What is Mr Trichet on about? Denial versus a centrally planned debt conversion

The ECB’s President has taken it upon himself to lead a ferocious campaign against the restructuring of the Greek debt. His resolute and singleminded opposition seems increasingly odd when projected against the background of a Greek sovereign debt whose dynamic is indisputably explosive. Is Mr Trichet simply a man in denial?

The honest answer is that he could very well be. Back in 2004, for instance, he gave a speech which made it clear to anyone who read it that Mr Trichet did not comprehend the eurosystem’s deep architectural flaws. But then again, it is never a good idea to underestimate the intelligence of anyone, especially an alpha-bureaucrat Frenchman, who has scaled the heights of our Frankfurt-based central bank against the express wishes of much of the German establishment. Thus, with only logic on our side, let us try to piece together what may be going on inside Mr Trichet’s mind.

My first axiom is that Mr Trichet understands just as well as the rest of us that the Greek debt crisis is so deep that it can come to one of only three outcomes: (a) a major default cutting deeply into Greece’s sovereign debt, (b) long term (perpetual) lending to Greece from the eurozone’s core countries, or (c) some serious centrally planned (at the European level) remedy that will, effectively, put in place new institutional mechanisms for overcoming the eurozone’s crisis.[1]

So far, Mr Trichet has chosen to throw no useful light on this debate. Instead, he has adopted a steadfast campaign against (a). He was even reported to have stormed out of an important meeting when Mr Juncker, the Eurogroup’s Chair, mentioned the possibility of a Greek debt restructure. Of the other two scenaria, it is also quite straightforward to assume that Mr Trichet rejects (b) as both infeasible and  undesirable: asking of German, Dutch, Austrian and Finnish taxpayers to finance the Greek debt ad infinitum is tantamount to creating a political dynamic within both the North and the South of Europe that will undermine the last remaining bonds that keep the EU together.

If my assumptions so far are correct, there is only one conclusion to be reached: That Mr Trichet is resisting a Greek debt restructure as part of a subterranean campaign in favour of outcome (c): a centrally planned European remedy. If so, what might that plan entail? The simple answer is: An elaborate debt conversion. A centrally planned mechanism, in simple words, by which existing (unsustainable) debts can be converted into new, longer term, sustainable debts. Why centrally planned? Because such a conversion, if carried out at a decentralised level, would not go far enough to reduce the debt burdens sufficiently. To put it plainly, private investors are unwilling to offer new repayment schedules that cut into Greece’s debt burden sufficiently. Debt relief requires a bigger player that will bang heads together in order to bring about a new, plausible, non-explosive situation. Who  might this big player be? I can think of no one other than the ECB itself. Having established that a debt conversion mechanism  is the name of the game, let us look at the two forms it might take.

One type is that Stuart Holland and I have been proposing for some time now – see the Modest Proposal for the Overcoming of the Euro Crisis. Its gist is that existing debt is split in two parts: the Maastricht-compliant debt and the remaining  debt. The former is then transferred, on a member-state by member-state basis (for member-states that request such a transfer) tout court to the ECB. The ECB then (a) issues its own eurobonds whenever part of that debt matures (and sells them at competitive rates in the global money markets), and (b) opens a debit account for each participating member-state (in which the latter repays this debt at a rate that is consistent with the eurobond rates and over a time period that reflects the eurobonds’ longer term maturity periods). In short, overall debt of up to 60% of a member-state’s GDP (the Maastricht-compliant debt) is taken off the member-state’s books and is financed, effectively, by non-EU investors. Immediately, the interest rate sovereign debt spreads fall across the eurozone and even member-states whose debt is well above the Maastricht limit find it much easier to roll over their (remaining) debt. In addition, having freed up the EFSF’s (and later the ESM’s) capital (from the arduous task of lending to insolvent states), the EFSF’s (ESM’s) financial might may be used to re-capitalise the private banks, thus ending the parallel sovereign and banking crises in one go.

The second type of debt conversion one can imagine would feature the following: Swapping of new member-state bonds for the old bonds that entail substantial haircuts for banks but which are, crucially for Mr Trichet, accompanied by accounting and tax regulatory changes that will soften the blow to the banks. For instance, new rules could be introduced that allowed the banks to accept haircuts without having to write down their assets on their balance sheets for an extended period of time (that is, until their other assets have recovered sufficiently).[2] Additionally, the magnitude of the haircuts could be made inversely proportional to the member-state’s growth performance, thus giving the creditors a stake in the country’s capacity to defeat recession.

If my assumptions are correct, Mr Trichet is resisting a Greek debt restructure not because he is emulating the proverbial ostrich but because he has his sights on a pan-European debt conversion plan of one of the two types described above. If so, which one?

I think that of all the questions so far this is the easiest to answer: When the Polish debt crisis was tackled by the Paris Club, the solution involved precisely that type of debt conversion: a haircut of 50% of Poland’s debt, a similar haircut by the creditors, and a host of legal and accounting tricks that allowed the creditor-banks to shield their balance sheets from an immediate write-off. And the head of the Paris Club back then? A certain Mr Jean-Claude Trichet (see Barry Eichengreen’s illuminating article). 

If this is what Mr Trichet is on about, the news is mixed. It is without doubt a good thing that the head of the ECB is not in denial about the need to tackle the crisis centrally and with overwhelming institutional force. On the other hand, if he is simply planning to tackle the Greek problem by means of a strategy that worked in Poland and in Argentina all these years ago, I very much fear that he is deluding himself. As I have written some months ago, there is a profound difference between those episodes and the current mess in which the whole of the eurozone is finding itself in.

First, we must never forget that this was a banking crisis before it evolved into a sovereign debt crisis. In the cases of Poland and Argentina, the US (under Secretary Brady) and the Paris Club (under Mr Trichet) were go betweens between insolvent countries (Argentina, Poland etc.) and solvent banks (US and French, primarily). Now, the ECB has to bang together the heads of insolvent states and insolvent banks. The problem’s order of magnitude, in order words, is far greater.

Secondly, in that crisis (which Mr Trichet helped resolve) the new debt was backed by the US Treasury (which stood behind the Brady bonds). Who will play the same role today? Given the state of disrepute to which the money markets have consigned Greek, Portuguese and Irish bonds, any new bonds coming from these insolvent states will be met with contemptuous indifference. And if Mr Trichet is expecting the German taxpayers to stand behind the new Greek bonds, he has another thing coming…

For these two reasons, nothing good will transpire if Mr Trichet is planning to delay a Greek debt restructure to buy time during which to persuade Mrs Merkel to let him do for Greece and the rest of the periphery what he did for Poland all those years ago. The insolvency of Europe’s banks and the absence of a Union bond will ensure that what was a successful ‘history’ will now be repeated as farce. It is in this sense that I insist on the first type of debt conversion; the type that we have outlined in detail in our Modest Proposal (which, by the bye, is now adopted by the Levy Institute as one of its Policy Papers).

[1] The reader may well protest that there are other possibilities not included in the preceding paragraph. E.g. the official scenario according to which Greece manages (through the combination of austerity, privatisation and structural reforms) to arrest its debt crisis. Or the doomsday scenario that has Greece leave the euro area altogether. In this sense, my first axiom [namely that Mr Trichet is only considering scenaria (a),(b) and (c) above] takes it for granted that Mr Trichet entertains none of the nonsense that has been peddled in recent weeks. 

[2] This would be similar to rule FASB 15 of the Brady Bond Plans which allowed the restructured loans appear on banks’ balance sheets at their original face value on the condition that the original capital did not suffer a haircut (i.e. only interest was affected). It would not be the first time regulators decided to re-label meat as ‘fish’ in order to bypass the banking world’s kosher rules and regulations.