Monday, December 5, 2011

The solution for the Eurozone debt crisis is simple

There was some excitement today over the announcement that Merkel and Sarkozy have decided that the European Union treaty needs to be rewritten to include sanctions on countries that exceed the 3% debt/GDP limit that they all agreed to way back when the EU was first established.

The problem with this "solution" is that the mechanism for enforcing sanctions is a deeply flawed concept. The best, and probably the only way to impose real sanctions on governments who spend and borrow too much is to let the market do it. When the yield on your bonds starts to skyrocket, you quickly realize that you can't continue to borrow. You either mend your ways and borrow less, and/or figure out how to grow more, or you default on your debt obligations. And even if you default, you will find it very difficult—if not impossible—to continue to be profligate. That's the way it has always worked in the bond market. It's quite simple: if lenders don't think you can repay your debts, they won't lend you any more money.

A market-based solution doesn't need any agreements or rewritten treaties. It also has the virtue of essentially eliminating moral hazard, since lenders would have a powerful incentive to do their due diligence every time they buy a bond, instead of simply relying on what ratings agencies are saying, or betting that they will be bailed out by taxpayers or other countries if things turn sour. A true market-based solution would even make the ratings agencies obsolete. No serious investor would ever base his decisions on what a ratings agency says anyway; the only purpose that ratings serve in today's world is to facilitate the ability of bureaucrats and technocrats to decide, for example, which assets qualify as Tier 1 capital for banks, effectively overriding the investment decisions of the private sector and thus providing fertile ground for moral hazard.

The only reason that no one is talking about a simple, proven, market-based approach to solving the Eurozone sovereign debt problem is that politicians (urged on no doubt by their investment banking constituents) fear that highly indebted Eurozone countries are more likely to default (i.e., to act irresponsibly) than they are to cut spending, and that this, in turn, puts Eurozone banks (who hold tons of Eurozone sovereign debt) at risk, and that this, in turn, puts the very viability of the Euro and the Eurozone economies at risk. Politicians love to think this way, because it makes them indispensable. The truth, however, is that when politicians step into the fray to fix things, they almost always make the situation worse.

Eurozone countries may indeed default, and defaults may be large enough to bring down the Eurozone banking system, but a collapse of the Eurozone economies is not necessarily the only way this can play out. Defaults happen all the time. Banks fail all the time. Defaults don't destroy currencies, they just destroy the value of debt issued in that currency. Defaults don't destroy wealth, since they are just the accountant's way of recognizing economic realities. Defaults don't destroy demand either, since debt is a zero-sum game: one man's liability is another man's asset. The value of global financial assets fluctuates by trillions of dollars every day and yet economic life goes on. There is a virtually unlimited supply of capital in the world ready to fund profitable new ventures and/or to recapitalize failed banks. Truth be told, the market has already wiped out almost 80% of the market cap of Eurozone financial institutions in the past four years, yet the Eurozone economies continue to function as always.

Will the politicians please stop trying to "fix" this Eurozone debt problem? A trillion or two of defaults might end up doing us all a world of good.

16 comments:

狂猪 said...

Market based solution is fundamentally pro-cyclical. In good times, the market is happy to chase yield and drive down price. There by encouraging debtors to take on more debt. In bad time, the market abandons all hope and freezes credit when the world needs credit the most.

In theory and in practice, market based solution had never worked in *extreme* situations.

Unless, you argue that the length of time is irrelevant. In that case, time does heal all wound. I would credit time for that and not market.

William said...

It makes sense up to a point. That point being the great unknowns of various derivatives: debt default swaps, CDOs, etc. - none of which I understand.

Whose going to be the AIGs (bag-holders) this time? Does the world just set back and let this problem play out to the very end - even if it means bringing down multiple financial corporations around the world??

It's ironic that markets have become so complex, interconnected and opague that the fear of the great unknowns protects the institutions which play in them.

RichmondG30 said...

The bigger issue here is that these politicians are doing all they can to save the European Socialized Cradle-to-Grave Welfare State, or at least bring it in for a softer landing.

What would Greece or Spain do if overnight, their access to credit disappeared? They have made promises to generations of citizens that they will not be able to keep. Pension checks will completely dry up or be severely cut back. If you think the social unrest to this point has been bad, just wait until the government sugar daddy runs out of money. Yikes.

Benjamin said...

The big mistake was for any sovereign nation to give up its currency printing press.

Sovereign debt is gilt, if they have the power of the press. You will get paid off, perhaps in inflated money, but there is no default.

Without that, now yields are skyrocketing on Greece, Italy etc.

Japan was way more over-indebted than these Euro nations. No default talk there. Japan has its printing presses.

I wish government would run balanced budgets---we forget even in good times (2000-2008) we ran huge deficits in the USA, with a GOP House, Senate and President for most of the time. Now we lecture Europe.

That said, I wish we could balance our budget, and follow a very stimulative monetary policy.

The worst policy is tight money. Then you get collapse.

狂猪 said...

As pointed out by previous commenter and to add to my list of prerequisites mentioned earlier, a market based approach has one more prerequisite.

A market based approach also require the degree of human suffering be irrelevant. This is because we have to ignore the extreme suffering market force can cause in society.

In my opinion, this requirement makes the approach immoral.

Scott Grannis said...

狂猪: Those who bought the PIIGS debt knew they were acquiring a less-than-risk-free asset. To make anyone else shoulder the burden of losses on those assets is immoral. At the same time, those who retired very early with exceptionally rich pension benefits granted by unaccountable politicians will inevitably have to get by with less than they expected.

It is still possible, however, to find a growth solution for the PIIGS's problems: radically slow the growth in government outlays, reduce regulatory burdens, eliminate tax loopholes and deductions, and cut and flatten tax rates. This would lead to genuine growth and immediately make all current debt obligations payable.

Public Library said...
This comment has been removed by the author.
Public Library said...

This was your most libertarian economic post in the last 2+ years. Glad to finally read it.

"Capitalism without bankruptcy is like Catholicism without hell"

It simply does not work but the powers that be (Bernanke the ring leader) are trying like hell to make it so.

This flows neatly into why we do not need a Central Bank. The market would set the price of money accordingly...

狂猪 said...

Scott,

"To make anyone else shoulder the burden of losses on those assets is immoral."

Are you suggesting that the market approach will not lead to this result?

In the last three years, the evidence is abundently clear that everyone is punished by market forces regardless of their involvement.

Furthermore, the world is too complex to neatly separate everyone into two camps, the innocent vs. the guilty. For example, during the good years, many workers in Germany disproportionally benefited because of their country's export oriented growth policies. Furthermore, the southern Europe's high consumption suppressed the euro exchange rate to the benefit of the north's exports. Lastly, it is the northern Europeans (northern savers) lending to the southern Europeans which encouraged the over consumption in the south.

In these context, can it really be argued that a worker in German should not help their counter part in Greece?

Scott, on your suggestion of lower government spending, why do you steadfastly refused to incorporate business cycle into the approach? In theory, a strictly balance budget approach is not optimal for society because it is procyclical. It makes things worse during both the good time and the bad time.

brodero said...

"A trillion or two of defaults might end up doing us all a world of good."

If this occurs...the initial market reaction will be??? And
what sort of government would emerge out of such a event??
( I seriously doubt democratic)

Frozen in the North said...

Scott:

There are no easy solutions in Europe, and the German and French had nothing new to offer yesterday. every solution being contemplated involves no pain for the Europe's rich countries (and banks), its wishful thinking.

BTW for those who think that the problem is Socialism cradle to grave its worth nothing that some of the more "socialist" countries in Europe are actually doing fine!

The big day is now only 3 days away (December 9th) -- prepare to be underwhelmed!

Finally Scott, the problem in Greece is certainly regulatory, but its also that the Greeks simply don't pay their taxes -- if anything strict enforcement (as the Germans want) will dramatically slow the economy.

The last problem is that Europe is a large, but closed economy... there are no "export markets" available anywhere (not China, or America). The only solution when countries are insolvent (Greece, Portugal and Ireland) is write-offs! the impact on European financial institutions (high leverage) and pension funds (large sovereign debt holders) is certain to be horrible -- expect social breakdown (you know, the reason Republicans buy guns...)

Dr William J McKibbin said...

"Will the politicians please stop trying to "fix" this Eurozone debt problem? A trillion or two of defaults might end up doing us all a world of good." Yes, the default option is simple and efficient. Then, there's the austerity option, which is unlikely to pass over the bar of public rejection. Finally, there's the monetary ezpansion option, which requires only that the central banks "print" money without any public mandate. Historicall, the monetary expansion option is what always happens. However, the default option is truly the most economically efficient way forward...

Dr William J McKibbin said...

PS: A discussion about polemics versus pragmatism is urgently needed in macroeconomics, today...

burmanhands said...

When I came to live in Ireland 8 years ago, there was money to burn. When I asked the source of this wealth - nobody seemed to know.
After all, Ireland had been one of the poorest countries in Europe. Only an uneducated man suggested it was that "Germans knew how to save and Irish knew how to spend". It only became apparent in 2009 how true this was.
What goes around comes around.

Benjamin said...

BTW, Perry at Carpe Diem has chart today that housing affordability is at all-time high.

Is this what anyone expected when people were fretting about "hyper-inflation?"

Obviously, we are in a period of very low inflation, or even deflation (if you are buying a home today, you are seeing deflation).

The inflation-scare was always based on misconceptions, and still is.

Jim said...

William:

Default is always the best option to clean the slate. Problem is that the contagion is worrying Geitner and Europe because of the financial industry and especially the already underfunded pension funds.

The dancing that is going on is a complete joke, but what do you expect?