Shahin Vallée, economist at BNP Paribas and Jérémie Cohen-Setton, PhD candidate at U.C. Berkeley argue that euro area leaders, although actively engaged in the definition of the EDRM, should refrain from publicly talking about it given the risk of self fulfilling prophecies.
A credible EDRM should be an integral part of the eurozone governance overhaul
The Task force set up to address European Economic Governance by President Von Rompuy will inevitably have to discuss the all important question of debt restructuring. This is an emotionally, intellectually and economically charged issue which has so far been held hostage by two strongly conflicting views. On one hand those along the lines of Nouriel Roubini argue that a debt restructuring is inevitable and should be undertaken sooner rather than later for the benefit of Greece and Europe at large. On the other hand, most European policymakers (Von Rompuy, Rehn and Sarkozy) keep hoping that the ongoing IMF/EC programme will be able to deliver the type of fiscal adjustment needed to restore solvency.
Both views are intellectually and practically flawed. An immediate debt restructuring would undermine the incentives in place for the Greek government to implement the needed structural adjustment and would prevent it from accessing financial markets while still running a primary deficit in excess of 4 per cent of GDP. More importantly, at a time when the European Banking system remains extraordinarily fragile and a moment when the European Financial Stability Facility’s rules of engagement remain unclear, it would inevitably precipitate a chain reaction likely to bring a few banks if not States into a tailspin. Restructuring might, at some point, be an option but it is certainly not the time for policymakers to implement it or even talk publicly about it.
On the other hand, refusing to discuss its possibility behind closed doors in the context of the task force is nothing more than an Ostrich strategy. What is needed is not so much a specific debt restructuring plan for Greece but a credible and effective European sovereign debt restructuring mechanism (EDRM) to complete the governance reform of the eurozone. The EDRM, almost regardless of its technical application, would have the advantage of reducing moral hazard for both governments and market participants.
Let’s be straight. Governments’ moral hazard is a much overrated idea. It has become the alpha and omega of eurozone governance discussions precisely at a time when the breadth of the Greek adjustment and the dire consequences of being bailed-out by European fellows have never been so clear. As it stands the current proposals for strengthening fiscal surveillance rely excessively on a flurry of centralised rules and sanctions devised to enforce fiscal responsibility and avoid moral hazard but the truth is that these updated rules and new sanctions are unlikely to prove any more potent than the defunct Stability and Growth Pact.
On the other hand, investors’ moral hazard is a much underrated idea that needs to be addressed. A crucial underpinning of fiscal and households profligacy was as much absurd spending practices as absurd lending practices, as financial markets loosened their lending standards in the years leading to the crisis. This behaviour was legitimised by the assumption that the EU and the eurozone would never afford to let one of its members fail – in contradiction with the no bail out clause of the Treaty. As this assumption proved correct, Europe has become schizophrenic and its policy interventions kept on challenging the letter and the spirit of the Treaty. Looking forward, the only way to reinstate a coherent policy is to balance the no bail out clause with a credible alternative. It is also an essential element to ensure that in the case of crisis, reckless lenders come to bear as much of the adjustment cost as irresponsible spenders.
But we need to overcome two important obstacles for the establishment of an EDRM.
First, Germany and France need to depart from their shaky positions on the EDRM issue. Germany, so far the EDRM’s strongest advocate needs to decouple the EDRM proposal from that of excluding deviant countries from the euro area (see Schauble proposal). France, which has lobbied intensely for the EDRM proposal to be removed from the agenda of the task force, needs to recognise that an EDRM is an essential part of the quantum leap forward regarding European Economic Governance.
Second, euro area leaders, although actively engaged in the definition of the EDRM, should refrain from publicly talking about it given the risk of self fulfilling prophecies. The history of the Sovereign Debt Restructuring Mechanism (SDRM) put forth by the IMF Deputy MD Ann Krueger in the early 2000 illustrates the need to be particularly careful on this issue. Indeed, it is clear in retrospect that the theoretical discussions spearheaded at the time by the IMF led to adverse market reactions in Argentina eventually forcing a disorderly restructuring.
The intellectual challenge of the current predicament is to make the EDRM a central part of any governance overhaul and realign incentives of both the fiscal authorities and financial markets without unduly challenging the ongoing adjustment in Greece. It is also a necessary step to make fiscal rules and commitments more credible by balancing the no co-responsibility clause of the Treaty with a credible no irresponsibility clause.