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Eurocrisis solution?

December 17th, 2010 · No Comments

A simple, brilliant plan that would square the euro vicious cycle debt…

If you’ve read Martin Wolf’s column in the previous post, you’ll be aware that the euro debt problem is near intractable. Banks and sovereigns around are lined up like domino’s and any fall anywhere might activate the nuclear chain reaction that could easily end in catastrophe.

We’re a bit bemused that Wolf, one of the best columnists around, doesn’t seem to be aware of the following solution.

From the conservative economist Jacques Delpla. It’s remarkably simple, yet remarkably effective. The essential points:

1) Divide the good from the bad debt. Good debt is all issued when debt/GDP was below 60%, bad debt the bonds issued when debt/GDP above 60%

2) Pool all the good debt into eurobonds

3) Countries remain responsible individually for the bad debt.

This won’t increase interest rates for the well behaving countries and keeps incentives in tact to reform for the bad behaving ones (which are problems if all debt were to be pooled).

It’s an excellent plan, creative, with all the right incentives.

Interest rates on good debt might very well fall and bad debt won’t infect good debt, even for the PIIGS countries, so even they will face lower interest rates on average (albeit not at the margin, probably).

This is the first serious plan that we’re aware off that I can see working for all EU countries, so I think it even has a fair chance of making it.

Here is a summary by the authors themselves:

The Great European Debt Breakup
Jacques Delpla and Jakob von Weizsäcker

BRUSSELS – Financial markets almost just succeeded in breaking up the eurozone. So the idea of harnessing the power of the market and of financial engineering to guarantee the euro’s long-term viability might seem paradoxical. But this is precisely what our proposal to split eurozone sovereign debt into senior and junior tranches aims to achieve.

The senior tranches would comprise debt totaling up to 60% of the GDP of each participating country. These countries would then pool this debt and issue a joint and several guarantee. The resulting “Blue Bond” (named after the color of the European flag) would be an extremely safe and highly liquid asset, comparable in volume to United States T-bills, thereby helping the euro’s rise as an international reserve currency and ensuring low refinancing costs for the bulk of eurozone debt.

By contrast, any debt beyond 60% of GDP would have to be issued as junior “Red Bonds” under purely national responsibility. These “Red Bonds” would make borrowing beyond 60% of GDP more expensive, thereby enhancing fiscal discipline and reinforcing the targets set by the Stability and Growth Pact.

Moreover, Red Bonds could be conveniently ring-fenced so that they do not destabilize the banking system, thereby ensuring that the no-bailout clause that applies to them becomes a credible proposition. For example, the European Central Bank should exclude Red Bonds from its repo facility and a standardized collective-action clause to facilitate debt rescheduling should be made mandatory for Red Bonds.

If implemented successfully, our proposal would lower the costs of debt service while strengthening the incentives for individual countries to pursue fiscally responsible policies. This is what distinguishes our proposal from suggestions that all eurozone debt be pooled in euro bonds in a spirit of solidarity.

But successful implementation of this plan requires a rock-solid governance structure that markets and taxpayers in the most stability-oriented eurozone countries can trust. In particular, the danger of “mission creep” – the temptation to expand the 60%-of-GDP debt ceiling for Blue debt – needs to be addressed.

That is why we believe that the annual allocation of Blue Bond emissions should be delegated to an Independent Stability Council. The council would offer a take-it-or-leave-it proposal to the participating countries on the allocation of Blue Bonds for the coming year. Each national parliament would then adopt the proposal, given participating countries’ role in providing the guarantees implied by that allocation.

Within this mechanism, countries that pursued reckless fiscal policies could be gradually excluded from the system by lowering their Blue Bond allocation. And countries unhappy with the system’s evolution could gradually exit it simply by rejecting their annual Blue Bond allocation for a sufficient number of years in a row – thereby no longer issuing Blue Bonds or guaranteeing the fresh Blue Bonds of others. The Independent Stability Council, not wishing to lose the Blue Bond club’s most stability-oriented members, would have a strong incentive to ensure that these countries’ interests are properly taken into account.

In economic substance, the Blue Bond scheme is compatible with the no-bailout clause in Article 125 of the EU Treaty, because the debt guarantee would apply only to senior debt amounting at most to 60% of GDP, the level that the Maastricht Treaty deems sustainable for any EU member state. Therefore, the guarantee would not apply to debt crises caused by excessive borrowing to finance unsustainable fiscal policies. To the extent that a higher debt ratio is allowed only in exceptional situations (Article 100 of the Treaty), such as natural disasters (where a bailout would be allowed), a legal conflict should not arise.

But the ultimate test for our proposal is whether the eurozone countries – their confidence shaken by the debt crisis – have an interest in coming together and participating in this voluntary scheme.

We believe they might. First, smaller countries with relatively illiquid sovereign bonds stand to benefit substantially from the extra liquidity provided by the Blue Bond. Second, countries with high debt levels would welcome this opportunity to control borrowing costs and to commit to stronger fiscal discipline after the current crisis. Even those countries uncertain about the benefits of enhanced fiscal discipline are likely to consider participation, because markets could interpret refusal as a bad signal.

But, provided that the Blue Bond’s institutional safeguards are sufficiently robust, the countries that stand to gain the most from the scheme’s promise of strengthened fiscal discipline are those that worry most about having to foot the bill for sovereign bailouts – now and in the future.

Jacques Delpla is an adviser at the Conseil d’Analyse Économique in Paris. Jakob von Weizsäcker is a research fellow at Bruegel, a Brussels-based think tank.

———[End of article]———-

For us, this is the best scheme so far. Anything else involves a level of solidarity (the strong subventing the weak) and a blunting of incentives ( “moral hazard”) whereby the weak, counting on the solidarity of the strong (as it is in the strong’s own interest to keep the financial system working) to bail them out.

The present financial stability fund suffers from these problems and policy makers have tried to blunt these problems by enforcing extremely tough conditionality on the receiving countries. But this in itself creates the problem of enforcing such tough austerity as to be counterproductive, so we highly favour the blue-bond scheme over the present one.

Tags: Sovereign debt crisis