Monday, November 30, 2009

Sovereign Default: Absolutely No Bail-Out... Perhaps...

There is a general feeling, in IMF statements and among financial commentators, that there are increasing risks of sovereign default (Dubai World’s crisis is not strictly a case of sovereign default but strengthens this feeling). Willem Buiter talks of “the likely imminence of the start of the final leg of the journey from household default through bank default to sovereign default”.

Within the EU, for at least a year, Latvia has been permanently on the verge of default by virtue of its Argentina-like combination of: the commitment to a hyper-fixed exchange rate tied to a strengthening currency, managed by a Central Bank acting as a Currency Board; large scale twin deficits, fiscal and commercial; rising foreign indebtedness; decreasing external competitiveness; increasing interest rates; lower FDI and financial capital outflows.

During the same period from time to time other EU members have seen the lowering of their credit ratings and the rise of their interest premiums above the German benchmark – early warnings of possible default. At the beginning of 2009 eurozone bond spreads suddenly widened. At some point Ireland had its credit-rating downgraded by Fitch from AA+ to AA-, while the OECD and the European Commission demanded drastic budget cuts, and its GDP accelerated its decline. Greece is the most recent EU candidate for default since mid-November, after the discovery of a government deficit suddenly rising to 12.7% of GDP, instead of the expected 6%, and public debt-to-GDP ratio headed for 135%, amply overtaking that of Italy while nobody was watching (gross external debt, public and private, was 149.2% of GDP at the end of 2008; the real exchange rate has appreciated by 17% since 2006, losing competitiveness; see Munchau, FT 30 November).

Suppose an EU member state, whether or not a euro-zone member, experienced a serious financial crisis to the point of default. Would the European Union and its financial agencies, and/or the other Member States, come to its rescue?

Art. 103: No Bail-Out

The possibility of a bail-out is considered and specifically forbidden by Article 103, section 1, of the Treaty establishing the European Community (TEC; ex-Article 104, currently in force and directly applicable from 1 January 1994; see the latest consolidated version of the current treaties, Official Journal of the European Union (OJ) 29.12.2006 C 321 E/84).

“The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.”

It should be stressed that Article 103 rules out not only any obligation to bail-out, but also any unilateral, voluntary and generous “assumption of the commitments of central governments, regional, local or other public authorities, etc.”, whether on the part of the Community or a Member States. No bail-out, period.


On 18 February 2009 the then German Finance Minister Peer Steinbrück speaking in Dusseldorf “signalled that [Germany] would support emergency action to protect the eurozone if one of its 16 member-states found itself in such serious difficulties that it could not refinance its debt.” (FT, “Germany ready to help eurozone members”, by Bertrand Benoit and Tony Barber). Mr Steinbrück noted that "We have a number of countries in the eurozone that are clearly getting into trouble on their payments", adding that "Ireland is in a very difficult situation". “The euro-region treaties don’t foresee any help for insolvent countries, but in reality the other states would have to rescue those running into difficulty” (EU Observer, 18 February 2009).

One might be inclined to say that Mr Steinbrück is no longer the German Finance Minister; and that in any case he had no authority to make that statement. And if the state of California can face the prospect of bankruptcy without any of the other federal states or the Fed or the US government turning a hair, why should an EMU country, especially if small, be bailed out in a considerably looser Union which is not even a Federation? Except that Steinbrück was not alone in his pronouncement, and there are two other clauses in the TEC that could plausibly be interpreted as providing for a bail-out, not only for EMU members but also for non-EMU member states. Not an automatic provision, but a possible course of action that could be taken on a majority decision.

Steinbrück’s statement was echoed shortly afterwards by Angela Merkel, speaking to foreign journalists in Berlin. Der Spiegel commented that “If Germany were to pay into a bailout based on its size relative to other eurozone countries, it would be forced to cover one-fourth of the entire tab. Peter Bofinger, a member of the German Council of Economic Advisors, actually quantified in €1.5bn a year the likely cost to the German taxpayer of a rescue operation within the eurozone. Then, in March 2009, Joaquín Almunia, then European Commissioner for Monetary Affairs and usually a tough custodian of fiscal and monetary rigour (the man who single-handed tried – though failed – to reduce the ERM-II band of exchange rate variation around the entry parity from 15% to 2.25%, just by his saying so), said: "If a crisis emerges in one eurozone country, there is a solution before visiting the IMF. Don't forget we are equipped to interact politically and economically to face the crisis, but these kinds of things should not be explained publicly." In March, the Irish Times reported that: "Unofficially, leading figures in Berlin admit that assistance for several EU members, including Ireland, is all but inevitable." In June 2009, Times columnist Anatole Kaletsky wrote: "Germany is at the heart of a huge plan to prop up crippled EU economies - not that the German people would ever know" (these quotations are taken from, 17 July 2009).

Articles 100 and 119: discretionary bail-outs

How could the unambiguous No-Bail-Out provision of Art. 103 be circumvented? Almunia did not say, at first, invoking discretion. One way in which it could be done with impunity is via the EU or its member states giving credit guarantees rather than subsidies or credits. A guarantee costs nothing if it is not called upon, though in case of default it may cost up to 100% of the sums guaranteed; but in any case such a contingent, quasi-fiscal, future liability does not usually appear in the current budget. After all, this is how the EU supported eastern European transition economies beyond its budgetary constraints in the early 1990s.

But there no need for such an escamotage. There is always the possibility of the Council granting financial assistance to a member state experiencing exceptional difficulties (Eurointelligence, “Did you know that there is an explicit bailout clause in the Maastricht Treaty?” 18.02.2009). Art. 100, section 2, states that:

“Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the Member State concerned. The President of the Council shall inform the European Parliament of the decision taken.” A similar provision for eurozone non-members is provided in Art. 119.

This provision was specifically referred to by Der Spiegel magazine in connection with the German Finance Minister’s statement. Angela Merkel also specifically referred to Art. 100 procedures. The possibilities were also mentioned of Germany issuing 'bilateral bonds' to raise money for struggling countries; or groups of several member states collectively floating a bond; Jean-Claude Juncker had proposed issuing a common euro zone bond for the 16 countries sharing the currency, a revolutionary idea that was supported by Almunia but met opposition from Germany. The source and therefore the scale of financial assistance would be affected, but clearly Art. 100 and 119 are sufficient to drive coach and horses through the No Bail-Out clause of Art 103 of the TEC.

Moscow rules

It is bad enough for EU member states to be subject to the fiscal straitjacket of the so-called Growth and Stability Pact, without those members that comply being subjected to the cost of bailing-out those who do not comply. It is bad enough for the ECB to provide emergency financial assistance to banks at its own discretion, without being subject to rules as a Lender of Last Resort; now the Council is to provide financial assistance to member states at its own discretion.

It used to be said that Soviet Law could be summarized by three basic rules: 1) Everything is forbidden. 2) Everything is allowed in special cases. 3) Special cases are decided by the Party. There is enough of that in Brussels already. Mutatis mutandis, this model is being replicated exactly by EU rules on financial assistance to member states: 1) Bail-outs are forbidden. 2) Bail-outs are allowed in special cases. 3) Special cases are defined by the Council.

Without rules, assistance may be provided not only on economic but on broadly political grounds: clearly the prospect of European assistance was used blatantly as an offer that Ireland could not refuse by failing for the second time to ratify the Lisbon Treaty. In March 2009, the German Ambassador to Ireland, Christian Pauls, warned that Ireland would "throw away its future" if it voted No to the Lisbon Treaty for a second time. He said, "A second No would have horrific consequences for Ireland and I am not the first to say it. I don't think there is anything particularly new in that." On 25 June, German MEP Jo Leinen said the Irish must vote "Yes" if they wish to continue to benefit from the "protective umbrella" the EU provides (, cited). Political pressure now is also being exercised on Greece: it is presumed that Greece would not enjoy EU financial assistance unless it complied with EU demands for budgetary cuts (as in the no-longer-secret letter by Eurogroup President Junker reported today in the Greek press).

Unsettled State of Play

With Moscow rules, there can be no foregone conclusion.

German taxpayers expressed their opposition to using public money to bail out other countries that have got into financial difficulties: 70.9% were against “helping countries like Ireland or Greece”, 24.8% were in favour, 3.4% did not know (Open Europe in collaboration with the Institute for Free Enterprise, Berlin; published by cited). One could argue that opposition to bailouts was also implicitly expressed in the German elections.

At present, EU borrowing is against the rules, but would be necessary to fund financial assistance to member states. Almunia recognizes that “a common bond” “is not politically viable today because some important member states said 'no'. This requires a political decision that is not in the hands of the Commission."

Doubts have been expressed about the possibility of intra-EU bailouts. The Former Chief Economist at the ECB, Otmar Issing, told the Frankfurter Allgemeine Zeitung that it would be a catastrophe to water down the 'no bailout' clause in the EU treaties, arguing that it would spell an end to "the political stability of the monetary union". He said that in order for financial discipline to prevail every member state must be responsible for its own debt and deficits: "without this there would be no end", he said (, cited).

But the best comment on bailouts was by Karl Otto Pohl, former President of the Bundesbank. He said that if Germany decided to bail out other members of the eurozone it would open a Pandora's Box, adding "It would be like jumping in a swimming pool without water".


Robin said...

You saw what happened in the US and worldwide when Lehman Brothers was not bailed out in mid-September 2007. Are you sure you want to repeat that mistake by not bailing-out an EMU member like Greece, or simply an EU member like Latvia?

chilosi said...

This is a comment to Robin comment.

If the other EU countries (or the European Central Bank) do not bail out a EU member this does not mean that the member will not be bailed out anyway. There is always the IMF to do the job. After all it is the job for which the IMF is specialized. Of course the IMF will put conditions, but this is the positive side of the IMF role. We do not want a situation where EU members will be induced to act irresponsibly just because they will be certain to be bailed out in the end. Moreover the consequence of a Eurozone risking to default on its foreign debt could be a weakening of the exchange rate of the Euro, an occurrence not entirely unwelcome under the present economic circumstances, and a further increase in the risk premium on Eu bonds, especially of the more indebted Eurozone countries, forcing some degree of fiscal discipline. The increased risk premium could reduce the degree to which Eurozone countries will be able to reflate through a more expansionary fiscal stance, which could be a negative feature under the present circumstances. But some greater degree of forced fiscal discipline on countries such as Greece or Italy could be welcome, and could increase longer run financial stability, both of those countries and of the Eurozone. After all, as far as those countries are concerned, to be prone to run excessive public debts is not a feature justified by the present recession, but rather a long-run consequence of the weakness of their institutions, which they should be induced to cure, in their own interest.
Of course all this will be not the end of the story and one may speculate on what the various consequences could evntually be. But simply to compare Lehman with Latvia is like to compare potatos with pears. For instance, in case of bailing out a bank or a big company such as GM, some conditions on replacing the top management of the bank apply. No such conditions could be envisaged as far as a government of a democratic country is concerned. To make a perhaps more suitable comparison: the reason of the financial problems of the US and of the weakening of the dollar are not the financial difficulties of the state of California, whose economy is one of the largest of the world, for which no federal bail-out is envisaged, and there was no financial bail-out in the past for the city of New York, if I well remember.

D. Mario Nuti said...

Robin: time flies – but only half as fast as you feel: Lehman Brothers was mid-September 2008.

When a bank defaults, especially a giant one like Lehman Brothers, confidence in the entire credit system is shaken, possibly beyond the borders of the country where the bank is based; the entire financial infrastructure is damaged. When a country defaults, it is primarily a problem for its creditors and – unless it negotiates debt reduction with creditors – for the country’s continued access to credit; it is not a collapse of the financial infrastructure whether in the country itself or internationally.

It has been said – probably by Fritz Machlup, but I cannot remember for sure: “No bank should believe that it might be bailed out in case of default, and every bank should be bailed out to prevent default”. If only our old friend Moral Hazard went away. The case for countries is not as strong as for banks, but the Moral Hazard problem is there as well.

Alberto: Yes, the IMF can and does engage in bail-outs: think of Russia in August 1998 – though subsequent Russian recovery has allowed the IMF to get its money back. Arguably the function of the IMF should be preventing government bankruptcy rather than supporting bankrupt governments after the event.

D. Mario Nuti said...

Update: see The Economist of 3 December, on precisely “What would happen if a member of the euro area could no longer finance its debt?”.
and my comment on The Economist's blog
as well as my follow-up on my Blog

M.G. said...

I still do not understand why we should bail out a country whose government fudged the accounts in various occasions.

D. Mario Nuti said...

From a moral standpoint you are absolutely right, Massimo. But often financial institutions have been bailed-out in spite of similar mis-reporting and false reporting. If you believe that there would be dire consequences from default - whether by countries or financial institutions, or industrial companies - the case for a bailout is still there.

I expect that probably you will agree with me that sovereign default, even by a country like Greece, would not be as explosive as that of Lehman Brothers. And I do not believe that the EU is ready to do anything except forcing Greece to take unpopular measures to improve its financial position.

M.G. said...

Indeed I agree. There is a certain degree of moral hazard in the system to purse any lack of accountability and transparency. I am one of the few convinced that it was the right decision to let Lehman fails, but also others institutions should have. Along the same lines Greece should not be helped, while actually the cheap financing from ECB is already doing that or has even been contributing indirectly to the deficit. So let the markets solve Greece's problems and no bailout.