Response to 'Time to jettison the plans to hit Greek creditors'

In his Financial Times column, ECB council member Athanasios Orphanides proposes that the way to restore investor trust and confidence in Eurozone sovereign debt and lower the cost to all issuers is to protect private investors from losses on this debt.

This proposal is in stark contrast to the blueprint for saving the financial system which says that private investors, in particular banks, should recognize the losses on the Eurozone sovereign debt to protect the real economy from the excesses in the financial system.

The rest of this post will look at Mr. Orphanides' proposal and highlight the differences between it and the blueprint.

Government debt markets are about trust.

All capital markets are about trust.  Specifically, they are about trust based on disclosure of all the useful, relevant information in an appropriate, timely manner so that buyers can know what they are buying.

The blueprint focuses on eliminating opacity in the financial markets and restoring trust.

Before the crisis, all eurozone governments enjoyed the benefit of their collective trustworthiness, co-operation and solidarity in the form of favourable financing conditions that contributed to the wellbeing of Europe.  

Investor trust in the eurozone has been badly shaken in the past two years..... 

Following Greece, a number of member states faced difficulties refinancing their debts or lost access to markets altogether, despite the implementation of unprecedented fiscal programmes. 

What caused this dramatic erosion of confidence? Was it the result of fiscal profligacy, such as that revealed in Greece, that marked the start of the slide? Was it the loss of competitiveness? Or current account imbalances? Without doubt, all these were contributing factors. 

But the contagion that has spread to so many eurozone member states points to a broader problem: the incomplete design of the euro area – lax monitoring, inadequate enforcement of the rules and non-existence of a crisis management framework. 

It also points to the collective failure of eurozone decision-makers to tackle this problem effectively – a failure that has been marked by a sequence of EU summits and aborted plans that have convinced some that a solution is beyond reach.

While Mr. Orphanides provides a very comprehensive list, it misses the elephant in the room:  the solvency crisis that began on August 9, 2007.

It was the decision by Eurozone policymakers to protect their financial system from any losses that transformed a bank solvency crisis into a sovereign debt crisis.

It was the subsequent adoption of austerity policies that exacerbated the sovereign debt crisis.

The blueprint explicitly says that reversing the decision to protect banks from losses is unambiguously good for the real economy and for sovereign solvency (I admit that reversing this decision is unambiguously bad for banker bonuses for at least a generation).

Two related decisions proved costly for the eurozone. First, following the summit in Deauville in October 2010, European leaders agreed to introduce a novel element in eurozone sovereign markets: the imposition of losses on creditors whenever a member state faced liquidity concerns. 

The message to potential creditors was clear: eurozone sovereign debt should no longer be considered a safe asset with the implicit promise that it would be repaid in full. 

Private sector involvement (PSI) was the new doctrine.

Actually, the novel element was the decision in 2009 not to allow banks to incur losses, but rather to try to bail them out of their losses.

The decision in 2010 was a restatement of the way that financial markets functioned prior to the bank bailout decision.  Investors are responsible for all gains and losses on their investments.

Second, at the EU summits in July and October, European leaders decided to force losses on holders of Greek debt. The Greek PSI reinforced the idea that holders of eurozone sovereigns should be prepared to incur losses even under circumstances that would not necessarily trigger comparable losses for sovereigns outside the eurozone. 

The decisions that raised the cost of financing in the eurozone by introducing additional risk on private investors were not without a useful purpose. 

The PSI risk raised (disproportionately) the cost of financing of member states with larger projected levels of debt. Thus, it would serve as a disincentive to fiscal profligacy, thereby guarding against moral hazard and reducing the risk of future crises. Adding PSI risk could improve governance.

I refer to this as market discipline.

Unsurprisingly, as investors digested the implications of the two decisions they increasingly fled eurozone sovereign markets. The resulting contagion was evident in the deterioration of borrowing conditions for other eurozone member states after October 18 2010, July 21 2011 and October 26 2011....

Is it possible that the on-going deterioration of the Eurozone economy in the peripheral countries as they implemented austerity policies played any role?  Is it possible that the economic performance made it doubtful that the peripheral countries could perform on their sovereign debt?

As the existential threat to the eurozone became clearer, EU leaders changed tack. On December 9 a change in doctrine reversing the Deauville PSI innovation was announced. In future, the eurozone would adhere to International Monetary Fund principles. Leaders also agreed on a new “fiscal compact” to enhance governance. 

Unfortunately, despite reversing the Deauville PSI innovation, investor trust has not been regained. A reason cited for this is that the December decision did not reverse the haircut on Greek debt....

Reaffirmation of the policy that banks should never have to recognize a loss does nothing to address trust.  Trust is a function of disclosure.

Consistent with IMF principles, one of the reasons for imposing the Greek PSI was to reduce the interest burden on the Greek government. 

But a serious limitation of their application in the eurozone is that the IMF principles examine a member state in isolation, ignoring contagion effects on other states.

If there were disclosure as proposed under the blueprint, contagion effects go away as all market participants adjust their exposure to what they can afford to lose based on the risk of the counter-party.

Reversing the Greek PSI decision would also raise the financing cost on the Greek government, but by restoring trust in the eurozone it would reduce the financing cost of other eurozone governments. Reversing the Greek PSI would benefit the eurozone as a whole. 

A 30-year low interest-rate loan to Greece could accompany the reversal of PSI to keep the financing cost on the Greek government as low as is presently contemplated. 

Mr. Orphanides has proposed a method for defeasing the Greek debt.

The key is to restore trust.