By David Apgar, co-founder of GoalScreen, a web app still in trials that lets investors test alternative price drivers of specific securities (free though the end of the year at www.goalscreen.com. He has been a manager at the Corporate Executive Board, McKinsey, the Office of the Comptroller of the Currency, and Lehman, and writes at www.goalscreen.com/blog.
What if there are good reasons for the preternatural calm of German Chancellor Merkel’s inner circle as the English-language media (based, after all, in the investor capitals of London and New York) light their collective hair on fire about the euro’s imminent immolation? Surprisingly, you can make a decent argument that the euro zone is at no risk of breakup – unless someone secretly switches its purpose from facilitating European trade to providing investors an implicit guarantee against losses.
The working assumption is that German calm reflects a pious belief in the power of crises to sober up borrowing governments and motivate a little austerity. It was on display Tuesday night at the French Embassy when luminaries as diverse as former ambassador Jean-David Levitte, former UNDP head Kemal Derviş, and former Treasury secretary Larry Summers all quickly agreed on it.
Suppose, however, the feasibility of Mediterranean austerity – austerity at a scale big enough to impress the bond markets – is not what Merkel’s team is counting on. Suppose instead the Germans are really counting on the feasibility of a series of orderly partial defaults.
Not that Merkel thinks austerity is a bad thing. She wants EU treaty changes like the 2%-of-GDP borrowing limit that European Central Bank (ECB) President Draghi hinted today might tempt him to buy more government bonds. But how much stock can she possibly put in a treaty change after her predecessor busted the current 3% limit every year he was in office from 2002 to 2005? (Merkel has busted it only twice – so far.)
There are limits to how good a thing austerity is and German history of the last, say, 80 years provides several arresting examples of them. The big unasked question is not whether austerity might be tolerable but whether defaults would be as intolerable as the bond media insist. Here’s why Merkel’s team could have quietly concluded that the costs of a series of partial defaults are unavoidable even without any defaults, that some of those supposed costs may in fact be disguised benefits, and that the alternatives to selective debt relief are probably unsustainable.
As far as costs go, massive European bank restructuring comes to mind, especially following a cool €300 billion or so of losses on government bond holdings. It’s hard to say anything nice about bank restructuring, but at least we know how to do it. We know, for example, how to split good banks from bad banks. (Hint: rank balance sheet assets by quality and liabilities by seniority and draw a line across the balance sheet after the last asset of reasonably determinate value.) That’s handy when you need banks with systems in place ready to restart lending. And we know these transactions work when free from political interference as they were in Sweden in 1992. We also have institutions like the ECB ready to fix broken banks – unlike broken governments.
Less widely discussed, massive European bank restructuring may be unavoidable even if Europe somehow enlisted enough ECB printing presses, enough future earnings of all those carefree northern European taxpayers, and enough future benefits of all those docile southerners to plaster a smile on the face of every bond portfolio manager at BNP Paribas and Commerzbank. The scale of the bailout needed to avoid further investor losses as of today – much less tomorrow or next week – would entail cross-border consolidation or de facto nationalization of a significant portion of the euro banking sector.
In one way, a bailout followed by cross-border consolidation and a lot of de facto nationalization could be worse than explicit restructuring. The bailout would cut interest rates on euro government debt enough that banks could keep a lot of it on their books at par. But that would delay recognition of true credit impairments. Delayed recognition of losses has not worked so well for Japan over the past two decades. An unflinching restructuring of banks with big losses on their books has the benefit of at least trying a different approach.
How about the dark threat of a loss of access to the bond market that hangs over every idle head contemplating partial default? For three years from 1986 to 1989 countless financial CEOs, spokespersons, commentators, regulators, lobbyists, journalists, consultants, and hacks warned Mexico would never sell another bond in our natural lives if anything like the structured default of the Brady bond were to occur. Once it occurred, Mexico was back in the market within about nine months.
Argentina’s (latest) default, by contrast, was a mess. But that’s the point. The markets readily distinguish defaults that are alternatives to large-scale riots from defaults reflecting political cynicism. It’s the market’s appraisal of the quality of its politics, not its macroeconomics, that accounts for the harsh treatment of Italy’s debt even as most financial analysts argued Spain was in worse shape.
Won’t unemployment be high in countries that restructure? Yes, rather like unemployment in countries that do not. With its own central bank, a country such as Italy could devalue its currency to soften the impact of austerity on jobs but austerity is what we’re questioning. It’s hard to find costs of partial defaults that aren’t also costs of pretending every euro government but Greece can pay par.
As serious as these costs are, moreover, none forces a breakup of the euro – not even the circumstances of hapless Greece, with its 50% debt-relief package. Countries can run distinct interest rates, inflation, budget policy, and growth rates within a currency union just as easily as US states can within the dollar zone. And investors can and probably do understand the distinctive risks those countries pose just as clearly as they understand the credit differences among the 50 states. Germany has good reason to protect the euro – but it may also have good reason to think it’s not under threat.
The alternatives to partial defaults by countries that can’t afford to pay rising interest rates, furthermore, may be unsustainable. The most popular alternative has the ECB stepping in to buy bonds every time investors try to cut their exposure. At first blush, it looks clean – no forced austerity, no messy investor losses and bank restructurings, no burden on taxpayers in creditor countries like Germany. The only problem is that it would be inflationary.
And that inflation turns out to be quite a problem. With such ECB generosity on offer – and with euro zone inflation looming – why would any bond trader with a pulse stop after dumping her Greek, Portuguese, Irish, Italian, and Spanish exposure? Why not get rid of the French and German paper in the vaults, as well? Get rid of it all. Well, maybe not the Estonian bonds. But the ECB would be buried.
If turning the ECB into a purchaser of last (and first) resort is not the fix it seems, how about replacing today’s dubious debt guaranteed only by issuing governments with euro bonds jointly guaranteed by, well, Germans? Surely this would have the enormous benefit of pacifying the markets and so at least take the past year’s panics out of the picture.
Euro bonds are such a good idea, in fact, that it’s hard to understand why US state and local governments, with their longer history of crises in a currency union, haven’t got around to using it. The image of a Texas legislator explaining an upcoming state tax hike at the barbecue to pay for the latest California bond issue does, however, help clarify the problem. Any promise by California not to borrow too much that would calm down our Texas legislator’s constituents around the grill would be enough to pacify California bond investors without a guarantee. Joint euro zone guarantees ultimately accomplish nothing more than the fiscal promises of individual euro zone states can accomplish without them.
Ironically, the ECB purchaser-of-last-resort and eurobond alternatives probably would break up the euro zone. The inflationary strains of the former, and the accountability problems of the latter, would never survive the next referendum in a euro zone state. The purpose of the euro is to facilitate trade and commerce – not facilitate government borrowing.
This, then, is the impasse euro zone bond investors have reached. To avoid losses, they clamor for alternatives that could disrupt the currency itself – one of the few things that might actually make them worse off in real terms than they are right now. A brave debtor country or two, backed against the wall, could save them from themselves. As Norman Bailey memorably said of the debt crisis of the 1980s, though, the bankers have no brains and the debtors have no balls.