Can financial innovations help the eurozone?
For all that financial innovation has got itself a pretty bad name recently, there’s no shortage of people with bright ideas as to how to address the euro crisis. Robert Barro is one. He thinks the euro should be phased out entirely, and has a plan for how to do just that:
Germany could create a parallel currency—a new D-Mark, pegged at 1.0 to the euro. The German government would guarantee that holders of German government bonds could convert euro securities to new-D-mark instruments on a one-to-one basis up to some designated date, perhaps two years in the future. Private German contracts expressed in euros would switch to new-D-mark claims over the same period. The transition would likely feature a period in which the euro and new D-mark circulate as parallel currencies.
Other countries could follow a path toward reintroduction of their own currencies over a two-year period. For example, Italy could have a new lira at 1.0 to the euro. If all the euro-zone countries followed this course, the vanishing of the euro currency in 2014 would come to resemble the disappearance of the 11 separate European moneys in 2001.
Is this workable? It all depends, I think, on the degree to which contracts could and would be switched over to German law during the two-year period of parallel currencies. While many people might be happy to see their euros converted to Deutschmarks at a rate of one to one, many fewer would be happy to see their euros converted to lire at the same rate. Which means that there would have to be some serious coercion — and a lot of court cases, too — before people holding euro contracts in Italy were forced to see those contracts redenominated in lire.
So while Barro is correct that this approach would help solve the sovereign debt problem, by allowing the likes of Italy to simply print new money to pay off their debts, it would also be a legal nightmare, as every contract turned into a fight between creditor and debtor over which currency it should become. The creditors, of course, would all want the contract to become Deutschmarkized, while the debtors would probably all want their debts to be converted to drachmas at that one-to-one rate. Given that the whole point of European monetary union was that it would become a single monetary union, trying to break it up into 17 component parts is certain to be a legal and logistical nightmare.
Would it be easier, then, to come up with a clever way of keeping the eurozone together? Because Jed Graham has one of those: he calls it Safeguard bonds, which is actually an acronym: Sovereign Approvable First-loss EFSF-Guaranteed Upfront Automatically Recallable Debt.
Graham’s idea is not that easy to understand, so I called him up and asked him to explain it to me. Basically, if countries signed up for a fiscal austerity program, they would be allowed to issue a certain quantity of Safeguard bonds, which would be guaranteed by the EFSF. Then, if at any point they broke free of their fiscal constraints, they would have to pay down 10% of the bonds, immediately, in cash. If you held €1,000 in Italian Safeguard bonds and the country ended up borrowing too much money one year, then Italy would automatically pay you €100 for 10% of your holding, and you’d be left with €100 in cash and €900 in Safeguard bonds; failure to do so would constitute an event of default.
The idea is that this would act as a real fiscal constraint: if a country were to avail itself of this facility, it would then be in a position where any fiscal slippage would be very expensive — because it would have to borrow at a very high rate to make the bond payment. Meanwhile, the EFSF-guaranteed bonds would trade at much lower yields, because of that EFSF guarantee, and because, under Graham’s plan, the ECB would step up and guarantee all Safeguard bonds in the event that EFSF monies ran out.
Because Safeguard bonds would be long-dated and very cheap, countries would have every incentive to use them to fund their current deficits — and thereby lock in fiscal constraint for the next 30 years.
It’s an intriguing idea, but technically extremely difficult to put together — these things are a bit like reverse CoCo bonds, in that they actually punish the issuer when the issuer gets into trouble. And, of course, as such they’re extremely pro-cyclical, if they ever get triggered. If a country suffers a nasty recession and sees its tax revenues fall a lot, the Safeguard bonds would get triggered and it would have to find a lot of extra cash just when it could least afford it.
I’m reminded of a clever idea that the World Bank had in the between 1999 and 2001, called the Rolling Reinstatable Guarantee. It was meant to be a way for the countries that used it — Thailand, Argentina, and Colombia — to reduce their borrowing costs by putting in place a World Bank guarantee which would cover the next coupon payment. In the event of a default, the World Bank would have to make the coupon payment, the country would have to pay the World Bank (because the Bank is a preferred creditor), and then the guarantee would get reinstated. Rinse and repeat.
When put to the test in the Argentine default, however, the mechanism didn’t work. And in general whenever people attempt to solve deep economic problems with the application of clever financial ideas, they fail. The eurozone might break apart, or it might stay together. But either way, financial innovations like these are not going to make much of a difference.