Opinion

Felix Salmon

The euro zone’s terrible mistake

By Felix Salmon
December 6, 2011

The FT is reporting today that the new fiscal rules for the EU “include a commitment not to force private sector bondholders to take losses on any future eurozone bail-outs”. If this principle really does get enshrined into some new treaty, it will be one of the most fiscally insane derelictions of statesmanship the world has seen — but it certainly helps explain the short-term rally that we saw today in Italian government debt.

Right now, the commitment is still vague:

Ms Merkel agreed that private sector bondholders would not be asked to bear some of the losses in any future sovereign debt restructuring, as she had insisted this year in the case of Greece’s second bail-out. However, future eurozone bonds will still include collective action clauses providing for potential voluntary rescheduling of private debt.

Ms Merkel said it was imperative to show that Europe was a “safe place to invest”.

You can safely ignore the bit about collective action clauses. They’re part of the sovereign-debt architecture now, and taking them out would be far more trouble than it was worth: they have to stay in, no matter what. The important thing is that they won’t be used — because if no one’s going to ask bondholders to bear any losses, then they won’t have any proposals to agree to.

The impetus for this completely insane policy seems to have come from the ECB, which genuinely seems to believe that bailing in private-sector banks, in the Greece restructuring, was the “terrible mistake” which caused the current euro crisis. Talk about confusing cause and effect: it was Greece’s fiscal disaster which caused the restructuring and the necessary bail-in.

To understand just how stupid this is, all you need to do is go back and read Michael Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.

Are we really going to repeat — on a much larger scale — the very same mistake that Ireland made? Does no one in Europe realize that this is the single worst thing they can do?

Markets reflect underlying realities, and up until now, the realities have been clear. Europe’s periphery is sinking under the weight of too much debt, and the result will be inevitable pain for private-sector creditors. The best case scenario is that those countries bite the bullet and restructure their debt now, since to delay is to make any restructuring much more painful and expensive than it needs to be.

The worst case scenario is that the EU kicks the can down the road with one new bailout facility after another, until it eventually gives up throwing good money after bad and imposes the restructuring which was inevitable all along. In that case, as one hedge fund manager was explaining to me last week, private sector creditors get devastated: because the EU and the ECB and the IMF won’t take any losses on their loans, all of the haircut, pretty much, will have to be borne by a private sector which accounts for only a fraction of the debt. So the private sector could end up with very, very little indeed.

Now, however, Angela Merkel has come up with another plan. The details aren’t clear, but it seems to involve the EU guaranteeing the debts of its member states. Why this is acceptable while eurobonds aren’t acceptable is a mystery: a mulit-trillion-euro contingent liability is hardly preferable to a couple of hundred billion euros of real liabilities. But there’s eurologic for you.

The immediate result of this plan is that everybody will rush into the highest-yielding bonds in Europe, which is exactly what seems to have happened today. The other effect of the plan, however, is that every country in Europe is now effectively guaranteeing everybody else’s debt. Which is more than sufficient to explain why S&P is minded to downgrade every country in Europe, up to and including Germany.

In order for markets to work, lenders need to suffer when they make bad lending decisions. If the Europeans didn’t learn from Ireland, couldn’t they at least learn from the Fed’s much-criticized decision to pay off all AIG creditors at 100 cents on the dollar? Blanket guarantees at par are pretty much always a really bad idea — and this one, if it comes to pass, will be the biggest one yet. It won’t end well.

Comments
22 comments so far | RSS Comments RSS

Of course “people in Europe” know that this is a criminal thing to do. The trouble is, those people are run and “represented” by a bunch of neoliberals who like doing such things, because they don’t care that their actions are unsustainable, so long as it helps them and their pals in the short run.

Again, this should not surprise you: there are ample reports out that tell you that Irish chap who decided to nationalize the banks and reward criminal behavior, was strong-armed into doing so by the ECB.

Posted by Foppe | Report as abusive
 

@Foppe – there were two people strong-arming the late Brian Lenihan – Trichet from the ECB, but also Geithner from the good ol US.

Posted by BarryKelly | Report as abusive
 

This will sound politically incorrect…but it’s payback for the Treaty of Versailles.

Posted by Daoist | Report as abusive
 

@Daoist – what are you talking about? This is doubling down rather than payback for Versailles. You’ve got it upside down. Speaking of which – not sure what the German people will make of it once they realize what it means for them. I hope not a Fourth Reich, though there is only so much that even the most guilt-ridden nations will take.

Posted by Abulili | Report as abusive
 

“Worse thing?” No, the rational thing.

The world economy poses diverse and chronic collective action problems for sovereign states. And history teaches that such problems rarely are solved.

A collective-action problem caused the world saving glut and, hence, the financial crises.

And a collective-action problem will cause depressed consumption as far as the eye can see.

Liberal pundits seem to think their jawboning will work.

But I think the planet needs hostile space aliens, bombing Beijing and Brussels and Leningrad and Pearl Harbor all at once.

Good luck.

Posted by JanSmith | Report as abusive
 

First, I believe Krugman has pointed out that the ‘too much debt’ re: governments on the periphery (sans Greece)is inaccurate.

Second, was all this supposed over indebtedness created by governments? After all, most of government spending lands in the pockets of private actors, correct?

The main point is that deficit spending and debt represents leverage. Over leverage always raises debt risk, whether it’s government spending or, more commonly in my opinion, in the private sector.

And yes, any inviolable guarantee of private creditors is stupid.

Posted by Beezer | Report as abusive
 

I don’t quite understand the criticism. Surely they aren’t saying that they will bail out any bank or company, but they will not allow any defaults on govt debt? This is the position of the UK and US governments, no?

Posted by mjturner | Report as abusive
 

I can’t understand how those idiots got to run the Central Bank of Ireland/ ECB/ Federal Reserve/ various regulatory bodies, in the first place. If only I could go back in time as a “fly on the wall” in their original job interviews, to see how they did it… I don’t understand how they could get through a competent job interview with the economic management skills they’ve been showing over the last five years. A few open-ended questions from an honest interviewer should have blown them wide open. And if they do have the skills to deal with this responsibly, then why aren’t they using them?

Perhaps a lot of the problem comes down to ACCESS TO INFORMATION. The investment banks (Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs etc.) had inside information on how the economy was really doing, some time before the central banks did. And when the expected crisis hit, at least one of those banks seemed to have it all planned out ahead of time, what they would do… They would direct the fire toward the feet of the Federal Reserve, telling them that unless they acted immediately to “reassure the market”, the ATMs would stop working for ordinary people within 24 hours… They held the entire market to ransom, to make sure their wealthiest clients wouldn’t bear the brunt of the inevitable bursting of the bubble (but at the same time, that their not-so-wealthy and not-so-privileged clients would share in the pain, so as to save the company from the glares of the dispossessed).

Is there any other way to understand what has happened?

Posted by matthewslyman | Report as abusive
 

They really think that Europe can do on a large scale what Ireland did on a small scale? They really plan to completely bail out the private sector at the expense of the government, should the bonds fall short?
Sounds like a sweet deal for private investors: we win, you win/ we lose, you win. Also makes me glad I don’t actually live in the eurozone. (Though the Belgians are probably laughing and thinking how clever they are not to actually have a government in this scenario.)

Posted by SusannaK | Report as abusive
 

And the alternative right now is what exactly? Haircuts? Brady Bonds? FOR ITALY???? Are you serious?????

That’s the point here, isn’t it? If you impose haircuts on government debt, that means government debt is not a risk free asset. If you impose (or imply) haircuts on Italian debt, and Italian debt is not a risk-free asset, then there is no country in the Eurozone that can issue risk free debt, because, as it turns out, a run on Italian debt has triggered a run on debt of places like Austria and Finland. In the absense of risk free assets to invest in, your banking system is absolutely doomed to be undercapitalized and eventually will fail. Moreover, Italy too will fail. Can anyone think of that scenario in anything other than apocalyptic terms?

There is a massive failure of analogy here. The right analogy is this. When a country like Ireland backstops its debt, that would be like New York City (or State of New York – doesn’t matter really) backstops its banks. It doesn’t work for many reasons, not least of which is the lack of control over currency. When Europe as a whole backstops European banking system as a whole, that’s rather like what we had here with Tarp and too big too fail. It was not pretty and it sucked to see bankers walk out with million dollar bonuses after crippling the economy, but it was ultimately a far superior alternative to letting the whole thing collapse. More importantly, it WORKED. And the solution to ugly bonuses is tighter regulation ex post, rather than just failure of the banking system.

Posted by Y.Alekseyev | Report as abusive
 

Can you say “50 Year Depression?”

Posted by myownexperience | Report as abusive
 

Can you say, “50 Year Depression?”

Posted by myownexperience | Report as abusive
 

Yeez! Any variations on the theme of ‘ECB Prints’ is off the table because there is no counterparty to the ECB to provide liabilities to its assets.

There are no funds available to ‘bail out’, ‘bail in’, ‘guarantee’ anything. The rules allow the national central banks to issue unlimited funds on their own accounts already (but these banks aren’t doing so).

The EU will mandate that bank bondholders will not be liable for losses. Who says? Banks are leaking capital, the only intangible is market discipline based on hopium. If bank assets are worthless the bondholders will lose everything regardless of what the Eurocrats decree. Broke is broke!

What’s missing is the realization that there is a reason why so much debt is necessary, now to keep the entire enterprise from collapsing. Europe is mired in an energy cleverly disguised as a debt/finance crisis. The European waste-based economy cannot earn its keep.

End of story.

Posted by econundertow | Report as abusive
 

It is possible that they are insisting on full payment of private creditors out of deference to the opacity of many of the GS-style private debt instruments. Partial payment would require an accounting, and thus transparency. And, of course, the terms of some of these transactions might cause even a slight haircut to be equivalent to a total loss, to a highly leveraged total loss.

They fear transparency in these private debt transactions more than anything else, even national ruin as you outline in its certainty. Some folks must be really on the hook to folks who are really on the hook in these transactions.

But, you see, we don’t know, we can’t know. if any of this is true, or who it might be true of. That’s the beauty of opacity in these matters.

Posted by gtomkins | Report as abusive
 

Ireland’s mistake was making insolvent bank creditors whole by having the sovereign assume the debt. It’s not clear that promising to make future sovereign creditors whole represents a similar mistake, as the repercussions for bank and sovereign default are quite different.

Posted by peterhsu | Report as abusive
 

No need to be too emotional about this. The bottom line is that they will have to borrow quite a bit in the next decade or too and investors need to be reassured given the Greek experience. After all, bond issuers have a legal obligation to repay. This is in many ways similar to the municipal finance sector in the US – the simple pledge that bondholders will be repaid before everyone else has provided confidence for people to invest in what are oftentimes very questionable securtities from a fundamental perspective

Posted by Tseko | Report as abusive
 

Mr Salmon is right: the proposal to “bail out” private bondholders is insane. It is a denial of democracy and capitalism and is a form of random socialism. Having witnessed the collapse of the Soviet Union and other socialist regimes it is strange that the west is now braying for an even more dangerous for of socialism: a completely unplanned one.

The US did this recently and it is clear that it was not the magic wand that its proponents hoped it would be. Its ramifications will take years to work their way through the US (and world) economies but they will be substantial and negative. One would have thought that the European politicians would have learned from the US’s mistakes. Unfortunately they, too, are looking for quick and easy solutions where none exist.

Moreover, it is not clear that the Eurozone governments will be able to find and borrow the money to pay the debts of Greece, etc. They all already have debts much greater than they will ever be able to repay. If forced to do so their only means will be to print huge sums of money, which is really NOT repaying what they borrowed.

One can only hope that regulating authorities in Europe (and world wide) are forcing the so called “banks” to discover who their real debtors are and to disclose them. For the authorities should be drawing up plans to cope with a world economy where many “banks” have failed and lending by them has greatly diminished. The world will be able to cope but it may require the seizing or nationalising much of the banking system. It will not please many in the US but the first pressures for such steps may well come from its people.

Posted by GivaFromOz | Report as abusive
 

You are at tree level. You try to get an overall picture of the global financial crisis so you rise above the trees, but instead of seeing a forest, all you see is a picture of a forest. Then you begin to wonder how real the trees are.

Anyway, I thought Mighty Mouse had promised to save the day by backing up the ECB? (That was when I first learned that the US is really an integral part of the EU.) Then the ECB could fund the IMF and bail out bondholders to its heart’s content. …??

Posted by hotturtle | Report as abusive
 

Mr. Salman, it is easy to criticize the actions and proposals of others from a safe distance. What specifically would you suggest governments should do when, as now, the existing numbers for a lot of entities don’t add up to solvency?

The debt problem is really a matter of the sanctity of bookkeeping, stacked up against the consequences of “running out of money.”

We are apparently compelled to alter existing indebtedness in such a way that real-world (the world beyond the trading floor) circumstances and behaviors do not have to change too much or too quickly, while much of the unpayable debt ceases to cause difficulties.

Accomplishing that task is mathematically possible, but anything one does will naturally foster a large number of overstated arguments among the interested parties.

Posted by Ralphooo | Report as abusive
 

Ms Merkel’s language says it all: “imperative”
Markets require freedom, or rather Freedom. The word “imperative” is for concentration camps.

Me best regards from Camp Griechenland.

Posted by archaeopteryxgr | Report as abusive
 

Now we have a bit of insight from Britain’s decision.

Posted by Intriped | Report as abusive
 

“Are we really going to repeat — on a much larger scale — the very same mistake that Ireland made? Does no one in Europe realize that this is the single worst thing they can do?”

If you assume that the whole goal of the ECB/Euro leadership is to ensure that northern European banks get repaid in full (in the short term), and d*mn the consequences, then everything they’ve done makes perfect sense.

Posted by Barry_D | Report as abusive
 

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