Sunday, December 6, 2009

A non-bail-out bail-out?

In our latest post (30 November) we discussed the possibility of a European bail-out in case of sovereign default by an EU member state, regardless of EMU membership. As it happens, The Economist of 3 December has a piece under Economic Focus on precisely “What would happen if a member of the euro area could no longer finance its debt?”.

The Economist recalls “That famous headline from the Daily News ran after President Gerald Ford refused to bail out New York City in October 1975, when the city was close to bankruptcy ... “: “Ford to City: Drop Dead.” “Within weeks Ford relented. Behind the belated rescue lay a fear that default by New York would hurt the credit of other cities and states, and perhaps of America.“

At present even high deficit and high debt countries like Greece, Ireland and Latvia can borrow at no more than 2-3 percentage points over the 3.1% rate on German bonds – hardly a danger signal yet – but this might not last forever, especially in view of their poor wage competitiveness.

The Economist acknowledges the ““no bail-out” clause that prohibits one country from assuming the debts of another [art. 103 of the Treaty establishing the European Community, see our earlier post]. That makes Greece’s public finances a matter between it and its creditors. Any promise, tacit or otherwise, of a bail-out by others would only encourage more profligacy (a view that mirrors Ford’s initial stance towards New York). In principle, a default by Greece or by any other euro-zone country would not threaten the euro any more than default by New York City in 1975, or California today, would mean the end of the dollar. Indeed, membership of the euro could help make debt-restructuring more orderly, since it would remove currency risk from the equation.”

But The Economist suggests an alternative, which is what actually happened to New York: “The non-bail-out bail-out”. Meaning: technical default, with some debt-holders not getting their money back, and a drastic fiscal squeeze. “The city had to cut public services, shed jobs, freeze pay, abandon capital projects and raise taxes to make sure it could pay back the federal loans. Such belt-tightening had proved necessary even in the months before the rescue. When it came, the president could claim that “New York has bailed itself out.”

“It is easy to imagine a similar kind of hard bail-out, should a euro-zone country ever run short of cash.” “It would be hard to sell
[the bail-out] to voters in rescuing countries unless, as in New York’s case, the interest rates on bridging loans were punishingly high.” “A tough-love bail-out would still need someone with deep pockets to provide the cash. Given the state of public finances even in more stable countries, such as France, that cannot be taken for granted. Germany is better placed but would be unwilling to act alone.”

The Economist is confused and confusing. Would there or would there not be a bail-out? This is the question. Even unilateral aid from Germany would have to be authorized by the Council, for it not to be prohibited by art. 103 of the Treaties establishing the European Community (see our earlier post). That conditions for a bail-out, if any, would have to be tough, or be preceded by self-imposed austerity, is another matter. The defaulting country can always turn down financial assistance if it does not like the conditions, but they may still be preferable to no bail-out.

The Economist fails to provide an answer. The crux of the matter – as pointed out in last week’s post, is the absolutely discretionary nature of a bail-out, depending exclusively on a Council’s decision on “exceptional occurrences”, on a recommendation by the European Commission.

And, in view of their analysis, what for?

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