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A NEW CRISIS MECHANISM

FOR THE EURO AREA

JAN-EGBERT STURM (EEAG)*

Introduction

When the fathers of the euro devised the common cur-rency, they endowed it with a set of rules to buttress itscredentials as a new global hard currency.According tothe so-called Stability and Growth Pact, no membercountry was henceforth allowed to have budget deficitsexceeding 3 percent of GDP, nor have public debtabove 60 percent of GDP. In addition, a no-bailoutclause was introduced to instil further discipline. Withsafeguards like that, what could possibly go wrong?

Well, if lack of enforcement makes the rules toothlessand therefore less credible, quite a bit can go wrong.Until 2010, there were 97 (country/year) cases of de-ficits exceeding 3 percent. Fully two-thirds of suchbreaches were not justified by the occurrence of a sig-nificantly large domestic recession. The rules devel-oped by the European Union to harness governmentdebt proved to be utterly ineffective.

The global financial crisis, however, shook marketsout of their complacency. And markets are less for-giving. When some euro-area countries’ credit rat-ings began sliding down the alphabet, financial mar-kets took notice and started to demand much higherinterest premia. That put an abrupt end to carelesslending and borrowing, but also brought about aserious crisis of the euro. Since then capital markets

have been extremely unstable, showing signs of dis-trust in the creditworthiness of, in particular, theGIPS countries: Greece, Ireland, Portugal and Spain.

Under the euro the natural constraints of currencypremia on excessive capital flows no longer exist. Acountry cannot inflate its debt away, because itsbonds are denominated in a common currencywhose value cannot be manipulated by nationalpolicymakers. Initially, the apparent immunity to adevaluation risk led market investors to virtuallyeliminate interest spreads, leading to excessive cap-ital flows and trade imbalances. After the financialcrisis, it became clear, however, that risk within theeuro area was not as small as investors believed, asa rising risk of default was taking the place of de-preciation risk.

Some widening of interest rate spreads relative tothe excessively low levels before the crisis is to bewelcomed and should be an objective of Europeaneconomic policy. In a well-functioning capital mar-ket, interest spreads are the price of country-specificdifferences in creditworthiness. When spreads arenot adequate, despite different repayment probabili-ties, mispricing causes countries with lower repay-ment probabilities to import too much capital.

The problem is that in crisis periods the self-correc-tion mechanism through which spreads balance outexcessive borrowing and lending may typically comeinto effect not only too late but also too sharply, withspreads swinging from too low to prohibitively highlevels in a matter of weeks – as often described by theliterature that stresses the danger of “sudden stops” ininternational capital flows. Brakes that block thewheels of a car may actually cause accidents insteadof preventing them. What Europe needs is an anti-lock braking system for capital flows. This is the goalof a much-needed new economic governance systemfor the euro area as a whole.

What is the main deficiency of Europe’s current eco-nomic constitution? To put it simply, markets foundample reasons to disregard government defaults as areal possibility. Investors knew that, at the end of theday, the euro-area countries would go out of their

* This article is based on EEAG (2011), The EEAG Report on theEuropean Economy 2011, “A New Crisis Mechanism for the EuroArea”, CESifo, Munich, pp. 71–96 (http://www.cesifo.org/eeag)published in February. It presents the design of a crisis mechanismthat strengthens market discipline by reducing implicit bailoutguarantees. Other aspects of fiscal and financial governance thathave been discussed since then will be analysed in the EAAG Re-port for 2012. The group for the Report consisted of GiancarloCorsetti (University of Cambridge), Michael P. Devereux (Uni-versity of Oxford), John Hassler (Stockholm University), GillesSaint-Paul (University of Toulouse), Hans-Werner Sinn (Ifo Insti-tute for Economic Research and University of Munich), Jan-Egbert Sturm (KOF, ETH Zurich, chairman) and Xavier Vives(IESE Business School).

way to come up with resources to keep a troubledgovernment afloat, disregarding the no-bailoutclause of the Maastricht Treaty. A key factor system-atically undermining the credibility of the no-bailoutprinciple is the fear of contagion and systemic con-sequences from default. Greece was not abandonedin 2010 because, in the perception of policymakers,Europe (and as a matter of fact, the whole world)could not run the risk of “another Lehman”.

Fears of contagion underlie the too-big-to-fail doc-trine: banks and countries are saved because theirdefault may result in a liquidity and credit crisis thatcould strangle the real economy at a national and in-ternational level. Protected by the implicit insurance,then, financial intermediaries take on too much risk,governments issue too much explicit and implicitdebt, with the result of raising the likelihood of a cri-sis and therefore of generalised bailouts.

These bailouts foster moral hazard effects. The gov-ernments of over-indebted countries continue bor-rowing and creditors continue providing cheap loansrecklessly. The interest spreads that would normallylimit the incentive to borrow if investors feared a de-fault risk are artificially reduced and hence there areexcessive international capital flows, perpetuatingthe trade imbalances that led to the current crisis.

For Europe, there is no alternative but to create rulesand institutions that induce market discipline. Cred-ibility of the no-bailout clause is the essential prereq-uisite. Europe cannot afford to abandon market disci-pline vis-à-vis debtors; this is the cornerstone of itscommon currency and common market. But thisrequires setting up rules and institutions that addressthe fundamental issue of containing the fears and thusthe risk of contagion via the banking system.

A plausible system could stand on two pillars. One isan EU-controlled public surveillance and supervi-sion process for public debt and the banking system.The other is a credible crisis mechanism that strength-ens market discipline by reducing the implicit bailoutguarantee that characterised the previous situationunder the euro while protecting the markets againstspeculative attacks and panic.

Political debt constraints

The Maastricht Treaty and the Stability and GrowthPact centred around the idea that there would be no

bailout and that surveillance and numerical rulescould be enforced with pecuniary sanctions to pre-vent fiscal crises altogether. This approach failedentirely. Despite or because of this frustrating out-come, the euro area has to try again, and now harderthan before, to overcome the deficiencies. A newStability and Growth Pact should provide tougherand more rigorous government debt constraints, andin our judgement the proposals of the Van RompuyCommission are worth pursuing. Some of the mea-sures advocated by the Van Rompuy Commissionhad indeed already been proposed by the EEAG inan earlier report (EEAG 2003, chapter 2). Our sug-gestions for a revised Pact still hold:

• The deficit limit should be modified in accordancewith each country’s debt-to-GDP ratio, in order todemand more debt discipline early enough fromthe highly indebted countries. As an example, thelimit could be tightened by one percentage pointfor every ten percentage points that the debt-to-GDP ratio exceeds the 60 percent limit. A countrywith an 80 percent debt-to-GDP ratio, forinstance, would be allowed a maximum deficit of 1percent of GDP, while a country with a 110 per-cent debt-to-GDP ratio would be required to havea budget surplus of at least 2 percent.

• Sanctions for exceeding the debt limits must ap-ply automatically, without any further politicaldecisions, once Eurostat has formally ascertainedthe deficits. The sanctions can be of a pecuniarynature and take the form of covered bonds collat-eralised with privatisable state assets, and theycan also contain non-pecuniary elements such asthe withdrawal of voting rights.

• In order to ascertain deficit and debt-to-GDPratios, Eurostat must be given the right to requestinformation directly from every level of the na-tional statistics offices and to conduct indepen-dent controls on site of the data gathering proce-dures. Eurostat should also be held responsiblefor failure to control.

• In case all the above assistance and control sys-tems fail and insolvency looms, the country inquestion may be asked to leave the euro area bya majority of the euro-area members.

• A voluntary exit from the euro area must be pos-sible at any time.

A credible crisis mechanism

While we endorse the attempt to rewrite the Sta-bility and Growth Pact, we are much more confident

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about the discipline that markets would impose ondebtor countries. It is true that markets overreactedin this crisis. But unlike the political debt constraints,the market constraints were eventually put in place,limiting abruptly a non-sustainable course. No polit-ical mechanism would have been able to forceGreece, for example, to carry out the present auster-ity measures in a way similar to what has now beenenforced by market reactions, even though these re-actions were mitigated by political influence.

The challenge to the euro area consists of defining acrisis mechanism in which a credible rescue strategystringently binds private investors (they need tohave to bear some responsibility in case of losses)while at the same time preventing a panic-like aggra-vation of market turbulences. In addition, this mech-anism should contribute to the stabilisation of thebanking system in order to avoid a spiral of actual oralleged emergencies, raising the need, or the tempta-tion, for further rescue actions.

A credible crisis mechanism must meet a number ofprerequisites:• It should not mutate into a transfer mechanism.• It should foster efficient risk pricing by markets,

ensuring that adequate interest spreads preventfurther distortions in international capital flows.

• It should enable a country in need of help to con-tinue fulfilling its governmental responsibilitiesand to initiate a reform programme that willreturn it onto an economically sustainable path.

• It should predetermine and limit investors’ maxi-mum losses.

Based on these prerequisites and on the EU coun-tries’ decisions of December 2010, in particular, theestablishment of a European Stability Mechanism(ESM), we propose a three-stage crisis mechanism:

Stage 1: liquidity crisis

If a country cannot service its debt, a mere liquiditycrisis will be assumed, i.e., a temporary difficulty dueto a surge of scepticism in markets that will soon beovercome. The ESM will provide loans of a limitedsize and for a limited time to countries whose debt-to-GDP level is not yet excessive. These short-termloans, senior to private debt, could, for instance, befor a maximum of two years in succession, a timespan long enough for the country to raise its taxes orcut its expenditures so as to convince private credi-tors to resume lending.

Stage 2: impending insolvency

If the loans are insufficient, the time has expired andthe country continues to be unable to service itsdebt or the existing debt is already large, an impend-ing insolvency can be assumed. Collective ActionClauses (CACs), which must form part of all gov-ernment bond contracts, will ensure that a countrycan choose a piecemeal approach when trying tofind an agreement with its creditors, dealing withone maturity of bonds at a time without holders ofother maturities having the right to also put theirclaims on the table. The negotiating country thenwould offer the creditors whose claims become dueso-called replacement bonds, guaranteed by theESM up to 80 percent, only under the condition thatthey accept a haircut, sized on the basis of the dis-counts already priced in by investors during the pre-vious three months, but of at least 20 percent and atmost 50 percent. This provision is aimed at prevent-ing turbulence in financial markets. Since the rele-vant average for calculating the haircut covers threemonths, the discount naturally charged by marketsat any point in time in anticipation of losses duringa possible crisis will be self-stabilising within thelimits. This should help prevent panic-driven lossesof market values shortly before the expected re-structuring or during the negotiations about restruc-turing. The haircut will see to it that the banks andother owners of government bonds bear part of therisk of their investments.

The term “impending insolvency” denotes a state ofacute payment difficulty, which may be overcome,however, after a limited waiver of claims and withthe help of partially guaranteed replacement bonds.This is to be distinguished from actual insolvencythat has far-reaching consequences for the indepen-dence of the state and puts the entire governmentdebt outstanding, no matter its maturity, at the cred-itor’s disposal. And it is not the same as a mere liq-uidity crisis, which does not pose the question ofdebt sustainability.

Stage 3: insolvency

Should the country be unable to service the replace-ment bonds and need to draw on the guaranteesfrom the ESM, full insolvency must be declared forthe entire outstanding government debt.A collectivedebt moratorium covering all outstanding govern-ment bonds would have to be sought between theinsolvent country and its creditors.

The threat of insolvency before universal introduc-

tion of CAC bonds

The mechanism is based on the idea that all newbonds in the market issued by all euro area countriesinclude CACs of the described type, i.e., with thepossibility of a piecemeal solution to impending in-solvency problems. On the one hand, the CAC bondsmake the risk of a haircut, in case of threatening in-solvency, explicit and structured (de facto, all bondsbear the risk of a cut, although unorganised). On theother hand, in case of impending insolvency, thesebonds have the advantage of being exchangeable forreplacement bonds, guaranteed to a considerable ex-tent (our proposal: 80 percent) by the ESM.

The crisis mechanism described above applies tobonds that have a CAC. In the transition period be-fore the new system becomes fully effective, bondswith and without CAC will coexist in variableamounts. The question arises therefore of how todeal with an impending insolvency involving bondswithout CAC.

As long as the presently valid rescue packages(Greece and EFSF) are in force, the problem will notarise. But a serious payment crisis may occur in aninterim phase, during which these rescue packages nolonger work and the conversion of the old governmentdebt into CAC securities has not been completed.

In principle, one could proceed in the way describedabove. The owners of newly issued CACs will stick totheir contract (for instance, they will not be able toexercise their claims before bond maturity). How-ever, nothing prevents owners of standard bondswithout CACs from exercising their claim prema-turely. Since, in addition, unanimity must be reached,negotiations will in principle be complicated.

Nonetheless, the plan provides a workable frame-work for negotiations between the affected creditorsand the ESM. Creditors ought to be offered some-what better terms, in order to reach agreement. It isconceivable that, after a haircut on the order of themarket discount and the above-mentioned limits (atleast 20 percent, at most 50 percent), the full remain-ing value of the old bonds could be exchanged intoreplacement bonds that are fully, rather than onlypartially guaranteed, by the ESM. And of course thegeneral rule that the sum of all guarantees must notexceed 30 percent of GDP needs to be respected. Itis essential that the principle that the haircut pre-

cedes the aid should not be given up even in thisimprobable special case, as the aid will have stabili-sation effects compared to what is laid down in therules of the Maastricht Treaty. Those who do notaccept the thus-specified aid offer may try to recov-er their claims in court, but receive no guaranteeswhatsoever from the ESM.

Stabilisation effects

After all old bonds have expired or have been ex-changed into CAC bonds, the crisis mechanism isfully operative. It will instil more debt discipline andwill help stabilise the markets. The risk of dominoeffects, like those evoked in May 2010 in order to jus-tify the discretionary rescue programmes amountingto billions of euros, will be effectively minimised.Our optimism rests on the following considerations:

• A strengthening of the Stability and Growth Pact,along the lines proposed by the Van RompuyCommission and largely accepted by the repre-sentatives of the member states, ought to induceat least some countries to reduce their budgetdeficits and outstanding debt.

• The announcement of the crisis mechanism willinduce investors to continue to demand interestspreads when buying new government bonds andto reduce credit granted to less solid countries.Higher interest rates will discourage deficitspending and lead to sounder government finan-ces. This market-driven mechanism will have astronger effect than all political debt limits.

• The protective shields, agreed in Washington andParis on 11 and 12 October 2008 after the Leh-man bankruptcy and amounting to 4,900 billioneuros, will remain intact. That alone makes abreakdown of the interbank market like the onethat occurred after the Lehman bankruptcy on15 September 2008 extremely improbable if notimpossible.

• The fact that a crisis mechanism exists, which inaddition limits the maximum losses, helps banksand other investors in planning for a country’spayment crisis. This should limit any possible tur-bulence in the financial markets. Since, in the sec-ond stage of the crisis mechanism, a haircut isstipulated, which conforms to the average marketdiscount during the last three months precedingthe announcement of restructuring measures, therisk of market turbulence is limited. Wheneverthe prices threaten to diverge from the movingaverage of the last three months, profitable andstabilising speculation becomes possible that will

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push the prices back to this average. In addition,strategic purchases or sales will hardly be able toaffect the maximum haircut during the negotia-tion period.

• A divergence of interest rates does not necessari-ly mean that banks are losing capital, as in thenormal case the interest rates of states with agood credit standing will be pushed down andtheir bond prices will be pushed up. This was alsothe case in the current crisis.

Related to the last point, we would like to emphasisethat the haircut is not in itself a destabilising elementof a crisis mechanism, as is sometimes claimed byinterested parties. According to our proposed rule,the haircut is engineered so as to exert a stabilisingeffect, as its size reflects – within the limits set – thediscount on the issue price already realised in themarket. The discounts on long-term Greek securitiesamounted to about 30 percent in early November2010 and also in May 2010. If a haircut of the pro-posed dimensions had been applied then, no marketturbulence would have been triggered, because theexpectations of the market agents would have mate-rialised. In contrast, a continuation and expansion ofthe comprehensive insurance rescue, which wasagreed in May 2010, would have resulted in a suddenincrease of prices, speculation profits and a consider-able destabilisation of markets. Not only downwardswings are destabilising. Upward swings are destabil-ising, too, because they may create opportunities foropportunistic speculation.

References

EEAG (2003), Report on the European Economy 2003, CESifo,Munich.

EEAG (2011), The EEAG Report on the European Economy 2011,CESifo, Munich.