Who pays is at the kernel of euro zone debt debate

 

POLITICIANS AND civil servants returning from their summer break will continue to confront unpalatable options to address the unrelenting euro zone debt crisis. Meanwhile, debate has intensified around some of the existing possibilities, while a number of new elements have emerged.

Apart from the issues that surfaced at the time of the July 21st summit deal, namely, expanding the size and mandate of the bailout fund and the possible introduction of euro bonds, the European Central Bank was forced to intervene on the secondary market to relieve pressure on Italian and Spanish bond yields.

However, opposition – notably from key elements in Germany – to this as well as other aspects of the July deal appears to have become more vociferous. A spanner has been thrown into the works by Finland’s insistence (followed by some others) that Greece provide collateral (such as gold reserves) in return for receiving bailout funds. In a new twist, several well-known economists have suggested that consideration be given to the ECB pursuing a much more expansionary monetary policy in order to inflate away the real value of the debt.

In assessing which of the various ideas on the table may eventually gain lasting political traction, it is helpful to consider what they imply for the critical question of who ends up paying for the debt crisis.

This lies at the heart of the debate. However, because of some of the technical complexities involved, the answers are not always immediately obvious. In essence, a sovereign debt problem arises whenever a country is, or is perceived to be, unable or unwilling to settle its obligations out of its available resources either now or in the future. This leads to market lenders insisting on unsustainably higher “usurious” interest rates which the country cannot accept. If official lenders do not provide funds at a subsidised rate, the country will end up defaulting.

There are only a limited number of ways to address this problem. In the first place, the country can be asked to pay up anyway. This would involve making greater efforts to increase the total amount of resources available (ie, remove impediments to achieving faster growth) and/or to devote a greater share of their resources to debt servicing (fiscal tightening).

However, there are obvious political and economic constraints associated with these options which imply that the country bears all the burden of paying the debt. A problem here is that creditors and debtors may not have a common perception of what may in fact be feasible. Hence, for example, the call from populist quarters in Germany for Greece to hand over islands in the Mediterranean in part settlement of the debt.

All other options involve some element of subsidisation. The use of the European Union’s bailout fund to replace non-existent market funding is the most straightforward, as the funds are seen to come directly out of taxpayer pockets (as occurred, for example, when the Dáil voted the Republic’s contribution to the initial Greek rescue effort).

There is a subsidy, since the interest rate, by definition, is less than what the market would charge to compensate for the risk involved. The Finnish collateralisation proposal is essentially a back door attempt to eliminate this risk and thus defeats the whole purpose of the exercise.

The use of International Monetary Fund resources also involves a subsidy. But this is less overt to the taxpayer, since the financing mechanism of the IMF can be accounted for in different ways in national financial accounts and parliamentary approval for each specific loan is not required.

Former IMF managing director Johannes Witteveen has recently proposed that the fund create an enlarged “debt facility” financed by all countries (including cash-rich emerging nations like China). This would spread the cost of the subsidy burden more broadly among the net contributors to the fund and might circumvent to some extent the political “lock” exercised by Germany on increasing the EU bailout facility.

Another set of options involves official attempts to alter the terms of market lending that the debtor would otherwise confront. The recent intervention by the ECB to influence the borrowing rates faced by Spain or Italy by buying up selected sovereign debt may well end up involving a subsidy. This is akin to intervention in the foreign exchange market and carries the same risks. Should debtor bond yields not move permanently downwards, the ECB could face significant financial losses which would be shared initially by constituent central banks (Germany bearing the brunt of this) and subsequently reflected in lower transfers from the latter to national budgets.

Moreover, such activities are likely to seriously compromise the ECB’s independence (which countries’ bonds does the ECB decide to buy and to what extent?). It is hardly surprising that the Bundesbank by all accounts strongly opposed this decision which surely can be viewed, at best, only as an emergency short-term measure

A similar attempt to artificially lower some sovereign debt yields is the the proposal to issue eurobonds. This at least involves a more transparent transfer of part of the risk away from the peripheral countries. However, in the absence of a virtual fiscal union (which hardly anyone considers politically feasible, at least for now) it will most likely continue to run into opposition from centre countries such as Germany.

Another approach is to reduce the stock of debt – for example by applying some kind of haircut scheme to its nominal value. At first glance the cost of this would seem to be borne by popular villains, namely imprudent bank lenders. However, banks are owned by taxpayers in some instances, while taxpayers could end up suffering the overall economic cost associated with a possible shock to the financial system via a loss of confidence. The merit of this argument is difficult, if not impossible, to assess in advance.

In the same vein, commentators such as Nobel prize-winning economist Paul Krugman, and former chief economist of the IMF Kenneth Rogoff, have recently urged the ECB to print money to generate more inflation. The effect of this would be to reduce the debt in real terms. Irish observers such as Constantin Gurdgiev and Michael Casey have also endorsed the idea. It is suggested that inflation be allowed to rise to, say, 5 to 6 per cent per annum but that, in order to prevent an inflationary spiral, wage growth be kept much below this figure.

Over the centuries governments have resorted to inflation as a way of solving their debt problem. But to put it bluntly, apart from the efficiency losses and adverse redistributive effects on the less well off, this amounts to robbing the taxpayer without bothering to go through the motions of raising taxes via the normal political process.

It almost goes without saying that Germany, the most anti-inflation hawk in Europe, would oppose it to the end. Moreover, the statutes of the ECB – designed at Germany’s insistence to avoid this – would most likely require modification.

In sum, all schemes apart from those seeking to wring more blood out of the debtor stone involve a taxpayer subsidy; some in a more transparent fashion than others. The debate on the merits of alternatives should address this aspect more directly. It should also give due consideration to side effects such as, in the case of haircuts, possible loss of financial confidence, or as regards inflation, the efficiency losses and social repercussions that could arise.

So far as the debate in Germany is concerned, two points seem to stand out to the outside observer. First, there is a reluctance to provide any “soft option” to a case such as Greece and a consequent desire by many to try to push the Greek authorities to the limit. Second, there is an emphasis on transparency and a strong reluctance to accept any tampering with the independence or inflation-fighting objectives of the ECB.

Whatever about the merits of the first aspect (which is ultimately a political and untestable issue since the “limit” is only identifiable, if crossed, in retrospect) they are right on the second. Indirect methods involving subterfuge, while they might have some short-term use, are no substitute for mechanisms which reflect political support from taxpayers. From this perspective, the direct use of the bailout fund seems the fairest and most sustainable way to proceed.


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