The Penny Is Dropping: Mervyn King, Daniel Gros, Jim O'Neill, and the increasing relevance of the Modest Proposal

26/06/2011 by

This blog has been risking its readers’ sanity by repeating ad nauseam, and in a myriad different guises, the claim that the euro crisis is, at root, a chain of bank insolvencies causally attached to another (derivative) chain of member-state insolvencies. And that, as such, all attempts to deal with the resulting Crisis by rivers of liquidity (to the banks by the ECB and to the states by the EFSF/IMF/ECB/EU) are bound to worsen the problem. So, when Mervyn King, Governor of the Bank of England, said the following a few days ago, I found it hard to fight off a creeping sense of gratification:

“Right through this crisis from the very beginning … an awful lot of people wanted to believe that it was a crisis of liquidity. It wasn’t, it isn’t. And until we accept that, we will never find an answer to it. It was a crisis based on solvency … initially financial institutions and now sovereigns.” [See his speech by which he presented the Bank’s first report on financial stability after the formation of a new tailor-made financial policy committee.]

A few posts back I had entitled an entry “The Penny may be dropping?” I think it is time to remove the qualifying ‘may be’ with an emphatic ‘is’. Mervyn King (not renowned for his radical tendencies or for his mingling with odd characters like your truly) confirms this by weighing in decidedly on the side of those of us who have been arguing for more than 18 months now that Europe’s commitment to denial is putting the global economy at risk. King summed it up thus:

(a) The current euro crisis is systemic and the greatest threat to the UK banking sector yet,

(b) “[P]roviding liquidity can only be used to buy time”, (c) “… [T]he belief, ‘oh we can just lend a bit more’, will never be an answer to a problem which is essentially one about solvency.”

While the mantra of ‘lending a bit more’ is reaching a climax these days (with another €100 billion being touted for bankrupt Greece), the debate on how to get out of this cul-de-sac is intensifying. FT Alphaville put it less than tactfully: You have “to be dropping acid” to think that the current policies will work.

All sorts of proposals are being considered, rejected, resuscitated back to life, ridiculed, complemented, often at once. Below I discuss three proposals (that are receiving much attention presently) before insisting, once again, that our Modest Proposal is uniquely comprehensive (and therefore more likely to succeed), more desirable in term of its long term outcomes and, lastly, more feasible from the perspective of political and institutional constraints.

1. Germany’s Roll-Over (Vienna Conference-like) Plan

It is well known that, in order to share more ‘fairly’ the burden of further lending to Greece between the taxpayers and the banks, Germany (and Mr Schauble in particular) has been pushing hard for a grand bargain between eurocrats (politicians and apparatchiks) and bankers. The touted bargain will have the bankers agree to a large scale purchase of fresh Greek bonds every time older Greek bonds mature (during the next couple of years, till the EFSF begets the permanent ESM); with the eurocrats throwing in some sweeteners which render the roll over more palatable to the recalcitrant bankers. Initially, Germany insisted that the bankers ought to be made an ‘offer they cannot refuse’. But such belligerence faded into the background in the face of furious resistance by the ECB and the French, both of whom recoil in terror at the thought of the ‘credit event’ that who follow the perceived of banks into new Greek bond purchases. So, what we now have is ‘informal talks’ with selected bankers who are being cajoled into ‘participating’. That this ‘plan’ is even part of the public discourse is clear evidence of the deep denial our leaders remain in.

First, it won’t happen. The great bulk of Greek bonds maturing in the next (critical) two years is owned by Greek and non-Greek banks (in contrast to pension funds whose bonds will be maturing, mostly, later) plus the ECB (which has declared no intention of rolling over its maturing Greek bonds). The sad fact is that no banker eager to avert his shareholders’ wrath (and writs), and to stay within the straight and narrow of his ‘fiduciary duty’, will ever choose to roll over maturing Greek debt when all analysts agree that the probability of a Greek default is well over 40%.

Secondly, if Mervyn King’s arguments (and my own repetitive claims) are correct, it makes no difference whether Greece’s new loans come from the EU, from the bankers or, indeed, from some benign deity. In a sense, it matters not one iota whether the banks agree to issuing new loans to Greece (via a Vienna style roll over) or whether the new loans will come from the EU’s other member states. In fact, it is a major error to narrate these fresh loans in terms of the ‘kicking the can down the road’ metaphor. For we are now in the realm of kicking a troublesome can uphill. And the more we kick it the heavier it grows and the steeper the gradient becomes.

2. Turning the EFSF bonds into a sort of European Brady Bond

Recall that the eurozone has been issuing eurobonds since last November. Tragically, they are hideous in their architecture and resemble the CDOs of yesteryear (toxic eurobonds I called them here). I am referring, of course, to the bonds issued by the European Financial Stability Fund (EFSF) for the purposes of providing a large part of the bailout funds for Ireland and Portugal. Greece has, so far, not borrowed from the EFSF but, instead, directly from other EU member states, the ECB and the IMF. So, here comes a new suggestion for how the Greek debt crisis can be averted.

The idea is based on a version of the Brady bonds (utilised in the later 1980s and early 1990s) to restructure the debt of Latin American and former communist nations. (See here for an earlier post in which I argued that the Brady bonds solution was inappropriate for the eurozone.) The new twist is the suggestion that the EFSF bonds play the role in the Greek crisis that the Brady bonds played in Latin America. In particular, German Ministry of Finance circles suggested that the EFSF exchanges some of its bonds for Greek government bonds (GGBs) held by Greek banks. That way Greek banks may be in a position to continue posting (these triple-A rated EFSF) bonds with the ECB for liquidity in case Europe decides to restructure the Greek debt, i.e. imposing a haircut on all existing GGBs without causing the Greek banks to begin a sequence of banking failures throughout Europe.

VERDICT: The reason why this idea will never fly is twofold: First, because there is no way that such a plan can be extended to Ireland, without seriously depleting the EFSF’s limited capitalisation. Secondly, because it does nothing to address the debt crisis of Ireland, Portugal and, indeed, of Spain and Italy (crises that will certainly explode once Greece defaults).

3. Daniel Gros’ plan to collect Greece’s debt under the EFSF and then restructure it

In a recent NYT article “Avoiding the Default trap“, (19th June 2011), Daniel Gros repeated his view that, the way things are going, (a) a Greek default is inevitable (see here for his impressive comparison of Greece and Argentina) and, thus, (b) the EFSF should be utilised in order to effect an orderly restructure of Greek debt, a planned default that causes minimal damage to all comers. The idea is simple and compelling: Offer all holders of Greek government bonds (GGBs) a swap with EFSF bonds “at current market price”. Gros assumes that no bondholder, in their right mind, will refuse to swap junk bonds with triple-A rated EFSF bonds, even at a hefty haircut of 46%. Once the EFSF holds all Greek debt, Gros continues, it can then make the Greek government an attractive offer: In exchange for privatisations and deep structural reforms, the EFSF will now swap its old Greek bonds for fresh ones of a much lower face value (absorbing the 46% haircut it received) and a longer maturity. Gros estimates that this plan will slash €130 billion of Greece’s debt, leaving it with a manageable debt to GDP ratio of less than 100%.

VERDICT: The Greek debt crisis is so acute that no single plan will do the trick. In this sense, Daniel’s proposal has merit. But only if its role in dealing with the crisis is marginal. Its main flaw is that it mistakes the current depressed price of GGBs for the price that would prevail if, suddenly, a large buyer (the EFSF) were to appear on the scene loaded with cash (or, equivalently, triple-A bonds). We should not forget for an instant that the current, market price reflects minuscule amounts of trades involving a tiny number of extreme traders (desperate risk averse sellers on the one hand and risk-loving speculators on the other). In effect, the current price is a marginal price whose level will more likely than not skyrocket the moment the demand side is bolstered (by the EFSF). This means that the cost to the EFSF of restructuring Greece’s pre-2010 debt will prove much larger than Daniel Gros anticipates. Moreover, and this is crucial, the cost will rise inexorably if this scheme were to be employed to deal with the concurrent Irish and Portuguese crises (leaving aside the very real prospect of having to do something about Spain).

Conclusion: Still no substitute for the Modest Proposal

Mervyn King was not the only voice to have caused me to think that the penny is, indeed, dropping. Consider the latest contribution by Jim O’ Neill in the Telegraph (25th June 2011) in which he warns Europe to be bold or face ruin. He writes that “Greece is not economically that important. Greek debt… is at around $450bn – is only around 20pc of China’s foreign currency reserves… Perhaps a more imaginative solution needs to be found. The problem is that Europe’s leaders don’t have an abundance of imagination.”

Well, Europe’s leaders may well be lacking in the imagination department but this does not mean that imaginative solutions have not come out of Europe. I submit it to you, dear readers, that our Modest Proposal is one such idea. Unlike the current ludicrous plans involving some voluntary roll-over, as well as the above ideas revolving around the EFSF (which contain interesting suggestions that may help at the margin of a comprehensive solution), the Modest Proposal has the advantage of dealing at a systemic level with the euro crisis, rather than treating the Greek malaise as a separate problem in need of a piecemeal solution. Unlike the proposal under 2. above, which again concerns itself solely with the Greek banks’ liquidity, Policy 1 of the Modest Proposal deals decisively with the entire eurozone’s banking system’s insolvency issues. And unlike Gros’ proposal (under 3. above) which effectively asks, again, the surplus countries’ taxpayers to buy back, and then restructure, Greece’s debt alone, Policy 2 of the Modest Proposal suggests a eurobond-financed (and thus revenue-neutral) horizontal transfer of the Maastricht compliant debt (up to 60% of its GDP) of each and every eurozone member state (that wishes to participate in this transfer) to Europe’s Centre (i.e. the one solid internationally recognised eurozone institution: the ECB). Lastly, Policy 3 adds a crucial ingredient to the anti-crisis medicine: a strategy for investment-led growth which is absolutely in sync with the Modest Proposal‘s first two policies. Such a comprehensive, imaginative, utterly feasible solution to the Crisis, once adopted, can always be embroidered with elements of some of the policies considered above; e.g. Daniel Gros’.

Is the penny really dropping? Jim O’Neill aforementioned article suggests so strongly when arguing that Europe: “…probably has to quickly try to turn EMU into a more optimal club than it has so far been in order to survive. A starting place might be to agree to introduce a true common euro bond for all members and for the 60pc debt to GDP that was permissible under the Maastricht Treaty.” One hopes that the dropping penny will land before the euro is past the point of no return.

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