The present Eurozone (EZ) crisis is usually seen as a sovereign debt crisis where highly indebted EZ governments are faced – as clients – by financial markets, including rating agencies. The potential solutions presented usually see the financial markets as the dominant actors, dictating the terms and conditions sovereigns have to meet in order to obtain financing at acceptable conditions. Consequently, in recent months we have seen both required returns on sovereign bonds skyrocket, especially, but not only for peripheral EZ countries, and sovereign debt of many EZ countries downgraded by rating agencies. The consequence of this is that private investors are warned that sovereign debt has become more risky and thus require even higher interest rates – a vicious circle.
The theory behind all this is that financial markets are efficient, i.e. that they direct capital to its most efficient use. Recent experience, however, has thrown severe doubts on this hypothesis: bond yields for all Eurozone countries between 1999 (when the Euro came into being) and 2007 were very close to German Bunds; now, suddenly, at Christmas 2011, for 10 year loans Greece has to pay a staggering 25.5%, Italy 6.8%, Spain 5.3%, Ireland 8.5%, Austria 3.0%, and Germany 1.9%. While UK and US debt ratios are significantly higher than those of the EZ (100% and 120% vs. 80%), they pay much less than the EZ, similar rates as Germany. While it is clear that Greece has a real debt problem, the assessments of the other countries seem unwarranted. Certainly, this relatively sudden change in risk assessment does not inspire confidence in the rationality of financial markets. This skepticism is reinforced by the fact that a large part of the bemoaned debt level of the EZ countries (around 30 pp) stems from the fact that after the 2008 crisis governments bailed their ailing banks with large sums of public (taxpayer) money: and now this is suddenly seen by the FM as a significant risk factor, to be punished by prohibitively high interest rates charged to the same sovereigns. In what kind of world are we living? Do we really need to let ourselves be dominated (and possibly ruined) by self-serving financial markets, which, moreover, have recently sold massive sovereign bond stocks to the European Central Bank?
Let me say clearly that I do consider a need to bring down sovereign debt levels. Altogether, EZ governments owe around 10500 billion Euro, i.e. 85% of combined GDP, clearly an unsustainable level. The large debt service requirements for public budgets crowd out socially positive and productive government expenditures. They also have a negative distributional effect , transferring income from general tax payers to national or international bondholders.
This note, however, is concerned with the financing mechanisms for government debt. Recent experienced shows that financing via private financial markets has not worked and subjects governments to large, irrational swings in the interest rates they have to pay. I consider the present Eurozone crisis to be of a “virtual” nature, caused by irrational financial markets, acting in their own interest and to the detriment of the total economy. (This excludes the policy and reporting faults that Greece has made and, to some extent, the policy failures of e.g. Spain and Ireland which caused massive housing bubbles in their countries.)
Governments, just like private enterprise, need stable framework conditions, in order to go about their important business. Their responsibility is the wellbeing of their populations. Thus, given high debt levels and given further needs to finance deficits in the future (albeit diminishing ones), ways need to be found to provide governments with stable medium-term financing conditions for their public tasks. The major financing source is a government’s taxation system. Many proposals have been made to make taxation systems more growth-friendly, more employment-friendly, more environment-friendly, and fairer. These reforms are not the topic of this note.
If in addition to taxation, external financing is required, both in order to finance new tasks, but also in order to re-finance existing debt, problems arise. As stated above, private bond markets have behaved irrationally, both with respect to the level of interest rates charged recently and their very high volatility. The latter stems from secondary trading of government bonds, which has become a large business and a profit center for private traders. This trading, like that of any other financial product, is enhanced and multiplied by modern communication technology: as long as bond trading required slips of paper being transferred from seller to buyer, trade was slow. Today, trades take only milli-seconds, computer programs trade automatically when they see the minutest arbitrage possibilities. So, one important improvement in the interest of governments could be to outlaw secondary trading of sovereign bonds. While in this model sovereign financing would still be done by private markets, they would distribute the bonds, pass them on to investors or keep them in their own portfolio, but basically keep them until maturity. Of course, for the individual bondholder, it would still be possible to sell her bonds before maturity (e.g. for a large purchase) to her bank, but the price would be determined not by rating agencies, but by a daily quote either by the ECB, the OECD or the IMF, i.e. a public institution. One alternative could be that all sovereign bonds are deposited not with private banks, but with the ECB or a European Monetary Fund (e.g. the European Stability Mechanism), such they cannot be traded. In this way sovereign bond yields would be relatively stable and change only when “real” changes in government policy occur, as assessed by an international public institution.
A further-going step would be to keep sovereign finance in private hands, but have all EZ governments guarantee each EZ country’s bonds. These are the so-called Eurobonds. Such guarantee would create a much more liquid bond market, because it would effectively pool all 17 countries´ bond issues. The fears spread in Germany, Austria and other surplus countries, that this would mean that the future Eurobond yields would be above their present yields, seem exaggerated. The empirical counter-example is the introduction of the Euro, when the very high yields for e.g. Greece, Italy and Portugal in a very short time came nearly down to German levels. Thus, interest rates then did not converge to the arithmetic (or any other) mean, but rather came down for everybody, without raising those of Germany. The same might happen with the introduction of Eurobonds.
There are not completely unfounded fears that the introduction of Eurobonds would create “moral hazard” for the peripheral countries, i.e. induce them toward profligacy in government spending, “because their interest rates are low, anyway”. This danger could be mitigated, by either the proposal made by the Bruegel Institute, i.e. that Eurobonds would only cover up to 60% of each government’s debt level, and that higher debt would have to be financed individually, at individual “market” rates; or, alternatively, by the proposal of the German Sachverstaendigenrat, which essentially goes to obverse way and would issue Eurobonds for the values above 60%, and leave the large “base effect” o the individual country to find finance for. Such Eurobonds could be issued by a new EZ fiscal authority (which is in the process of being created) where each government puts in its demand for bond finance and where the eligibility for Eurobond issue would be assessed by this authority.
A general decision would have to be made, whether to apply Eurobond financing only to future debt, both new and refinancing needs, or also to the existing stocks of debt.
A third, and the most radical, proposal would eliminate the private markets from government finance altogether and put this into the hands of an accountable, democratically legitimized public institution. The most natural candidate for this would be the European Central Bank, which is a public institution charged with maintaining price stability and stability of the financial system of the Eurozone. Its mandate would need to be amended and widened, if it were to issue government bonds for member countries. This model would also obviate the rule in the Maastricht Treaty, forbidding “monetary financing” of government activity. It has been argued that this – rather unusual – rule was imposed on the Eurozone countries by private financial sector lobbying, which wanted to keep the lucrative and purportedly risk-free business of government finance in private hands. Turning this large business segment over to a public institution would deprive private banks of a risk-free asset for their balance sheet, but also of the profits made from this business of issuing, distributing and trading these assets.
It can be convincingly argued that the public interest in stable and sustainable finance of public tasks is more important than the profit motive of private financial market actors. In the above way, the ECB would become a true “lender of last resort” for sovereigns, a role it has so far accepted only for private banks.
The price of these government bonds issued by the EBC could be set by the ECB itself, or by other public sector institutions, like the OECD, or the IMF who routinely assess economic policies of their member states. In this way, the purported influence of private rating agencies for government finance would be eliminated – and with it “event-driven” assessments which put more emphasis on visible events than on the underlying benefits and problems with government policies.
If the ECB became the sole issuer of government bonds, it would receive existing government assets as collateral, in addition to claims on the future taxing power of the governments. These assessments would be part of the price-setting mechanism of sovereign bonds. In this way, the ECB could also impose conditionality on the respective governments, in consensus with the fiscal authority.
If the ECB were given such an important additional role – additional to its present mandate – ways would need to be found to make the ECB democratically accountable, preferably to the European Parliament. The ECB president should be required to appear before the Parliamentary Monetary committee once every quarter, not only to give her assessment of the state of the EZ economy, but also to lay out her plans for the ECB in the future. It might also be considered to give the European Parliament a larger role in the selection of the ECB president.
Private financial markets have utterly failed to provide stable financing to sovereign governments at sustainable and acceptable levels. This has severely impaired the functioning of sovereign states, and their required response to the Eurozone debt crisis has endangered the recovery from the deep crisis. Moreover, financial market mis-assessments have created a second wave of recession by becoming hysterical about the sovereign debt problem, thus even threatening the viability of the Eurozone. Another of the absurd reactions of the EZ banks is their refusal to participate in a Greek debt restructuring. They were so successful in their threat to stop financing of all of Eurozone debt that EZ heads of state at their meeting of December 8 revoked their earlier request for a 50% “haircut”, i.e. write-down of Greek sovereign debt by banks holding these assets. It is a strange market which only participates in the upside movements, i.e. profits, but does not accept risks, and thus losses. In the meantime, banks have shed these bonds and sold them to the ECB and EFSF.
Eurozone banks are at a significant crossroads: They need to increase their equity ratios (mostly to 9% of balance sheet) at the request of financial supervisors (Basel 3). Many of them say they might need additional public money, in order to achieve this, even though nobody wants to be the first to be seen as requiring assistance. European Banking Authority assessment is around 250 billion E in required equity. At the same time, EZ banks deposit daily around 400 billion € in the ECB at interest rates of 0.5%, instead of lending them. If this cash flow exists and exceeds the required recapitalization needs, why does the EBA (or the ECB) not force the EZ banks to turn this cash flow into reserves and into equity and thus meet the recapitalization requirements which are supposed to shield banks in the future of similar crises as the most recent one?
It looks as if the combined EZ banks are just trying their luck: they want the sovereign bond business, but without risk; they ask unsustainably high interest rates from peripheral EZ countries, thereby ruining these countries’ chances to recover from the crisis: maybe the banks just jack up yields, in order to force governments once more to introduce Eurobonds, thus further reducing their risks, without taking the business away from banks; they deposit twice as much money daily in low-yielding ECB instruments than they would need to fulfill recapitalization ratios, and, and, and…..
It is high time to call their bluff and show them that “business as usual”, i.e. like before the 2008 crisis, is no longer possible. We need to go back to have banks being the servants of the real economy, not its masters. We need to take the highly responsible business of government financing away from highly irresponsible private financial markets, such that governments can go about their important business of safeguarding the wellbeing of their citizens. The private financial markets will never be able to do that. This task is not in their terms of reference.