You shall not default, the ECB commands it | FT Alphaville

You shall not default, the ECB commands it

If you’ve ever read about central bankers in the 1930s objecting to countries coming off the gold standard, this post may cause a slight feeling of déjà vu…

On Thursday, the European Central Bank published its usual monthly bulletin on economic developments in the eurozone. But October’s edition contains these rather extraordinary comments (especially in light of recent moves to change the Greek bond swap)…


Private sector involvement (PSI) has occasionally been used in the past in the resolution of sovereign debt crises… However, this box argues that past experiences with PSI applied to countries that were not part of a monetary union are not comparable and thus do not provide reliable guidance. Within a monetary union, financial markets are very closely integrated, and the negative economic impact of PSI is therefore much more extensive. The application of PSI to one member country may put at risk the financial stability of the currency area as a whole.

PSI could also damage the reputation of the single currency internationally, possibly adding to volatility in foreign exchange markets. In particular, public and private international investors may be cautious about investing large portions of their wealth in assets denominated in a currency of sovereigns that may not fully honour their obligations and may be willing ex ante to rely on PSI in some circumstances.

(How can the ECB argue this isn’t a euro crisis then?)

Against this background, the ECB has strongly advised against all concepts that are not purely voluntary or that have elements of compulsion, and has called for the avoidance of any credit events and selective default or default. All euro area governments need to demonstrate their inflexible determination to fully honour their own individual sovereign signature, which is a decisive element in ensuring financial stability in the euro area as a whole. The risks of PSI underline the importance of strong governance in a monetary union to ensure sound fiscal positions in all member countries at all times. They also emphasise the need to have an effective crisis resolution mechanism at the European level – the European Financial Stability Facility and, from mid-2013, the European Stability Mechanism – to ensure that financial assistance can be provided effectively and under strict conditionality should a euro area country experience problems in the future with obtaining refinancing in the market.

(We’ll hold our tongues on whether the ECB thinks a bout of high inflation would be more preferable as a way for sovereigns to try liquidating their debts…)

This is why the ECB won’t tender its Greek bonds into PSI, for one thing…

On the one hand, the central bank is only pointing out what we all recognise by now: sovereigns default in waves and the correlation involved makes it deadly for sovereigns to rescue other sovereigns. Frankly though, we’re amazed if the ECB thinks it has the suasion power to tell sovereign debtors what to do. And by linking the euro explicitly to a no-default rule, we would argue that they only make it more likely that sovereigns will leave the euro altogether in order to default.

Interestingly, the ECB misses at least one relevant past experience with PSI within a monetary union. This would be the British Empire and the “sterling zone” in the 1930s. Bank of England officials were venomous in resisting debt relief for Depression-hit governments in Newfoundland and Australia, although it did happen in “light” form.

Like we said — déjà vu.

Related link:
Default as state of normalcy – FT Alphaville