08 August 2023

Graham Bishop - Anthology of papers on Market Displine in EMU 1989/1993

My central point was that public debts denominated in a currency that a government could not order to be “printed” – the euro – had a fundamentally different credit quality than paper money that could be printed at will – in extremis. But this was an `inconvneient truth' at the time.

I have drawn together this anthology of my earlier works on the possible role of “market discipline” in ensuring financial stability in the Economic and Monetary Union (EMU). My first paper was published by Salomon Brothers in 1989 during the Maastricht Treaty negotiations and the final paper in the series was published in 1993.

That different quality should be reflected properly in the newly developed system of risk weigh􀆟ngs for banks holding public debt as a core asset. This argument was seen as an `inconvenient truth’ at the 􀆟me, and the Basel Commitee on Banking Standards (BCBS) con􀆟nues to obfuscate on this point - despite my submission to its consulta􀆟on in 2019.

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The European Union is engaged - yet again – in a debate about “fiscal rules” intended to prevent an unsustainable build-up of public debts that might threaten the integrity of the common currency – the euro. The debate seems to just be a con􀆟nua􀆟on of the arguments in the run-up to agreement on the Maastricht Treaty when the concept of “market discipline” was rejected in favour of “rules” to be enforced by finance ministers.
In the ensuing decades, ministers have never enforced these rules – un􀆟l the financial markets (ac􀆟ng as so-called `bond market vigilantes’ ) refused to fund what financial market par􀆟cipants regarded as unsustainable debts in several EU states. In response, Euro area states were forced to create the European Stability Mechanism (ESM) and the European Central Bank (ECB) had to create a series of new facili􀆟es that approached the very edge of Treaty prohibi􀆟ons on `bail outs’ and `monetary financing’.

Remarkably, the new proposals for fiscal rules target “net expenditure” that excludes debt interest on the basis that it is not directly controllable by the Member State. However, market analysts are perfectly capable of plugging in actual/feared interest rates into their models of public debts – just as they did in 2010/12 – and drawing unpleasant conclusions about sustainability as debts are rolled over at higher spreads. Such calcula􀆟ons will quickly re-awaken discussions of the `doom loop’ between the leading banks in a state holding excessive quan􀆟􀆟es of their home government’s then-unsustainable debts.

Italy’s blocking of revision to the ESM Treaty and Germany’s unwillingness to complete the European Deposit Insurance Scheme (EDIS) illustrate that risks to financial stability remain significant – if merely latent.

 

Full anthology

© Graham Bishop