. To the extent that crises tend to have an important regional element, resources may become extremely stretched in the moments when these are most needed, such as at present. The feature that is more promising of the Gros and Mayer proposal is one with narrower mandate – a regional sovereign bankruptcy court. On that score, the regional institution would be filling a gap in the existing financial architecture. The authors should expand their proposal beyond the sovereign to consider what role the new institution could play in sorting out the messy blur that currently exists between public and private debts. Clearly Greece’s and Portugal’s problems are in the sphere of sovereign debt but Europe’s debt problems going forward importantly involve the orderly workout of massive private debts (Ireland, Spain and the UK are not alone on this score).
Desmond Lachman writes that Gros and Mayer have failed to notice that sovereign borrowing is now done preponderantly in the securitisation market rather than in the form of bank loans. This makes the idea of a Brady Bond-style restructuring obsolete. In this context, it is instructive to recall that almost ten years after it defaulted in 2001, Argentina is still shut out of the international capital market and it is still to come to terms with the holdouts on around 25 percent of its outstanding debt at the time of its default.
Roberto Perotti writes if the funding mechanism is here to address the moral hazard problem, it must be largely self-financed by the problem countries themselves: as such, it is best understood as a co-insurance mechanism between problem countries which makes it unlikely to work. Concretely, by the authors’ calculations this facility would today give Greece access to something like .65 percent of its GDP (its accumulated forced savings), plus any additional discretionary fund from the pool of all accumulated savings. However, .65 percent of GDP would make no difference to Greece today; and by the authors’ back of the envelope calculations the intervention needed would eat up the whole fund just for a small country like Greece. The key problem country, Spain, with a public debt just above the Maastricht level this year, would have made virtually no contribution to the EMF. In the end, effective intervention, especially when the risk of contagion is high, is likely to depend on the discretion of Germany and other non-problem countries, just as it does now.
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