Ifo Viewpoint No. 128: The Way Out of the Crisis
Munich, 23 September 2011
The countries in the Eurozone’s periphery are stuck in a balance of payments crisis of a kind last seen in the USA at the end of the Bretton Woods system. The peripheral countries have become too expensive and are burdened by huge current account deficits that can no longer be financed. The European Central Bank (ECB) and the community of nations are trying to contain the crisis by providing hundreds of billions of euros in cheap loans, in a clear breach of the Maastricht Treaty. While it is important that help be provided, this policy is not only legally objectionable, but also economically wrong, because it hinders the downward adjustment of stocks, goods prices and wages, and thus delays the mending of the balance of payments imbalance.
For one thing, it makes markets vulnerable, because keeping up the prices of private and public paper creates a one-sided downside risk. The investors know that the prices can only move one way from their artificially high level: downwards. This makes them nervous and prompts them to keep a wary eye on whether there is enough rescue money left. The slightest doubt stokes the crisis anew and forces the rescuing countries to commit even more money. This is not only rather demeaning for the parliaments of Europe, but also a sure-fire way to keep private capital well away from the crisis countries. If prices were allowed to fall without intervening, some banks would take heavy losses and would need to be supported, but afterwards calm would reign. At lower prices, private capital would be once again willing to finance the foreign trade deficits. For another thing, the rescue policy perpetuates these deficits, because it props up the inflated goods prices and wage levels that resulted from the days of cheap credit. Hard as it is for politicians to admit it: only when wages and prices come down relative to their trading partners’ will imports fall and exports pick up. That is the only way for the distressed countries to become competitive again.
Any country threatened by insolvency during this process should be helped by the community of nations through the Luxembourg rescue facility (ESM), but not by setting up such a fund as a self-service shop. The fund should instead provide partial-coverage insurance for government bonds, i.e. insurance with a deductible that protects against excessive risks while requiring creditors to bear part of the burden. This basic idea was formulated by the European Economic Advisory Group at CESifo (EEAG) earlier this year.
Basically, this idea proposes to distinguish among three phases in a crisis: a liquidity crisis, an impending insolvency, and a full-blown insolvency. The emphasis is placed upon the impending insolvency, which must be addressed in order to avert the occurrence of a full-blown insolvency. If a country cannot service its debts, it will be assumed that it is facing a liquidity crisis and generous assistance will come its way, as is the case now with Greece, Portugal or Ireland, but for a maximum of two years. If at the end of this period it still cannot service its debts, it is clearly not undergoing a mere liquidity crisis: it is threatened by downright insolvency. In this case, the country in question must get its creditors to agree on a haircut of the debt maturing at the time. The haircut would be sized on the basis of the discounts already priced in by investors during the previous three months, but of at least 20% and at most 50%. The country can offer its creditors, after applying the haircut, newly created replacement bonds, to be partially guaranteed by the ESM, in exchange for the maturing bonds. The guarantees would be limited to a given share of GDP. Only when the sum of the guarantees exceeds the limit stipulated or if guarantees are drawn, a full insolvency would be in place, in which case the entire sovereign debt will be on the table.
The maximum loss to an investor in a ten-year bond, in this case, is limited to 60% of the nominal value. A 4.8% risk premium would suffice to cover this risk, even if default were expected to occur with certainty. The model thus ensures that risk premiums continue to be applied, reflecting the corresponding creditworthiness and working against excessive borrowing and lending, while at the same time it puts a limit to them. Investors would then enjoy something akin to a partial-coverage insurance against a sovereign insolvency that protects the country’s creditworthiness and prevents panic reactions in case of a crisis.
Since the problems will be dealt with as they arise, the country in question will be encouraged to institute austerity programmes in order to convince investors of its creditworthiness. No debts will be wiped out in one step so that the old game can start anew. Instead, the problem will simmer on, forcing the country to undergo the necessary real depreciation through the introduction of its own austerity measures. Only so can the Eurozone regain its equilibrium.
Professor of Economics and Public Finance
President of the Ifo Institute
Published as “Der Ausweg aus der Krise”, WirtschaftsWoche, No. 36, 9 September 2011, p. 48.