MUNICH ― Having already agreed to double the AAA-rated lending capacity of the European Financial Stability Facility, the special fund created by eurozone states to provide assistance to troubled member economies, European Union countries are now discussing the conditions under which the EFSF’s funds will be made available. The crucial issue is the extent to which creditors will have to participate in rescue measures by accepting “haircuts” ― that is, partial losses on their claims.
Representatives of overly indebted countries, and of countries whose banks are strongly exposed as creditors, argue that haircuts would destabilize the European financial system, generating contagion effects tantamount to a second Lehman Brothers crisis. But the European Economic Advisory Group at CESifo, a group of economists from seven European countries, has rejected this view in its latest report, just released in Brussels.
The group argues that a Lehman-like crisis cannot happen for the simple reason that it already did happen. In October 2008, a month after the Lehman collapse, the G8 countries agreed to rescue all systemically relevant banks, while rescue facilities to the tune of 4.9 trillion euros ($6.7 trillion) were established worldwide ― and are still largely intact today. Should one of these banks run into trouble because of a sovereign-debt default, the necessary rescue funds will be readily available. Another breakdown of the interbank market is therefore very unlikely.
Instead, the group’s report underscores the true risk for Europe: a return to the soft budget constraints ― both private and public ― and excessive borrowing that overheated its southern and western periphery and gave rise to destabilizing trade imbalances. Haircuts would contain this risk by encouraging closer alignment of each country’s interest-rate spread with its creditworthiness ― the essential tool by which markets impose discipline on debtors.
The report acknowledges that help without haircuts would be useful in a mere liquidity crisis resulting from dysfunctional markets. But haircuts in the case of a solvency crisis are indispensable for the stability of the European financial system itself. Thus, they form a key part of the group’s detailed proposal for a rescue mechanism that could serve as a blueprint for a new European financial governance system.
The proposed mechanism distinguishes between illiquidity, impending insolvency, and full insolvency. If a country faces payment problems, a mere liquidity crisis is to be assumed for the first two years, during which generous financial help would be available. If the crisis persists, the country automatically enters an impending insolvency procedure, in which help would be available only after a 20-50 percent haircut for the maturing debt. The old government bonds in this case would be converted at a reduced rate into replacement bonds, which are partly guaranteed (at 80 percent) by the participating states.
Only if the guarantees are called in does a full insolvency occur, with the entire public debt being rescheduled. Under this scheme, investors would face a potential insolvency risk, but the maximum loss they could expect is limited to 60 percent of their investment. This level of protection would induce them to invest their money only if the borrowing country offered a reasonable, limited interest-rate premium over safe assets.
The proposed crisis mechanism would effectively insure government bond purchasers against the risk of insolvency, but it would entail deductibles that compel bondholders to assume some of the investment risk. The insurance would prevent panic, should a crisis occur, but the deductible would induce prudence beforehand, reducing the risk of a crisis in the first place.
It is sometimes argued that automatic haircuts should not be part of the European rescue mechanism, given that even the International Monetary Fund often provided its help in previous sovereign-debt crises without applying them. Tough sanctions and constraints, it is said, would also be able to induce debt discipline.
This argument is not very convincing, at least when applied to Europe. For one thing, the failure of the EU’s Stability and Growth Pact has raised serious doubts as to whether political debt constraints would ever be respected, unless they are imposed and controlled by the IMF itself.
More importantly, the IMF typically helped countries that had their own currencies and thus could counter international capital movements by adjusting their exchange rates. When capital moves into a particular country, its currency appreciates, cooling off the export sector sufficiently to compensate for the booming domestically-oriented sectors that profit from the availability of foreign credit. Flexible exchange rates thus serve as a self-stabilizing device that protects capital-importing countries against overheating.
This mechanism is not available in a monetary union such as the eurozone. There, capital inflows create asset bubbles that tend to overheat the domestic economy and drive up wages and consumer prices inordinately. When the bubble bursts, the afflicted country can restore competitiveness only through a painful process of real depreciation. Its wages and prices must lag behind its competitors’ for years, while its economy goes through an extended slump until a new equilibrium is found.
For this reason, it is simply not possible to run a currency union of separate countries without market discipline. The eurozone urgently needs a crisis mechanism with automatic haircuts for cases of impending insolvency. That way, limited interest-rate spreads could do the work of its missing exchange-rate mechanism.
By Hans-Werner Sinn
Hans-Werner Sinn is a professor of economics and public finance at the University of Munich and president of the Ifo Institute. ― Ed.