Wednesday, December 16, 2009

European Bail-Outs: Unaffordable, Illegal, Conditional

The possibility of sovereign default within the Eurozone is still being contemplated uneasily by economic commentators. “Is the Greek crisis the beginning of a deeper sovereign debt crisis that could destabilise the Eurozone?” Paul de Grauwe (Leuven University) argues convincingly that “… with Eurozone government debt standing at 85% of GDP at the end of 2009, the Eurozone is miles away from a possible debt crisis. Things are different in some individual countries, in Greece in particular, a country with a weak political system that has been adding government debt at a much higher rate than the rest of the Eurozone and that in addition has a debt level exceeding 100% of GDP. So, while the Eurozone as a whole is no closer to a debt crisis than is the US, some of its member states have been moving closer to such a crisis.” Fair enough, especially considering that Greece has been cooking the books before and after joining the Eurozone, its government has just rejected any serious macroeconomic maneuvre, and is heading for a budget deficit/GDP ratio now officially set at 12.6% of GDP but more likely to reach 15%, and poised to exceed 130% government debt/GDP ratio.

Paul de Grauwe then asks: “Is it conceivable that a debt crisis in one member country of the Eurozone triggers a more general crisis involving other Eurozone countries? My answer is that yes, it is conceivable, but that it can easily be avoided.” His reassuring stance, unlike his optimism on sovereign default, is utterly unconvincing.

Paul is confident that a general crisis would be avoided because “A Eurozone bailout is likely”. “The other Eurozone governments are … very likely to bail out Greece out of pure self-interest. There are two reasons for this: First, a significant part of Greek bonds are held by financial institutions in Eurozone countries; these institutions are likely to pressure their governments to come to their rescue. Second, and more importantly, a failure to bail out Greece would trigger contagious effects in sovereign bond markets of the Eurozone. … The local sovereign debt crisis would trigger an avalanche of other sovereign debt crises. I conclude that the Eurozone governments are condemned to intervene and to rescue the government of a member country hit by a sovereign debt crisis.” This is arbitrarily selective pessimism, a worse case scenario for contagion – without the support of precedents – turns out to be a best case scenario for the likelihood of a bail-out. Paradoxically, Paul’s pessimism on contagion transforms itself into excessive optimism about a European bail-out.

What about the cost? Paul de Grauwe tells us that a bailout is affordable: in the unlikely event that Greece defaults on the full amount of its outstanding debt, “a bail-out by the other Eurozone governments would add about 3% to these governments’ debt – a small number compared to the amounts added to save the banks during the financial crisis.”

Would it be legal? Paul de Grauwe dismisses the no-bail-out clause of Art. 103 as “a misreading of the Treaty. The no-bail-out clause only says that the EU shall not be liable for the debt of governments, i.e. the governments of the Union cannot be forced to bail out a member state. But this does not exclude that the governments of the EU freely decide to provide financial assistance to one of the member states. In fact this is explicitly laid down in Article 100, section 2.” “Eurozone governments have the legal capacity to bail out other governments, and in my opinion they are very likely to do so in the Eurozone if the need arises.”

Here are three strong objections, on the affordability, legality, and conditionality of a European bail-out.

The bail-out of a country like Greece is affordable – but only up to a point: we should consider that 3% of an average 85% of GDP is a non-neglibible average 2.55% of their GDP on top of their already excessive deficit/GDP ratio which most of them are already required to reduce by extant excess-deficit procedures decided by Ecofin. And an affordable bailout of a country like Greece could be followed or accompanied by the bailout of another country in Paul’s list of troubled economies, “Spain, Ireland, Portugal, Belgium” [not Italy, thanks Paul, but why not?], or even an EU member outside the Eurozone, like Latvia, for which a similar case for a bail-out could be made, and has been made repeatedly over the last year. Or - sooner or later on current trends - the UK.

Art. 103 is adamant: “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…”. The misreading is by Paul de Grauwe: Art. 103 states unambiguously that the Community not only shall not be liable, but shall not assume other Members' public liabilities – thus including necessarily any unilateral aid or support. It also rules both bail-out and unilateral “assumption” of the same obligations by Member States as well as by the Community.

True, a discretionary bail-out is allowed by Art. 100 – and, for that matter, by art. 119 even for non-Eurozone members – but not automatically. Such a discretionary bail-out requires three conditions: 1) a recommendation to that effect by the European Commission, 2) unspecified and therefore arbitrary “exceptional occurrences” – suggesting more of a swine flu pandemics than financial pandemics; and 3) a qualified majority vote by the Council. Paul de Grauwe fails to mention such conditions.

Finally, presumably the “assumption” by EU authorities or Member States of responsibility for a bailout would have to be accompanied by the EU and or Member States' ability to impose conditions on economic policy and especially on the fiscal policy of the bailees. Angela Merkel effectively expressed this requirement by proposing “a huge transfer of sovereignty to the centre, when she said that the EU should have a right to intervene in a situation like [the current Greek situation] (presumably in exchange for a bailout guarantee)”, see Wolfgang Munchau, FT 14 December. Writing in Handesblatt yesterday, Sebastian Dullien and Daniela Schwarzer “make the case that a clear rule should be established on the conditionality of support. The rule should forsee that the country temporarily loses sovereignty over fiscal policy to the European Commission or the Eurogroup, which should be given a veto power over national budget for a specified post-crisis period.” (, 16 December).

Markets obviously do not believe there is going to be a European bail-out – or Greece would not have to pay a 250 points premium on its debt over the rate on German bonds. And if markets do not believe in a bail-out, why should investors who have received that premium because of such a disbelief benefit from a bailout? Let them take the full risks with the premium that has gone with it.

Having said all this, one can only agree with Paul de Grauwe’s bottom line, that “... the Eurozone governments should make clear where they stand on this issue. Not doing so implies that each time one member country gets into financial problems the future of the system is put into doubt.” Brussels transparent and clear rules should replace those - arbitrary, discretionary and unpredictable - that in our post of 30 November we called ”Moscow rules”.

1 comment:

D. Mario Nuti said...

Paul de Grauwe commented on this post via e-mail. With his permission I reproduce our exchange here:

Paul de Grauwe: First, the addition of 3% to the governement debt of the EU (which stands at 85% of GDP) does not mean that the deficit increases by 2.55%. The deficit is only increased by the interest payments on the additional debt. This would be something like 3% times 4% (assuming that this is the average interest burden on the debt), a very small number, i.e. 0.12%. Second, I do refer to the conditions for a voluntary bailout, be it that it is in a footnote where I cite the text of article 100. Finally, I do not understand why you say that the term "exceptional occurrences" would not apply to a financial crisis that is the most severe one in the last seventy years.

D. Mario Nuti: I reckon the funds disbursed to bail out Greece by the other Eurozone countries would first appear as additional expenditure in their government budgets, thus raising the deficit by an estimated average 2.55% of GDP. The additional borrowing necessary to fund that expenditure would raise government debt by the same amount, as well as raise future interest charges on the additional debt to the yearly tune of 0.12% of GDP as you suggest. But the 2.55% would add to the current deficit here and now.

Sorry I had missed the footnote to art. 100 conditions, though I would have stressed them in the text instead of talking of a voluntary bail-out as a foregone conclusion. And yes, I accept that we are facing “a financial crisis that is the most severe one in the last seventy years” but I feel that a case to include exceptional financial occurrences has to be made specifically. AND there must be ropes rather than strings attached...

Paul de Grauwe: Typically when a government bails out another one, it takes over the latter’s debt and issues his own debt. That’s also what I assumed when I wrote that a full bailout would add 3% to the eurozone government debt. (Alternatively the rescuing government can extend its guarantee on the troubled government’s debt, like when the US bailed out Mexico). These operations do not involve any cash disbursement. Therefore the deficit is not affected. Only later when the higher debt leads to more interest payments the government budget deficit is increased.

D. Mario Nuti: Fair enough - though guarantees are quasi-fiscal devices to conceal potential fiscal exposure, and I cannot visualise the 3% being added to debt without figuring as deficit first. I would have thought this is part of accounting consistency and transparency.