The German Council of Economic Advisers has mooted an interesting proposal to deal with excessive public debts in the Eurozone (Andritzky et al. 2016a, 2016b). This is a major remaining gap in the Eurozone, which governments would prefer to keep ignoring. Although the authors should be commended for bringing it up, their proposal suffers from some inherent weaknesses.
It is obviously essential to prevent another Greek PSI, which was so long in coming that most private lenders escaped scot-free, pushing the debt into public hands and thus reducing the scope of the operation while burdening helpless taxpayers. It is also crucially important to rebuild the no-bailout clause, which requires that member states be able to restructure their debts if they cannot serve them anymore. This is why the IMF has put forward its own policy principles; so indeed, the genie is now out of the bottle.
The proposal suffers from two logical errors. Its two-step procedure – first, extend debt maturity; second, trigger a debt restructuring – is justified by the familiar distinction between illiquidity and insolvency. Like many others, the authors accept this distinction as it applied to governments. However, it has long been recognised, that insolvency does not apply to governments (Eaton et al. 1986, Bulow and Rogoff 1989). One reason is that legal rights are fuzzy. Another reason is that it is not even clear how one can compute the present value of future public spending and receipts, not to mention how to evaluate the value of public assets. In fact, governments are never insolvent. One can ask instead whether honouring public debts is economically sensible and whether it is politically feasible. But that is a value judgement, not a formal assessment. A third reason is that illiquidity and insolvency are not separate concepts in a world of multiple equilibria, which characterise debt crises. It follows that a sovereign debt crisis requires a single step.
For this step to be successful, it is highly desirable that sovereign debt instruments include a collective action clause of the kind advocated by the authors, in line with much of the literature, going back at least to Krueger (2002). The key insight here is what we now call bail-in, namely, that debt-holders be forced to accept losses. Herein lies the second logical error. As long as public debts are held largely by domestic creditors (including banks), governments will have to deal with the losses, one way or another. In particular, banks may fail and need to be bailed out, which implies that a significant chunk of forgiven debt will resurface promptly as new public debt. This is what Brunnermeier (2011) has called the ‘doom loop’ between governments and domestic banks. The proposal does not consider this lethal problem.
The proposal also suffers from several weaknesses. To start with, decisions are guided by arbitrary thresholds. This is already a major weakness of the Stability and Growth Pact (successive revisions have tried to move away from the 3% deficit ceiling and the 60% debt ceiling was obsolete by the time the euro was launched). As the authors note, rules that are not enforced undermine incentives to obey them. Arbitrary thresholds are especially problematic when the decisions are to be taken by unelected officials, which is the case of the EMS. The proposal implicitly tried to alleviate this weakness but allowing for bands instead of single targets, but the result is to worsen the situation as it gives more discretion to the EMS. The stated intention is to establish a rules-based process – which is commendable – but the rules must be both robust and economically justified – which they are not.
Two other major weaknesses concern the second stage. The depth of the restructuring is to be set by the EMS on the basis of debt sustainability analysis (DSA). The IMF has developed DSA, only to discover its arbitrariness, exemplified during the early phases of the Greek crisis. Note first that this procedure refers to sustainability, not solvency – a nod to the inadequacy of this concept, as mentioned above. Yet, DSA does not avoid the problem of assessing future incomes and receipts of a government. Present value calculations are remarkably sensitive to slight variations in assumptions concerning interest and growth rates over the long run (Wyplosz 2011). Well aware of this difficulty, the IMF increasingly presents its DSA calculations as an exploration of their relationship to the assumptions. The implication is that the EMS would have to make a decision on the basis of superficial calculations, deepening the difficulty of relying on delegating decisions to unelected officials. This is compounded by the fact that debt restructuring involves massive income transfers. This is the other weakness – only elected officials can make such decisions. Because the only elected officials that we have are governments and their parliaments, debt restructuring must be a national decision. The IMF procedure is to negotiate debt restructuring with national governments, requesting that it officially be their decisions. This may be what the authors have in mind, but then they should carefully spell out the procedure.
In the end, the proposal makes the case strongly that collective action clauses should be applied not just to the financing of deficits, but also to maturing debt refloating. Under the first approach, the volume of debts subject to the clause will be kept insufficient for far too long. Otherwise, the proposal recycles well-established ideas but imbeds them in an original setup that suffers from grave limitations. In addition, they refrain from alternative proposals (Pâris and Wyplosz 2014, Corsetti et al. 2015) that aim to deal with excessively large debts as soon as possible, rather than waiting for the next crisis. Waiting for trouble is the strategy of choice of policymakers, fiercely defended by the German government. The proposal serves to strengthen a strategy that is politically expedient but economically dangerous.
References
Andritzky, J, L Feld, C Schmidt, I Schnabel and V Wieland (2016a) “Creditor participation clauses: Making orderly sovereign debt restructuring feasible in the Eurozone”, VoxEU.org, 21 July.
Andritzky, J, D Christofzik, L P Feld, and U Scheuering (2016b) “A mechanism to regulate sovereign debt restructuring in the euro area”, German Council of Economic Experts, working paper, Wiesbaden.
Brunnermeier, M K, L Garicano, P R Lane, M Pagano, R Reis, T Santos, S Van Nieuwerburgh and D Vayanos (2011) “ESBies: A realistic reform of Europe’s financial architecture”, VoxEU.org, 25 October.
Bulow, J and K Rogoff (1989) “Sovereign debts: Is to forgive to forget?”, American Economic Review, 79(1): 43-50.
Corsetti, G, L P Feld, P R Lane, L Reichlin, H Rey, D Vayanos, B Weder di Mauro (2015), A new start for the Eurozone: Dealing with debt, Monitoring the Eurozone 1, CEPR Press.
Eaton, J, M Gersovitz and J E Stiglitz (1986) “The pure theory of country risk”, European Economic Review, 30(3): 481-513.
Krueger, A O (2002) A New Approach to Sovereign Debt Restructuring, IMF.
Pâris, P and C Wyplosz (2014) PADRE: Politically Acceptable Debt Restructuring in the Eurozone, Geneva Report on the World Economy Special Report No 3, CEPR Press.
Wyplosz, C (2011) “Debt sustainability assessment: Mission impossible”, Review of Economics and Institutions, 2(3): 1-37.