Lorenzo Bini-Smaghi – Member of the ECB's Executive Board – has produced a brilliant defence of the no-default strategy currently pursued by the Eurozone authorities (Financial Times 2010).
His arguments are straightforward.
- Public debts are widely-held instruments so that a default would harm domestic banks and domestic citizens.
- Default would possibly trigger bank runs and force governments to take extreme administrative measures like the freezing of bank accounts (this is what Argentina did during its 2001 corralito); this is not the sort of thing that true democracies do.
Default, he argues, would be nothing more than a “quick fix” that produced much worse consequences than the alternative policy, namely years of tight fiscal policies and structural reforms.
Shortcomings in the reasoning
These are mostly solid arguments though it would be interesting to understand why democracies cannot default and what structural reforms have to do with fiscal discipline and, if they do, how soon their beneficial effects can be felt.
The weakness in the argument is that it contains no serious effort at considering the “bad luck” – but likely – outcome of sovereign debt rescheduling. He writes as if what the ECB wants is what will happen.
In fact, for nearly a year now, policymakers, including the ECB, have been running behind events.
- Initially Greece was told not to ask for IMF help and to make do with a promised loan of € 10 billion.
- Eventually a € 110 billion loan was granted with the IMF, showing how far off the mark policymakers were.
- Worse, perhaps, this loan was not to be called a by its real name – a bailout. Calling it for what it was would have run against the spirit of the Treaty’s no-bailout clause – and quite possibly the letter of the Treaty as well.
The reason given for this new contribution to eurospeak was that the 180 degree reversal of previously set principles aimed at avoiding contagion and defaults. But both will happen.
Contagion is now under way and default is widely anticipated.
- The ECB, who once vowed never to buy public debts outright, has done so on large scale, and the end is far from being reached. Indeed, it is now asking for recapitalization.
- The ECB’s asking for more capital is a fairly clear admission that it is no longer ruling out sovereign default.
The need for a Plan B: What if a Eurozone nation does default?
If Lorenzo Bini-Smaghi is right and Europe weathers today’s storm without a sovereign debt rescheduling, his logic makes sense. But nothing is sure in this life. Instead of ruling out highly plausible outcomes, the ECB should explain how they will react if defaults were to happen.
Default would be a terribly messy situation. Policy responses – responses that would have to be put in place extremely rapidly, over a weekend in the best of cases – will be crucial in shaping the gravity of any default’s implications. This is reason why the ECB needs to think ahead on this.
Lorenzo Bini-Smaghi recalls examples of botched defaults but is remarkably silent on what he would do if he were to face such a situation. Planning for the worst is surely preferable to arguing for only considering the best.
Thinking ahead on six critical issues
At the very least, six complex questions must be dealt with as a matter of urgency.
- A first question is whether Eurozone member states can face down the markets.
We know that public debt redemptions will accelerate in the new year. According to the IMF, the financing needs of Greece, Ireland, Portugal and Spain over the last quarter of 2010 and 2011 – most of which will come due in the early part of 2011 – add up to € 320 billion. Add Italy and you get € 712 bn. It is understandable that the ECB has called for an enlargement of the European Financial Stability Fund (EFSF) which can provide up to € 440 bn. but this request has just been turned down by the Heads of State. The IMF can add some money at some notice, but this is limited.
In short, it is unlikely that we have the means to quiet down market concerns if they lead to a refusal of providing fresh money.
We have only a few weeks before we find out how the markets react; recent downgrades by the rating agencies, however, belie the official optimism.
- The second question concerns the strategy of avoiding defaults.
Officially, creditors are not to face haircuts until 2013 when the new fund will come into existence, following unanimous ratification of a “minor” Treaty change.
This sort of ratification is far from certain and markets are most unlikely to wait until 2013. Lacking a collective mechanism, each member country will be left to fend for itself. This is not just a recipe for bushfire contagion, it also guarantees the kind of messy management that Bini-Smaghi offers as a reason for ruling out defaults.
Put differently, by not making adequate preparations we raise the odds of a very bad scenario.
This is surprising. Sovereign defaults are not rare events, nor are they black-or-white events. Most sovereign defaults are partial as they take the form of debt restructuring that result in limited “haircuts”.
Borenstein and Panizza (2008) identify 20 such defaults over 1981-2004, almost one per year. None of them occurred in Europe – we have to go back to the interwar period to find a European default – but there is no reason why it should not be the case.
The same authors find that the costs of default are “significant but short lived” and that they “seem to shorten the life expectancy of governments and officials in charge of the economy”. This last point may explain why policymakers tend to delay the day of reckoning and in doing so, raise the eventual costs of defaults.
Europeans may see themselves as unworthy of defaults but their current behaviour fits pretty well the general pattern.
- Third is the question of how Eurozone member states can organize defaults if and when they become unavoidable.
The current approach is to impose patterns-of-behaviour on member states that are deemed to be acceptable. Greece and Ireland have been severely constrained in their policy choices by a combination of sticks – heavy political pressure – and carrots – the loans. Both have worked with surprising effectiveness probably because these are small countries.
But if a country is eventually forced to default, will the process also be subject to collective monitoring? The usual process involves negotiations with the creditors. Can the Eurozone countries whose banks and citizens are creditors advise defaulting authorities? Or should each country be left free to tease out the best deal that it can?
- The fourth question is whether one country’s default will trigger others; if so, we need to identify steps that ring-fence the first defaulter to prevent this.
We know that pouring money on the problem has not worked so far. Nor has the imposition of tough fiscal stabilization measures on Greece first and Ireland next succeeded in convincing potential target governments to do what it takes to placate market concerns. We don’t even know whether this is possible.
- Fifth is the scary prospect that defaults would put a number of financial institutions, some of them systemically important, in jeopardy.
Bini-Smaghi explicitly argues that avoiding bank failures is a good raison to bail out governments. His view is that it is cheaper, which may well be the case.
But what about moral hazard? The official answer seems to be that the solution is a toughening of the Stability and Growth Pact, but many observers believe that the pact has lost all credibility and that, anyway, it cannot be made to work.
A related issue is political. German taxpayers hate bailing out their own banks but they seem to hate even more bailing out profligate foreign governments.
At any rate, if sovereign defaults cannot be avoided and if some banks will fail as a consequence, how can we avoid a repeat of the Irish story, the fact that bank bailouts ineluctably lead to sovereign debt crises?
- The final issue: the ECB is asking for an additional € 5 bn. in capital, to bring its total to about € 10 bn.
It has reportedly bought public bonds for an amount that is between € 60 and 80 bn. and it could be forced to add much more if larger countries like Spain and Italy join the fray. A moderate haircut of 20% could thus lead to losses that exhaust the ECB’s enlarged capital. More capital can be added, of course, but do we understand the implications for its independence?
Undoubtedly, policymakers will respond that they cannot discuss openly these issues for fear of pouring oil on a burning fire. This is probably true, but one can hope that they are actively working on these complicated issues and will be ready when and if needed.
Maybe publicly denying the problems provides a smokescreen for internal work on Plan B. Maybe, but then maybe not.
Eduardo Borensztein and Ugo Panizza, “The Costs of Sovereign Default”, IMF Working Paper WP/08/238, October 2008
Financial Times (2010) “Europe cannot default its way back to health”, 16 December.