Remarks delivered at the Plan B Conference in Madrid, 20th of February 2016.
8 May 2016 by Daniel Munevar
The first part of this presentation dealt with the parallels between the Latin American debt crisis of the 1980’s and the current crisis in Europe. In this second part of the discussion I will attempt to develop a series of ideas on how to think of an integral framework for debt management in the context of the discussions of DiEM and Plan B.
In short, the crisis can only be resolved if and when insolvency is properly addressed. For this end, there are many possible scenarios and technical tools that can be thought of in order to overcome insolvency. Therefore, the issue is not one of lack of alternatives. It is rather a matter of correlation of political forces and power. The election of one tool over the other and, by extension, the choice of a given distribution of losses will always be a result of political decisions both at the national and EU level.
Just in the context of the discussions taking place in the different gatherings of DiEM and Plan B one can think of a range of possibilities to address the potential or de facto insolvency of sovereigns and banks in Europe. On one end of that spectrum is the achievement of a collaborative solution based on the actions of a Pan-European coalition to democratize the EU. By definition, this entails forgoing the implementation of unilateral measures in what is being defined as a process of retreat to the cocoon of the nation-state. On the other end would be the rejection of the economic model implicit in the membership of the EU through the enforcement of sovereign measures. This would include, but would not be limited, to policies such as exit from the Euro, unilateral defaults or nationalization of the banking sector, among others.
From a broad perspective, one can find problems with both options. In the case of the first one, it assumes a significant degree of flexibility from the institutional structure of the EU. However, an argument can be made that the negotiations between Greece and the EU showed that such structure not only is extremely inflexible but also the authoritarian extremes which is willing to go in order to maintain the current status quo. In addition, it also assumes that countries are willing to go against their perceived short-term interests in order to achieve a pan-European solution. This didn’t happen in the interwar period and there is no reason to expect it will happen now. In the case of the second one, the attempt to overcome what are in fact European wide problems through national policies might be an ill-fated attempt to return to a world that no longer exists. Off course, the adoption of unilateral and sovereign decisions at the national level doesn’t preclude the formation of international alliances or demonstrations of solidarity. Yet, the economic and political uncertainty surrounding the impact of the implementation of unilateral policies, such as exit from the Euro, might also open the door to the dark nationalistic past of the continent. This complex environment simply highlights the need for individuals and organizations engaged in the search of alternative solutions to the problems of Europe to have open minds and be prepared for any eventuality on the basis of an informed discussion.
In the specific case of debt, and even though the specific composition of the menu of solutions is yet to be decided along the lines just discussed, an integral framework for debt management in Europe should be composed of at least 3 elements: an audit of the EU led bailouts conducted since the beginning of the crisis, a sovereign debt Sovereign debt Government debts or debts guaranteed by the government. restructuring mechanism and a banking resolution mechanism. The reason to group these 3 elements together is that there is a tight link between the policy response to the crisis, the distribution of its costs and the closer interaction of sovereign and banks in the region. In this last regard, its key to make it clear that it is simply not possible to tackle the problems of sovereign debt without addressing the impact of any measure on the solvency of national banking systems, and vice versa. Lets now assess each one of these elements.
In the case of the need to audit the official bailouts, their design and implementation was based on the notion that all debts in Euros shall be repaid. Not only was this premise flawed, leading to the socialization of losses of the financial sector, but also is extremely troubling once light is shed into how it translated into effective policy measures. To start with, a recent audit of the adjustment programs conducted by the European Court of Auditors states in no uncertain terms that not only the EU Commission did not see the crisis coming but also that it was completely unprepared to the scope and challenges associated to it. While the Commission was busy learning the ropes of austerity policies, the IMF
International Monetary Fund Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.
When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.
As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).
The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.
http://imf.org changed its operative rules, under German and French pressure, in order to rubber stamp unsustainable programs, as was the case in Greece. In the meantime, the ECB ECB
European Central Bank The European Central Bank is a European institution based in Frankfurt, founded in 1998, to which the countries of the Eurozone have transferred their monetary powers. Its official role is to ensure price stability by combating inflation within that Zone. Its three decision-making organs (the Executive Board, the Governing Council and the General Council) are composed of governors of the central banks of the member states and/or recognized specialists. According to its statutes, it is politically ‘independent’ but it is directly influenced by the world of finance.
https://www.ecb.europa.eu/ecb/html/index.en.html was operating in the background ensuring the protection of private creditors. It accomplished this by issuing threatening letters to sovereign governments in order to guarantee their compliance with adjustment programs.
In this regard, an audit on the adjustment programs is meant not only to shed light on the way these programs were designed and negotiated but also to open a discussion on the distributional impacts at EU level derived from these decisions and whether they are valid and justifiable. A practical example of how to think of these issues can be found in Ireland. In 2010 the country was forced to bailout in full the creditors of the banks in the country. At the time, this decision was justified as necessary in order to avoid a EU wide financial panic. However, by doing so under pressure of the ECB, Ireland assumed a burden that could and should have been shared by other countries whose banks were exposed to the fallout of the Irish banking crisis.
However this would not be a pedagogic or theoretical exercise but rather a procedure with a specific outcome in mind, namely the reduction or cancellation of debts derived from the bailouts. One could think of many ways in which this could be accomplished, but for practical reasons in this space I will just mention two options along the spectrum of pan-Europeanism and assertion of national sovereignty. On the one end, the burden of these debts could be redistributed at the EU level through a mechanism of debt mutualization, or even they could be cancelled directly. On the other, a country could declare a moratorium on these debts in order to force a process of renegotiation. As explained before, both ends of the spectrum would involve costs and problems: the first option is extremely unlikely whereas the second would involve significant financial costs given the low interest rates
When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…
The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation. and long periods of repayment of official loans.
The second element of the framework is the creation of an official sovereign debt restructuring mechanism. Eight years into the crisis, GDP
Gross Domestic Product Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another. and GDP per capita remains below its pre crisis levels in most of the south Europe. In the meantime, the failure of austerity policies has continued to increase the debt to GDP ratios in those same countries well above the levels observed in 2008. In this context, the sustainability of public debt in countries like Portugal, Spain or Italy has become a direct function on the ability of the ECB to compress bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. spreads across Europe. Any attempt to implement expansionary fiscal policies would run against the vulnerabilities derived from high levels of public debt as well as the opposition of the ECB. Thus, its clear that to stimulate economic growth, short of a European wide investment program or a European federal budget, additional measures will be required to address the debt overhang that affects most of the countries in the south.
As pointed out before, there are many ways to think about these measures. For example solutions that are based on a European wide solution could include the issuance of perpetual bonds to be bought by the ECB to replace debt below the Maastricht level of 60% of GDP; it could be based on the issuance of Eurobonds following the same principle; or it could rely on an investment program financed through the issuance of bonds by the EIB to be purchased by the ECB. Whereas the first two options would help to reduce the debt to GDP ratio by reducing sovereign debt, the third one would do so by accelerating economic growth. Then again, the issue with these options would be that in some cases they would require treaty changes, and in all cases European wide support which in the current context is hard to envision.
On the other end, you could have the implementation of unilateral measures, ranging from voluntary debt exchanges to temporary moratoriums on payments, or even imposed write-downs. The capacity of a country to implement this type of measures, and the ensuing costs in terms of litigation, risk premia or access to fresh funding, would be broadly mediated by two factors. First, the possibility to amend debt contracts either through Collective Action Clauses (CAC) or changes in national law, if domestic law governs such contracts. Its no coincidence that one of the key objectives of the 2012 Greek debt restructuring was to strip away from the country the capacity to amend sovereign debt contracts by placing bailout funds under English law. Second, if a significant share
A unit of ownership interest in a corporation or financial asset, representing one part of the total capital stock. Its owner (a shareholder) is entitled to receive an equal distribution of any profits distributed (a dividend) and to attend shareholder meetings.
of the debt is held within the country, as its usually the case, a write-down would have a cascade effect over the solvency not only of banks but also of pension funds
Pension Funds Pension funds: investment funds that manage capitalized retirement schemes, they are funded by the employees of one or several companies paying-into the scheme which, often, is also partially funded by the employers. The objective is to pay the pensions of the employees that take part in the scheme. They manage very big amounts of money that are usually invested on the stock markets or financial markets. and other financial institutions. The presence of pari-pasu clauses in turn limits the ability of governments to carve out specific groups of creditors in order to spare them from the losses, as they would be subject to lengthy processes of litigation by creditors. Thus, any serious discussion about restructuring public debt must include proposals to tackle these knock on effects over domestic actors, and specially banks.
The third element of the framework deals precisely with the issue of how to handle bank insolvency. Countries like Ireland or Spain entered the crisis with low levels of public debt. However, the socialization of losses from the financial sector through bank bailouts translated into significant increases of public debt. This process is an ever-latent danger as in times of crisis the line that separates private from public debts tends to disappear. This continues to represent a serious threat to Europe for at least two reasons. First, the size of the balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. sheets of banks in most of the countries of the continent is still a multiple of the national economy. Thus, the failure of a number of small or medium banks, or a Too Big Too Fail bank, could cost significant amounts as a share of the domestic economy. Second, a decade of low growth and high unemployment has saddled banks with an ever-growing pile of bad loans. For countries like Italy or Portugal, they represent a ticking time bomb.
In this context, how can the issue of bank solvency be handled in such a way so as to reduce the costs of bank rescues for the taxpayer? A pan-European solution would involve both significant expansion, and changes of the rules, of the common rescue fund that is part of the EU Bank Recovery and Resolution Directive (BRRD). Currently this rescue fund is simply too small to deal with even a regional banking crisis. Therefore, the incentives to shift the costs of banking exposure in times of crisis between countries, as was done by French and German banks with the Greek crisis, is still in place. Instead, a redesign of this fund would create incentives for governments to limit in a significant way the risks taken by banks in order to limit the potential exposure to a crisis. Furthermore, it would help to shift the costs of a banking crisis from the weakest systems to the financial capitals of the continent. Just from this description it’s clear that this rosy scenario is extremely unlikely given the current correlation of political, and financial, forces in the continent.
In contrast, a domestic based solution would have to rely on the implementation of bail in mechanisms as well as extensive use of public banks. In practice this would mean that losses incurred by insolvent banks would be passed on to private shareholders, bondholders and large depositors before requiring the use of public funds. Furthermore, once public funds are required this would be done in exchange of voting shares and management control of the rescued institution. The rationale for this approach would be twofold. First, if in ultimate instance the risks assumed by a private bank will be transferred to the public sector, effectively privatizing profits and socializing losses, it stands to reason that the public sector should both share the profits and limit the risk taking of banks. Second, if the private bank doesn’t fulfill the public interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. , then the government should ensure that the bank effectively behaves like a utility, ensuing access to key services that a bank should provide at low cost such as a functioning payment system, capital allocation and risk management, among others.
However, this type of approach is not exempt of risks and problems. The threat of an effective bail in mechanism can induce a bank run. Those agents that would stand to bear the losses of insolvent banks would sell their shares, bonds or transfer their deposits abroad. We are already witnessing this type of behavior in the significant drop in European bank shares that has taken place in 2016 and the increased fragility of banks in countries like Italy or Portugal that has come along with the implementation of the BRRD. Thus, the implementation of this approach might require additional and radical measures such as capital controls or even exit from the Euro in order to establish a functional framework. The scale of the changes required could make of this an extremely uncertain and costly process.
This overview shows in a very simplistic way the complex and entangled nature of the problems associated to debt in Europe. As the experience of Latin America shows, these problems will only be solved once insolvency is recognized and dealt with. Lets hope that movements like Plan B and DiEM play a central role in shaping that answer.
is a 30-year-old post-Keynesian economist from Bogotá, Colombia. MPAff. LBJ School of Public Affairs at the University of Texas at Austin. From March to July 2015 he worked as a close aide to former Greek finance minister Yanis Varoufakis, advising him on issues of fiscal policy and debt sustainability. He was previously fiscal advisor to the Ministry of Finance of Colombia and special advisor on Foreign Direct Investment for the Ministry of Foreign Affairs of Ecuador. He is considered to be one of the foremost figures in the study of Latin American public debt. He is member of CADTM AYNA.
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