Graham Bishop, 1 December 2010

 

Ireland’s economic misfortunes have now precipitated far-reaching changes that must cause a major re-think of many core elements of the EU’s regulatory framework for eurozone members. The driving force is the belated recognition by eurozone political leaders that the nature of their debts was fundamentally altered when they gave up the power to print money to repay such debts. Given the huge scale of public debts – tripled as a percentage of GDP in the past four decades - markets are now posing an even more fundamental question: Will political leaders countenance an even higher degree of solidarity than they agreed as recently as May?

 

Recognition of the change in the nature of the debts must surely flow through into the details of technical regulations, but it also highlights an historic political development because the interests of eurozone members increasingly diverge from those of non-members. For eurozone members, phrases such as “shall regard their economic policies as a matter of common concern” (Lisbon Treaty, Art 121) have suddenly stopped being innocuous words in a Treaty that few citizens ever read. Instead, they have been transformed into a political reality that has the power to eject governments as electors are forced to confront the practical results.

It is now clear that the scale of the crisis has moved beyond denigrating “speculators”. Conservative, risk-averse investors are now contemplating the implications - formally and suddenly – of unleashing default risk in government debt. What can Governments now say to a pension fund holding a government bond approaching maturity when it asks: why should our pensioners re-invest their life savings in a bond from a state that has deep-rooted problems that could lead to default? Consider the treasurer of a conservative bank that will be obliged by Basel III to hold a portfolio of government bonds where some could conceivably take a haircut that is likely to exceed the bank’s capital buffer, thus ruining the bank?
 

If the answer to such questions is increasingly that conservative investors decide to take any repayments of principal and invest the proceeds in a safer state, then a full-scale “run” on much sovereign debt is already underway.

“Europe” changed during the weekend of 9 May 2010. By chance, that was the 60^th anniversary of the Schuman Declaration that paved the way for the post-War reconciliation between France and Germany: "Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity. The coming together of the nations of Europe requires the elimination of the age-old opposition of France and Germany...." The single market, and the euro itself, are powerful illustrations of those concrete achievements that have led on to the current solidarity. So any unravelling of the achievements would strike at the core of the whole concept of the European Union.

 

That was the fear that drove EU leaders in May to accept far-reaching changes to economic governance, and especially for eurozone members. In September, the European Commission fleshed out the concepts with a package of six detailed proposals that “will integrate all revised and new surveillance processes into a comprehensive and effective economic policy framework.” It included “A regulation on the effective enforcement of budgetary surveillance in the euro area”, and many provisions of the proposals apply to eurozone members only. Indeed, voting on sanctions will be restricted to such members.

 

In the context of the EU’s normal decision-making process, these evolutionary steps are both radical and extraordinarily rapid. But if a genuine “run” out of government debt is indeed developing, then revolutionary change may be close at hand.

 

At the technical level, the separation between the eurozone and “other EU members” surfaced even more pointedly in the 28 November Irish agreements. The Eurogroup, rather than ECOFIN, announced that “Rules will be adapted…to send a clear signal to private creditors that their claims are subordinated to those of the official sector…” Moreover, “Eurogroup Ministers will make a unanimous decision on providing assistance.” They also decided that identical collective actions clauses (CAC) will be included in “all new euro area government bonds starting in June 2013” to enable creditors to accept a legally binding change in terms – including haircuts.

 

So the Eurogroup has concluded that its members may get into a situation where they do not pay the interest and principal on their loans in a timely fashion – thus accepting that a credit risk can crystallise. Moreover President van Rompuy has “indicated that his proposal on limited Treaty change to the European Council…will reflect today’s decision.” That proposal is thought to centre on amending Article 122 of the Lisbon Treaty (see box below) but in a way that does not transfer any new powers to the EU.

Article 122 1. Without prejudice to any other procedures provided for in the Treaties, the Council, on a proposal from the Commission, may decide, in a spirit of solidarity between Member States, upon the measures appropriate to the economic situation, in particular if severe difficulties arise in the supply of certain products, notably in the area of energy. 2. Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the Member State concerned. The President of the Council shall inform the European Parliament of the decision taken

 

This raises a number of questions:

1.    If the proposed recipient of the assistance has failed to follow Eurogroup advice – even to the point of suffering sanctions – that State can hardly be said to be acting in a spirit of solidarity. So it ought not to be eligible for assistance.

2.    If the crisis is the natural, logical consequence of its own actions, then it may be difficult to argue that the events are “beyond its control”. It now seems Greece’s national accounts misled the rest of the EU. Irish commentators are increasingly discussing the nexus between politicians, property developers and bankers.
 

3.    When ECOFIN has so strikingly failed to find the courage to discipline its members, the European Parliament may not be willing to agree to a Treaty change that continues this failed system. It may want to be involved more than merely being “informed”. That could go beyond the current proposal of increased “automaticity”: Commission proposals are accepted unless they are over-turned by a qualified majority of Member States.
 

Solutions to these questions increase the possibility that the debts of eurozone members will manifestly be subject to a credit risk event and suffer a reduction in value. In the language of accounting standards, they would be “impaired”. Should holders of such debts be forced to recognise that in their accounts – just as they must mark down a commercial loan?

 

For the hypothetical pension fund who wishes to minimise the risk to its pensioners’ living standards, such questions are likely to be deeply disturbing. The conservative, risk-averse response is likely to be that principal repayments will be re-invested in bonds that, after the 2013 introduction of CACs, will be issued by prudent governments. They would have a sound fiscal position and no obvious problems of lost competitiveness, political discord etc. which might suddenly risk default in the years ahead.

 

Investors have learnt, to their cost, that “facts” can change with astounding rapidity. In 2006, Ireland was toasted as the AAA Celtic Tiger with a public debt ratio of only 25% of GDP and a fiscal surplus of 3% of GDP. Just four years later, an overblown banking system had ruined the whole country and left government bondholders in despair. It is easy for bondholders to draw up lists of states with some combination of high public debts, poor competitiveness, over-sized banking system etc.

 

Governments outside the prudent group may have to pay an uncomfortably high price for funding, and thus risk a de-stabilising rise in their interest costs if their public debts are high. Investors do not need to wait until 2013 to foresee these possibilities. Indeed those banks which are seeking to meet the Basel III standards for 2016-18 may already be acting to reach them quickly. Why would they hold bonds of countries that could suffer problems after 2013? They have the word of finance ministers that pre-2013 debt-holders have nothing to fear. However these ministers are part of the very institution that permitted Europe to get so over-indebted in the first place. So why should such ministers be trusted?

 

Is it right that the regulatory framework governing all types of financial institution in the EU should continue with the fiction that debts of EU-penalised governments are risk free and that they are suitable, readily-marketable assets in which banks should hold their liquidity? In Basel III, the global banking supervisors continue to permit this now self-evident fiction. The Irish have just sent a torpedo into the middle of the Basel III concepts. At the very least, the Eurogroup must act together to change EU regulations to take proper account of the new reality they are imposing.

 

Ideas to resolve these difficulties were presented by this author in April this year, and much earlier (see Market Discipline on Eurozone Public Debt). But are nuanced debates on such technicalities about to be swept away by a tsunami?