The sovereign debt crisis exposed weaknesses in the Eurozone’s financial architecture that may not have been fully anticipated when the founding treaties of the Eurozone were drafted. Key among these weak spots are the provisions of the Treaty of Lisbon which regulate intergovernmental debt obligations and preclude direct financing of sovereigns by the ECB.
As de Grauwe (2011) pointed out, entering into a monetary union alters the character of sovereign debt radically, since no individual nation has control over the currency in which debt is issued. Monetary union members thus face a situation similar to that of emerging economies who borrow in foreign currency -they may face a liquidity crisis in the sovereign debt market when there is a sudden reversal of capital flows, even though their solvency may not be fundamentally questioned.
The Eurozone’s financial architecture prevents the easy resolution of such liquidity crises. Article 125 of the Treaty of Lisbon arguably rules out one nation from assisting another by taking on part of the liability of another nation with its so-called no-bailout clause. This clearly fed into the Eurozone’s sovereign debt problem (Pisani-Ferry et al. 2013). Actually, this hurdle was already there in the Maastricht Treaty of 1992, in advance of the 2009 Lisbon Treaty.
New thinking: Analytic foundations for amending Article 125
In a recent paper, we attempt to provide an analytical foundation for an amendment of Article 125 of the Treaty of Lisbon (Basu and Stiglitz 2013).1 What we are arguing for is the Treaty to be amended to permit joint liability in international lending. The paper does not go into institutional details of how this may be done, but constructs a game-theoretical model to motivate such a legal-institutional change.
The bulk of international lending in the world takes place on a bilateral basis. Suppose a small country j borrows from an international bank to finance a power station project. Suppose also that the probability of success depends on the effort that country j puts into the project. There are occasions when j will be unable to pay back because the project may have failed when the time comes for repayment. This possibility of bankruptcy, and the awareness of the agents that this may happen, has important implications for the functioning of the credit market, and, in particular, introduces a standard ‘moral hazard’ problem and the possibilities of all kinds of inefficiencies.
When there are incentive (moral hazard) effects in credit markets, effort (e.g. devoted to ensuring success) is typically a function of the interest rate charged. As a result, the probability of default depends on the interest rate charged. But the interest rate charged is a function of the probability of default. There can thus be multiple equilibria: a low interest rate, low default probability equilibrium and a high interest rate, high default probability equilibrium (Greenwald and Stiglitz 2003).
One consequence of the de facto limited liability of country j in case of inability to repay the loan is that country j will put in less effort than is efficient, in the sense of maximising the value of total profit – consisting of the sum of the borrower’s and the lender’s expected gains. The inability to specify actions that ensure adequate effort as part of the loan contract is at the heart of the moral hazard problem. The moral hazard problem not only results in inefficient levels of effort, but also in a lack of availability of credit.
Lending arrangements to restore efficiency
This raises the question, is there a lending arrangement that can recover this lost efficiency? The answer is yes, if certain conditions are fulfilled. The essential condition is that there exists a wealthy and powerful nation with which country j has close economic ties. This may be a trading and business partnership through which this partner can observe the borrower’s behaviour. Suppose there is such a nation k that has close connections with country j – maybe because they are both part of a currency union or trading union and so have regular trade and business interconnectivity.
Let us suppose that k does some business with j, (say, a joint power project) which gives j a return of R, and that k gets a reasonable surplus from its dealings with j. There is then scope for an efficient shared liability arrangement. Nation k stands as guarantor for the loan taken by country j. If j’s project fails, it will step in and repay the loan to the bank. It can be shown that it will be worthwhile for k to make this offer if it can put in some subsidiary clauses. What k has to do is to use the joint business venture contract tactically to force j to put the optimal amount of effort into the power project for which it was borrowing the money. Moreover, k needs to threaten to pull out of the joint venture if j does not put in optimal effort in the project. If j reneges, and undertakes a level of effort below the optimum, then j pulls out of the venture, and so does k.
The challenge is to find a set of contracts that constitute an equilibrium and are self-enforcing, i.e. it pays each party to sign the contract (they are better off signing the contract than not doing so), and all ‘threats’, e.g. to terminate the relationship if the other party does not fulfil his part of the agreement, are time-consistent: should the other party renege, it must be, at that point, in the interests of each party to act in the way they promised (‘threatened’). We can show that it is, in fact, easy to construct such contracts, and that it is an equilibrium for both of them to do so. With such contracts, it is optimal for j to provide the optimal level of effort.2 This will leave country j and the bank as well off as before, and k better off.3 The guarantee from country k by itself lowers the risk of default as it reduces the interest rate charged by the bank on the loan to country j. This, by itself, ensures that there is some surplus to be shared; and the contract design in turn ensures that the surplus can be shared in such a way that all parties to the contract are better off than they would be without the guarantee. The third-party guarantee ensures, in turn, that the good equilibrium (low interest rate, low probability of default) in the lending game prevails.
From theory to practice
The model described is at one level the illustration of a simple, abstract three-person game, but it is also an allegory of many important, real-life problems, where cooperative action could make all parties better off. Could it, for example, pay for Germany and the UK to take on the liability for debts incurred by Cyprus or Slovenia from some international investment banks? This model shows that the answer is yes, and it also illustrates the design of a contract that can improve credit flows to Cyprus and Slovenia. Lenders who may have no knowledge of or familiarity with these nations will be willing to lend, knowing that Germany and the UK will use their standing, trading, and other business relations with Cyprus and Slovenia as leverage to make these borrowing nations be more vigilant in the use of the credit, and also stand as guarantors of last resort if the project for which money is borrowed fails.
Unfortunately, today joint liability contracts that can enhance efficiency are difficult to implement in the Eurozone countries because of restrictions imposed by the laws and treaties that bind the EU, and in particular, the Treaty of Lisbon. Hence, the need for amending the Treaty of Lisbon, so that it is possible, under certain conditions, for one nation to stand guarantee for another nation’s borrowings.4
Basu, K and J Stiglitz (2013), “International Lending, Sovereign Debt and Joint Liability: An Economic Theory Model for Amending the Treaty of Lisbon ”, World Bank Policy Research Working Paper No. 6555.
De Grauwe, P (2011), “The Governance of a Fragile Eurozone”, CEPS Working Document No. 346. (Published in 2012 in Australian Economic Review, 45(3): 255–268.)
Greenwald, B and J Stiglitz (2003), Towards a New Paradigm in Monetary Economics, Cambridge: Cambridge University Press.
Pisani-Ferry, J, A Sapir, and G Wolff (2013), “EU-IMF assistance to euro area countries: an early assessment”, Bruegel Blueprint 19.
Schafer, Hans-Bernd (2012), “The Sovereign Debt Crisis in Europe, Save Banks Not States”, European Journal of Comparative Economics, 9(2): 179–195.
1 Relatedly, Article 123 of the Treaty of Lisbon prohibits direct credit from the central bank to any sovereign and also disallows the purchase of government bonds from the primary market. As a consequence of this, the ECB is not a lender of last resort to any government but only to banks (Schafer 2012). We do not address this important issue in this paper.
2 Technically, it is possible to write this entire range of interactions starting with the Bank and j and then bringing in k and the Joint Venture game out as an extensive-form game so that this joint liability contract and the strategies it specifies is sub-game perfect. The argument critically hinges on the existence of multiple equilibria in the Joint Venture game which is a sub-game of the full extensive-form game.
3 It is possible to have additional features in the regulatory system, which enable a part of the additional benefits to accrue to the smaller country that was doing the borrowing in the first place.
4 As is often the case, in some cases there are inefficient “work arounds” circumventing the restrictions. Removing the restrictions would be clearly preferable to using convoluted means for circumvention which do not work very well and merely create a source for financial intermediaries to earn additional money.