EU must choose its lies wisely
You can lie to taxpayers or you can lie to creditors, European authorities are learning, but doing both at the same time is very hard.
The proposed policy that current senior creditors to troubled states will not face losses on their loans but future private lenders will be forced to share in losses with taxpayers is so irrational, so bound to fail that it falls out of the realm of economics and into the ambit of brain injury.
European Union member states will this week hold a summit at which they will create a permanent fund to lend to troubled members under co-called strict conditions of fiscal responsibility.
At the very same time, leaders of the 27-country European Union will sign on to a pronouncement by euro zone finance ministers saying that private lenders will have to share the pain, on a case-by-case basis, of any sovereign debt restructuring after 2013.
So let’s recap, because this is truly bizarre: Lenders to Ireland or the other troubled states won’t take a hit now but if they stick around until 2013 then they will take losses along with the taxpayers. Oh yeah, and the current round of bailouts are aimed at seeing Ireland and Greece through the next couple of years, at which point it will become extremely dangerous to lend to them, as their economies will have shrunk, their debt burdens bloomed and private lenders will be on the hook.
To add to this, the European Stability Mechanism, the name of the new fund, will be senior to all creditors except the International Monetary Fund, meaning that in the event of a bankruptcy it would be paid first. Ratings agency Fitch looked at this provision and quite rightly said that it might lead to lower ratings on shaky euro zone sovereigns.
The only way you could make this policy mix work was if you could find a very rich lender with no ability to conceptualize the future. Hmm, let’s see a rich entity with limited ability to fully imagine a future state – it must be the European Union!
Few private lenders will stick around, they will sell their bonds and the only buyers will be the EU or ECB, which itself as it understands this predicament is hugely unwilling to play along.
Germany and France are both so unwilling to both have principles and pay for them that they are refusing to act on proposals for common European bonds and are expected to resist moves to increase the size of the European Financial Stability Fund, the vehicle now being used for bailouts.
Germany and France in October began to insist that private creditors would share the pain, thus touching off the current euro zone mini-crisis and bringing forward the ” rescue” of Ireland. I say bring forward because most rational observers realized that Ireland could not pay the debts of its banks, despite having pledged to do so.
Private creditors knew that Ireland is insolvent, as is Greece and very likely Spain, but also knew that since there is no escape hatch from the euro and no apparent will to end the union or bring down insolvent banks that their loans were reasonably safe.
German and French taxpayers know this too and are not happy, as it means their tax money will be flowing to the periphery for years to come. Hence, German and French tough talk and insistence that private creditors will pay in future, which in turn forces investors to act on their analysis of insolvency and sell.
Private money is quite happy to keep funding a bankrupt entity but only so long as the moral hazard play, the implied guarantee from on high, is still in force.
Why then haven’t spreads on weak euro zone bonds risen even higher? Well, besides the fact that the European Central Bank is actively buying, it is the fact that investors can’t quite believe that the European Union is serious.
They know that getting out will be a disaster and a humiliation but that forcing private creditors to take haircuts could cause a banking crisis. So, no haircuts and no reckoning.
Investors are betting, at least for now, that the EU is lying to taxpayers, or to itself, rather than to them.
My guess is that we go on like this for a while; periodic crises that force the EU to pledge ever more money to member states without ever acknowledging that they are insolvent or forcing their private creditors to swallow losses.
That ends only if one of three things happens; the market decides that it won’t lend to Germany and France anymore, the weak nations revolt from austerity or the taxpayers of Germany and France decide that euro-geddon is better than picking up every check.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)