03 January 2012

Charles Wyplosz: Happy 2012?

The crisis is, first and foremost, the result of policy mistakes. The authorities have never articulated a clear diagnosis. They cite a long list of woes. Some are correct but obvious, for example, the absence of fiscal discipline in the eurozone and the associated moral hazard inherent to rescues. Others are sideshows, for example, large current-account imbalances. Most are deeply misleading, for example, blaming financial market speculation and rating agencies pessimism or worrying about inflationary risks and about widening budget deficits. To round up this depressing list, some problems are conspicuously ignored or played down, for instance, the sorry state of commercial banks, the need for serious debt defaults, and the absence of growth prospects.

According to Wyplosz, the crisis will not stop until the following actions are taken:

1. Governments that lose market access must be bailed out in one way or another. For "effectiveness" and "moral hazard" reasons, the bailout should not be complete; instead it should encourage debt restructuring.
   1. "Effectiveness", because countries with large public debts are unlikely to grow and, therefore, unlikely to be able to run down their debt to GDP ratio.
   2. "Moral hazard", because defaults simultaneously reduce the debt burden and give incentives to governments to do what it takes to recover market access. Defaults would also help with another moral hazard, this time borne out of investors’ beliefs that Eurozone governments never default (investors have been receiving large yields since the start of the crisis).
2. The bailout must be carried out by the ECB because the required amounts are unknown and could be very large. The total value of eurozone public debts is about €9,000 billion. The European Financial Stability Facility (EFSF) can mobilise, at most, €200 billion, and the IMF can be expected to put up a similar amount. “Friends” such as China will not add that much. Only the ECB can mobilise any amount of money as it becomes needed.
3. Banks must be recapitalised, if possible before some sovereigns default. The amounts needed are not based on the previous crisis – the consequence of the subprime disaster – but on the future crisis once defaults occur. If the banks cannot raise sufficient capital, the EFSF can provide the funds.
4. Addressing moral hazard requires the firm establishment of fiscal discipline throughout the Eurozone – and quickly. The treaty route is unlikely to lead anywhere.

Alternative to a new treaty: ‘Fiscal Discipline Board’ and ECB collateral rules

The current proposal for a new treaty that would allow suspension of sovereignty is extraordinarily intrusive. The proposal is for some European authority (the Commission? Or some other body?) to take over fiscal policy in a country that runs afoul of the Stability and Growth Pact. The idea that a country loses fiscal policy sovereignty is inspired by IMF programmes. These programmes, however, are never imposed from outside. Countries apply to the IMF, on their own, and they negotiate conditions. This makes a huge difference.

A much better arrangement is possible without a new treaty. Currently, in its routine refinancing operation, the ECB accepts as collateral a wide range of assets. Most central banks accept only – or mainly – treasury bonds. The unusual arrangement of the Eurozone is an artefact of history – because practices differed considerably among future Eurozone countries, the ECB decided to accept every asset that was previously accepted. The ECB has the authority to decide what collateral it accepts and it could decide to only accept treasury bonds issued by governments that exercise fiscal discipline. It would work as follows.

The ECB would ask an independent body to examine the fiscal policy framework of each member country. The body, call it the Fiscal Discipline Board, would look for arrangements that adequately constrain member governments, for example the German debt brake or the Dutch coalition agreements. The ECB would bind itself to follow the Board’s judgment. A country that has not adopted arrangements deemed adequate, or that does not abide by its own arrangements, would face the consequences: high borrowing costs, possibly loss of market access. The presumption is that the situation would be promptly corrected.

Details need to be worked out: Who would appoint the Fiscal Discipline Board? What means would the board have? Would there be a possibility of appeal? These are fairly simple issues, much simpler that the new treaty proposal. The key point is that this procedure does not call for a treaty, it does not tread upon sovereignty (fiscal discipline arrangements are left to each country, there is no threat of outside intervention or fine) and it should reassure the ECB, which is currently rightly concerned by moral hazard. By relying on an independent Board, the ECB would not have to pass judgement that can be construed as political. It would also reassert its independence, as it can decide on its own to adopt such an arrangement.

Moreover, all this can be done virtually overnight.

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