In the NZZ,
In a CEPR discussion paper Christian Bayer, Chi Kim, Alexander Kriwoluzky analyze redenomination risk during the European debt crisis and how the European Central Bank’s interventions affected this risk. They conclude that the risk fell in the case of Italy but increased for France and Germany.
From the abstract:
… first estimate daily default-risk-free yield curves for French, German, and Italian bonds that can be redenominated and for bonds that cannot. Then, we extract the compensation for redenomination risk from the yield spreads between these two types of bonds. Redenomination risk primarily shows up at the short end of yield curves. At the height of the euro crisis, spreads between first-year yields were close to 7% for Italy and up to -2% for Germany. The ECB’s interventions designed to reduce breakup risk successfully did so for Italy, but increased it for France and Germany.
See also this earlier blogpost.
In an NBER working paper, Arvind Krishnamurthy, Stefan Nagel, and Annette Vissing-Jorgensen analyze which components of bond yields were affected by the European Central Bank’s government bond purchasing programs.
Given the institutional restrictions on monetary policy in the Euro area, the ECB had to carefully argue why it intervened in the first place. (To many, the case was obvious; the ECB intervention amounted to quasi-fiscal policy. But an intervention with this objective would not be covered by the rules of the Euro area.) It gave two reasons for the SMP, OMT, and LTRO:
The ECB has publicly stated that these policies reduce redenomination risk, i.e., the risk that the Eurozone might break up and countries redenominate domestic debt into new domestic currencies, and financial market “dysfunctionality,” i.e., segmentation- and illiquidity-induced pricing anomalies.
The authors decompose bond yields into five components: an expectations hypothesis component; a euro-rate term premium; a default risk premium; a redenomination risk premium; and a component due to sovereign bond market segmentation. To identify the non-observable, country-specific components (reflecting default risk, redenomination risk, and sovereign bond market segmentation), the authors use information from asset prices that are differentially exposed to these components.
Specifically, they use the fact that
foreign-law sovereign bonds denominated in US dollars cannot be redenominated through domestic law changes … and redenomination into a new currency should affect all securities issued in a given country under the country’s local law equally.
The authors find that
the default risk premium and sovereign bond segmentation effect appear to have been the dominant channels through which the SMP and the OMT affected sovereign bond yields of Italy and Spain. Redenomination risk may have been present at times and it may have been a third policy channel for the SMP and OMT in the case of Spain and Portugal, but not for Italy. … default risk accounts for 30% of the fall in yields across SMP and OMT for Italy. Segmentation accounts for the other 70%. For Spain, the numbers are 42% (default risk), 15% (redenomination risk) and 43% (segmentation). For Portugal, the numbers are 40% (default risk), 24% (redenomination risk) and 36% (segmentation). For the LTROs, we find that their effect on Spanish bond yields worked almost entirely via the sovereign segmentation channel. We show that the more substantial impact of the LTROs on Spanish sovereign yields than on Italian and Portuguese sovereign yields is consistent with Spanish banks purchasing a larger fraction of outstanding sovereign debt in the months following the introduction of the LTROs.
In a CEPR discussion paper, Christoph Trebesch and Jeromin Zettelmeyer argue that
ECB bond buying had a large impact on the price of short and medium maturity bonds … However, the effects were limited to those sovereign bonds actually bought. We find little evidence for positive effects on market quality, or spillovers to close substitute bonds, CDS markets, or corporate bonds.
A multiple equilibria view of the crisis would probably suggest otherwise.
In the FT (Alphaville), Marcello Minnena explains what type of currency denominations of Euro area sovereign debt constitute credit events; and how markets assess the risk of such denominations.
After the Greek default in 2012
new ISDA standards entered into force: contracts made since 2014 protect against euro area countries redenominating their debt into new national currencies [unless the debt is redenominated] into a reserve currency: the US dollar, the Canadian dollar, the British pound, the Japanese yen, or the Swiss franc. In all other cases, the only way to avoid the triggering of a credit event is if the switch to the new currency does not result in a loss for the investor: “no reduction in the rate or amount of interest, principal or premium payable”.
Since 2014 two types of sovereign CDS therefore coexist: the old (ISDA 2003) and the new (ISDA 2014). The latter has always traded at spreads wider than the CDS-2003, but the difference (the ISDA basis) has generally been small: 15-20 bps for Italy, 8-12 bps for Spain, 2-4 bps for France, and 1-2 bps for Germany.
Since January 2017, the spread difference for Italy and France has increased by roughly 20 basis points.
In his slides, Charles Wyplosz presents a narrative that emphasizes vulnerabilities and institutional failures.
In the NZZ (August 7, 2015), René Höltschi provides an excellent overview over the status of European Monetary Union (EMU).
- EMU combines centralized monetary policy authority with decentralized fiscal powers. This creates the risk that national governments try to free ride.
- Heterogeneity across Euro Zone member states renders centralized monetary policy difficult. Without national monetary policy instruments, prices and wages need to adjust more in the face of asynchronous business cycles.
- The stability and growth pact was meant to address the first issue. It failed, for political reasons. Markets didn’t impose sufficient discipline either; they anticipated bailouts.
- Hopes for reduced heterogeneity—as a consequence of EMU—have been shattered.
Reforms so far:
- During the crisis, member states established rescue funds and agreed on various crisis measures.
- They pursued a two-pronged strategy. On the one hand, they tried to build on the decentralized approach of the Maastricht treaty. On the other, they aimed at closer integration in the form of banking, fiscal and eventually, political union.
- Major responsibilities in the area of banking supervision and resolution have been transferred to the European Central Bank. Bail-in procedures have been agreed upon.
- No major changes occurred in the fiscal policy domain. The “Six-pack” and “Two-pack” measures to strengthen fiscal discipline, coordination and supervision have proved ineffective (e.g., no action against France).
Proposals and discussion:
- The recent “Five-presidents’ report” distinguishes between short-term (until 2017) and longer-term (until 2025) measures (see below). The report proposes to strengthen the existing framework before moving towards closer integration (Euro treasury, macroeconomic stabilization, fiscal and political union). France and Italy have voiced support.
- Fiscal union entails a common budget and potentially, a common unemployment insurance. Unity of liability and control would require that fiscal competences are centralized as well. In turn, this would require changes of the European treaties.
- A further strengthening of banking union, e.g. delegation of banking supervision to a newly created European authority (rather than the European Central Bank), also would require treaty changes.
- But throughout Europe, there is no desire to delegate powers to “Brussels.”
- Instead, skeptics like the Bundesbank or the German Council of Economic Experts advocate a bankruptcy procedure for Euro-zone governments: to strengthen discipline and encourage monitoring by financial markets any assistance by the European Stability Mechanism should be preceded by private creditor bail-ins (extensions of maturity, haircuts).
- Some observers also advocate exit from the Euro zone as an ultima ratio measure. But others argue that this very possibility would undermine the stability of the Euro area.
- Commissioned in October 2014 by the heads of state and government, the report has been published in June 2015 by presidents Jean-Claude Juncker (European commission), Donald Tusk (European council), Jeroen Dijsselbloem (Euro group), Mario Draghi (European Central Bank) and Martin Schulz (European parliament).
- In the short term, the report proposes: to improve elements of the previous “six-pack” and “two-pack” reforms, including streamlined coordination and supervision of national fiscal policies;
- a common backstop for national deposit insurance systems;
- a European fiscal council serving as watchdog; and
- independent national agencies to monitor competitiveness.
- For the longer term, the report proposes: completion of monetary union and fiscal union;
- macroeconomic stabilization, stopping short of permanent transfers or income equalization schemes; and
- a Euro zone treasury.
- Accountability as well as the role of national parliaments and the European parliament in coordinating fiscal policy is to be strengthened. The Euro zone is to be better represented vis-a-vis third parties. Intergovernmental arrangements (for example the European Stability Mechanism) that were created during the crisis are to become integral parts of the EU treaties.
In a Vox column, Jeremy Bulow and Ken Rogoff argue that perceptions of Greek net debt repayments over the last years are wrong.
[C]ontrary to widespread popular opinion, the net flow of funds (new loans and subsidies minus repayments) went from the Troika to Greece from 2010 to mid-2014, with a modest flow in the other direction after Greece stalled on its structural reforms.
They also make some other points:
- Cash withdrawals, non-performing loans and capital losses in the wake of the 2012 Greek government debt default hurt the Greek banking system.
- Mistrust of the Greek government by European partners and Greek citizens slowed down the recovery.
- Greece has incentives to avoid a default on its official loans since default might trigger lower EU subsidies; the loss of other benefits of EU membership; less ELA funding and other forms of financing at below market rates. (Harris Dellas and I have argued the same in our paper Credibility for Sale.)
- As Greece approached the point of being a net payer its bargaining stance hardened.
Vincent Boland and Peter Spiegel suggest in the FT that the ECB coerced Ireland into applying for a bailout in 2010, based on letters recently released by the ECB. The ECB, in contrast, argues that the bailout was unavoidable anyway, and that the Irish Minister for Finance shared this view. In a Q&A section on its website the ECB writes:
While the ECB always acted within its remit and in line with rules established for the whole of the euro area, there are limits to the support that the Eurosystem can provide to banks in the Member States. … First, collateral has to be adequate; and second, counterparts have to be financially sound and solvent. The letter dated 15 October 2010 from the former ECB President recalled these rules and their implications for Ireland. … [Another letter dated 19 November 2010] explained the conditions under which further provisions of ELA to Irish financial institutions could be authorised. In his already public reply of 21 November 2010, the Irish Minister for Finance stated that he fully understood the concerns raised by the ECB Governing Council.
The ECB also addresses the question why it opposed the bail-in of bondholders in 2010:
As regards the possible bailing-in of senior debt in late 2010, it is important to recall the words of EU leaders in a European Union statement of 29 October 2010 and during the G20 meeting in South Korea on 12 November, according to which burden-sharing of senior debt would not be applied until mid-2013. … Furthermore, the necessary EU governance tools to address the bail-in of creditors, which were set out in the Bank Recovery and Resolution Directive (BRRD) and have been fully endorsed by the ECB, were not available in late 2010. … any potential burden-sharing of senior debt in the immediate aftermath would first and foremost have had negative spillover effects on the financial stability of Ireland, as well as on other European countries.
In Prospect Magazine, Ken Rogoff reviews Martin Wolf’s account of the financial and European debt crises as well as his policy conclusions. Along the way, he offers his own views. Some excerpts:
Wolf rightly believes that one needs to look at the entire global economic system to understand what happened.
… he essentially concludes that there will be no long-run financial stability without kicking banks out of the money creation business, leaving it as a government monopoly, much as leading “Chicago Plan” economists first suggested in the 1930s.
Although Wolf makes a coherent case for considering this radical reform [the Chicago plan], he is rather circumspect on just how bad things will be if we don’t do it. For one thing, he seems to agree with Chicago economist Robert Lucas (whom he otherwise sharply critiques) that if the US financial firm Lehman Brothers had not been allowed to fail, the financial crisis would have been far less acute.
But if one really believes this, then why take all the risks of radical change? Anyone advocating a radical fix, as Wolf does, needs to convert the many politicians, financiers, regulators and even academics who conclude that the real lesson of the crisis should be to never let big banks fail. (This is certainly not my position.)
… By mulling whether the crisis could have been mitigated simply through better tactics during the weekend of 13th-14th September 2008, Wolf undermines his own case for radical reform. To be clear, I think that a major financial collapse would have been very difficult to avoid regardless of how Lehman was handled. Thus Wolf is fundamentally right: radical change is needed. Turning to the eurozone, … He is right that Germany bears its share of responsibility. But he emphasises the potential role of German fiscal stimulus far too much, and correspondingly underestimates the importance of regulatory failures, the rigidity of the 2 per cent inflation target and, above all, northern recalcitrance to restructure and write down southern debts.
… The first problem with Wolf’s simple arithmetic is that Europe is not a closed economy, and indeed Germany depends vastly more on exports to China and the US than exports to the periphery.
… If the capital flows to the eurozone periphery had been mainly in the form of direct foreign investment or equity (instead of short-term debt), they would have been far less problematic. … Germany’s biggest mistakes, by far, were in financial regulation that produced instability.
In truth, the southern Mediterranean countries in Europe are a place where there really is secular stagnation … But secular stagnation in the periphery would have been happening with or without the financial crisis … what could Germany have done? … First, it should have acted earlier to take a euro break-up off the table. Second, it should have found a way to restructure periphery debts at lower interest rates and with more time to repay. Third, it should have moved earlier to endorse a looser monetary policy at the European Central Bank (ECB). Fourth, and more for itself, it should have expanded infrastructure investment at home and abroad.
… rather than pouring fiscal stimulus into a German economy that has for some time arguably been overheated, it would have been far better to give periphery countries more help. … The point that periphery countries suffer from debt overhang should be an obvious one by now …
Wolf finds convincing the comparison between Spain and the UK made by the Belgian economist Paul De Grauwe, who argues that Spain would have been in much less trouble if it had had its own currency. True, but misleading. The claim overlooks the fact that, in many ways, Spain has still not completed the transition from being an emerging market to being an advanced economy. … But governance and institutional development can take many generations to unfold. My overwhelming presumption is that these countries would still have had problems containing their debts. … It is ludicrous to think the periphery has a mere liquidity problem. That is why the debts needed to be written down, or more likely stretched out at lower interest rates, which amounts to the same thing.
… So Germany could have done more to alleviate the crisis in the periphery. But the best way was not to increase spending in Germany, but to help increase spending in the periphery. Even the IMF has finally reached this epiphany, arguing that it should have insisted on “bailing in” private creditors in Europe; that is, making lenders take losses. Instead, too much of its lending effectively just helped to pay off private creditors, and did not provide meaningful budget relief.
Anyone worried about austerity in the periphery should have been first and foremost focused on writing down debt. The idea that arguing for such policies, and that worrying about the effects of debt overhang on growth, amounted to favouring “austerity” is simply ludicrous.
… Austerity in the periphery eurozone is an entirely different animal to that seen in the US and UK. The eurozone periphery suffered a classic sudden stop in private lending, and although the “troika” of the IMF, European Commission and the ECB did step in to help, they were too limited in their willingness to write down debt. Facing a sudden withdrawal of financing, periphery countries had to reduce expenditures.
For the US and UK, the decision to expand and then gradually reduce deficits gave policymakers considerable discretion over the exit strategy. For these countries, one can meaningfully speak about the trade-off between stability and stimulus….
Another key pillar in recovering from a financial crisis should be to boost infrastructure investment. Virtually every economist of every stripe agrees with this recommendation. … Administration officials privately expressed concern that infrastructure projects would take too long to get off the ground, and by the time they did, the spending would no longer be needed. My book with Carmen Reinhart, This Time Is Different, suggested that the recession was likely to be around for a long time, and that infrastructure spending would be extremely helpful.
… In fact, the ostensible argument over debt has nothing to do with progressive and conservative differences. It is about the size of government.
… The financial crisis does create an additional and very important argument in favour of fiscal stimulus, and Wolf is absolutely correct to highlight it. When an economy is at the zero bound on interest rates, and the central bank is unable or unwilling to stimulate inflation, fiscal policy is more effective in raising output. … However, the empirical size of the “fiscal multiplier” (how much output rises relative to increased government spending) is widely debated, and the evidence is very thin. … The fact the UK and US both achieved solid growth in the face of fiscal cuts would seem to contradict the view that multipliers are always and everywhere very large.
… Wolf, in line with Krugman, appears to believe that even wasteful government spending would raise welfare, a claim that is at best debatable.
… As for the resulting debt burden not being an issue, it is far from obvious that governments were wrong to worry about the fiscal burden, as debt more than doubled within a very short time. The ability to issue large amounts of debt in response to crises is a valuable option for governments. But if a country’s debt starts to reach a situation that is perceived as risky, the option might not be as available when needed most.
… Wolf now argues that of course we all knew there would eventually be a vigorous recovery in the UK. I can only say this was not obvious from reading either the Financial Times or the New York Times. Again, this is a matter of calibration, and the awful forecasts of those who focused excessively on fiscal policy and nothing else, underscores how difficult real-world policymaking can be.