Friday 8 June 2012

The European Redemption Pact and Moral Hazard

In November 2011, the German Council of Economic Experts has suggested a European Redemption Pact (ERP) as a means of addressing the Eurozone financial crisis. Under this scheme, which is quite similar to the Modest Proposal published by Yiannis Varoufakis and Stuart Holland in November 2010. In the German proposal, the Eurozone countries would pool their debt obligations over the Maastricht criterion, i.e. for that debt portion over 60% of GDP. The amount over 60% would be jointly guaranteed by the entire Eurozone. In the Varoufakis / Holland proposal, the inverse would occur: the European Central Bank would issue Eurobonds guaranteeing the first 60% of debt-to-GDP of all Eurozone countries. 

In the German proposal, any country not receiving support from the European Financial Stability Fund would be able to “pool” their debt in a new financial structure, which would receive a joint guarantee by every non-EFSF Eurozone member. (We note that Greece, Ireland and Portugal are already in the EFSF and are thus presumably prevented from participating).

Each Eurozone country would be able to participate contingent on:

a.  Introduce a constitutional “debt brake”, i.e. a constitutional commitment to reduce debt to the Maastricht level or below;

b.  Introduce a specific national economic plan with ring-fenced special tax provisions to debt service of both its 60% debt-to-GDP and its debt guaranteed by the ERP.

c.  It would have to sign over 20% of gold and foreign exchange assets in its central banking system as collateral for the ERP guarantee.

The German Council gives the example of Italy, which it estimates would have to assure a primary surplus of 4.2% of GDP, assuming Italian GDP grows at 3% per year, the ERP has a refinancing cost of 4%, and Italy has an average 5% for its remaining debt.

This proposal is quite similar to the revised Modest Proposal of Varoufakis and Holland. In the Modest Proposal, the first 60% national debt limit would be refinanced using  pEuropean Central Bank bonds. The Modest Proposal includes a commitment to growth, via loans provided by the European Investment Bank (EIB), as well as a commitment to austerity. 

Both proposals accept, but fail to account for, how the political and financial fundamentals of such a plan would work.

It is worth remembering that at the heart of any financial transaction or system is the assumption of trust and confidence. Absent this condition, no amount of loan covenants or collateral guarantees will induce a borrower and a lender to enter into an agreement, let alone respect it. This problem is currently magnified (a) between Eurozone member states, and (b) between the Eurozone and the rest of the world.

Let’s take the political dimension first. Within the confines of the Eurozone debate, the Germans are portrayed as martyred taxpayers while the Greeks are condemned as spendthrift liars and thieves. Whatever the truth of the situation, Europe’s politicians have sufficiently poisoned the well of intra-Eurozone trust to the extent that it is now impossible to conceive of a German taxpayer agreeing to pool liabilities in this way.

Outside the Eurozone, there is similarly little confidence that the 17-member currency union has either the financial or the political nous to get in front of the problem, rather than trail haplessly behind it. There is also little evidence that the International Monetary Fund has a handle on the situation, judging by its record to date, and by recent remarks by its Managing Director.

Let’s now look briefly at the financial dimension. In the Varoufakis / Holland proposal, the authors presume that the ECB will guarantee the first 60% of debt:GDP. This will require a massive increase of the ECB’s balance sheet assets, which are already dangerously over-exposed from its direct purchases of sovereign debt and its Long Term Refinancing Operations (LTRO) (and prior liquidity operations).

An ECB guarantee will only function as long as the Eurosystem central banks take steps to expand their asset base accordingly, while possibly increasing the ECB balance sheet independently. Although this is possible, it will encounter important financial and practical difficulties in the current climate.  

In the German ERP proposal, the idea is for an expanded EFSF/ESM to be created which would issue guarantees for refinancing. This plan is slightly better in that (a) the EFSF countries are presumably not included, and (b) there is a 20% collateral post as a specific resource allocated to this fund. Furthermore, it counts a 4% ERP refinancing cost, which is important in the current market. Most cash assets have fled to havens which render a negative interest rate after inflation.

This does not answer the question whether the 20% collateral post will be sufficient, or whether new collateral will have to be raised (particularly in light of Eurosystem commitments to the ECB). But at least this is a measurable indicator by which an interested analyst could run various forecasts and simulations.

The deep problem with the ERP is the same as that of the Eurobond: it makes each Eurozone country jointly and severally liable for the debts of another Eurozone country. This is difficult to imagine in the current political environment. It is also difficult to imagine objectively: debt brakes and other frills aside, there is very little evidence to suggest a country can be induced to maintain acceptable debt levels over time. Particularly over the next 25 years, when Europe will have to cope with dramatic demographic changes, and the damage these will create on national pension systems. 

My conclusion is that Europe is not ready for such a move. On the one hand, it there is no political credibility for it, either within or without the Eurozone. On the other hand, I have to ask why a standard debt work-out process is so objectionable. This is hardly a new feature of economic life, and in private sector occurs on a daily basis. Thus:

·    If Spain fails to recapitalise its banks, it should let its banks fail, and find other ways of managing the fall-out for the benefit of its individual depositors or other “innocents”;

·    If Greece fails to get its public finances under control, it should default on its public debt, with all the consequences this implies for current public spending and private consumption.

I fail to see how increasingly complicated financial support schemes remove the moral hazard implicit in investment decisions made by governments or banks (or German owners of Spanish vacation homes). Since they do not remove either moral hazard or basic human behaviour, it is clear to me that neither a debt brake or a ring-fenced tax system will survive over time. There will be myriad future opportunities to fiddle with public or private expenditure over time, and particularly given the inevitable decay of the European social model in the next 20 years.

Let me reiterate my comment on moral hazard: both the Modest Proposal as well as the ERP suggest, and indeed are based on the idea that lasting changes to human behaviour and debt incurrence are possible as a result of an Eurozone financial structure. I see no evidence for this either from economic history or from current affairs.

If we take the Greek case, for example, one would assume that if “virtuous decisions” were possible, the entire political class would have been replaced. In fact, the political class is intact, and pursues the same failed policies and political tactics.

If we take the Spanish case, we see exactly the same situation. The management of Spanish banks that over-lent are still largely in place. The owners of Spanish property are still in place. The desire to invest in property remains high, whether as a distressed asset, or as a “dream home”. These same factors have led to so many property booms and busts remain – European system or no system. It has nothing to do with a debt brake or regular public spending.

As a result, I am in favour of using classical debt work-out tools, either at the public or private levels, to resolve this crisis. In my opinion, the well-meaning but flawed attempts by Eurozone officials to solve the crisis by setting up support mechanisms prevent a timely and cost-effective resolution to the crisis. Their efforts would be better deployed in creating temporary social support mechanisms rather than by increasingly complex and morally questionable bail outs of the banking system which has contributed so much to this crisis.

© Philip Ammerman, 2012

Philip Ammerman is Managing Partner of Navigator Consulting Group and European Consulting Network. He works in the field of investment management and due diligence in Europe, the former Soviet Union, and the Middle East. 

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