Europe Gets Debt Relief One-Third Right: Business Class

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By Harald Uhlig

On July 21, European leaders decided on a new plan for Greece and new rules for the European Financial Stability Facility. They also came up with two remarkable oxymorons: The private sector will voluntarily agree to losses and Greece won't default for now, but instead will selectively default on some of its obligations. President Nicolas Sarkozy of France and Angela Merkel, the German chancellor, seemed to be smiling.

Did they have reason to celebrate? While the leaders took a step in the right direction, I would argue that the glass is only one-third full. The euro zone still faces several thorny issues, but the proposals that were offered to resolve them are more in conflict than in harmony.

First is the question of Greece. It is suffering under its weak economy, out-of-balance government and enormous debt burden. Will it be able to repay? The European leaders have agreed to reduce that debt by about 20 percent to 30 percent of gross domestic product; some of the relief will be achieved via transfers, some of it through elective defaults. Yet many believe that won't be enough. Greece's debt accounts for less than 5 percent of all sovereign debt in the euro zone. If the goal was simply to bail out Greece, it would have been easy for other member countries to do so, and not particularly costly. Clearly, that wasn't the point.

The solution that was devised amounts to merely applying a bigger Band-Aid on a profusely bleeding wound, trying to balance moral hazard concerns with the needs of a patient who should be in intensive care. The bleeding has been slowed, but it remains to be seen whether it will be staunched.

The second partial solution applies to the banks. They should be required to take losses, too. Unless, of course, they are so weak that they need further help. And they should continue to lend to Greece. Unless, of course, that lending would be too large a risk to their balance sheets.

Well, what then? As it turns out, the banks profited handsomely. Greek debt had been sold at a substantial discount in the markets, and the discount would have been larger had it not been for the bets by some on a bailout of the type that we have just seen. A prudent bank would have sold that debt long ago. Instead, those that kept it on their books were rewarded, getting a better deal than their prudent competitors. The “losses” only qualify as such when compared with the face value of the debt, not when compared with previous market values.

In addition, banks didn't have to maintain capital against sovereign debt and could keep using those assets as collateral to borrow from the European Central Bank. It all amounted to a subsidy to the banks that gambled. That is hardly the way to put an end to moral hazard. Still, it could have been worse: The European leaders could have decided to make them whole.

The goal of restoring market discipline was only partially achieved, too. If markets know that Merkel will always pay, is it a surprise that yield spreads vis-a-vis German bonds will shrink? The risk premium in the markets amounts to a premium on the uncertainty of what Merkel and Sarkozy will do. Call it the Merkel-Sarkozy confusion premium. That doesn't amount to a market signal about the fundamental problems in these countries, though. The Stability Facility will buy on the market at market prices, but these prices will then reflect the very fact of the EFSF's actions. The ECB applies market-price-based haircuts when accepting lower-grade sovereign debt as collateral, but the central bank inflates these prices by accepting this debt at all. In short, these market prices are deeply distorted. But is a good sign to see that they are acknowledged as reflecting investor sentiment rather than some kind of conspiracy by speculators.

Finally, there is the partial attempt to address systemic risk, and the risk of contagion, that is to say the spread of the crisis to Portugal, Ireland, Belgium, Spain and Italy. At stake are the financial stability of the euro zone and the survival of the single currency. This was always the key issue, and it remains so. Too much attention has been focused on the comparatively minor problem in Greece. Too little attention has been paid to preventing a financial meltdown in the euro zone.

But what, exactly, is the nature of that contagion? There are two possibilities. The first is simply the question of whether France and Germany are going to pay for everyone. Markets have now learned that they might, and that is a safer assumption now than it was a few weeks ago.

But this may backfire: given all the money and political capital that have been devoted to Greece, there may be too little left to go around for the next crisis. In any case, the funds are too small for Spain and Italy, leaving policy makers to cross their fingers and hope that a rescue won't be necessary. The more interesting possibility for contagion is the mutual distrust in a financial system where many banks have exposure to sovereign-debt risk without appropriate precautions and information.

The good news is that these problems would be easy to resolve by adopting the following measures:

--Mark sovereign debt to markets;

--Demand capital requirements for risky sovereign debt;

--Refuse to accept sovereign debt as collateral for the ECB if the ratings are questionable;

--Require that banks have no risky sovereign debt on their balance sheets. Let regular investors hold the debt instead;

--Encourage (or force) banks to be prudent and sell their risky sovereign bonds before they become a problem;

--Close banks that are insolvent once their portfolio is marked to market;

As easy as this seems, it is almost the opposite of what has happened. Instead, banks have been encouraged to live dangerously and hold on to the distressed debt, even in some cases to double down and hide the problems. Merkel and Sarkozy will pay, just bet on it.

There are some encouraging signs, though, that the European Banking Authority would like to mean business when running its stress tests of the banks. There are also indications that the Stability Fund rather than the ECB will engage in government bond purchases in the future. That could help the central bank improve its increasingly bad reputation with the public in Germany and elsewhere. And once the Stability Fund holds large parts of the sovereign debt of a euro zone country, an orderly debt reduction can be negotiated, rather than a roll-the-dice surprise default.

So the glass is one-third full; but it also is two-thirds empty. The problems are far from over. The semi-transfer union in Europe will cost taxpayers in France and in Germany dearly, and the plan may not solve the key problems of systemic risk and safeguarding the euro, or could only do so in a very indirect, inefficient and costly way. As we have seen, there were far better and cheaper policy options available.

As a result, disenchantment with the euro will keep growing in the northern countries. Sarkozy and Merkel may be smiling now, but there is a considerable risk that they won't be smiling for long.

(Harald Uhlig is chairman of the economics department at the University of Chicago and a contributor to Business Class. The opinions expressed are his own.)

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-0- Jul/28/2011 21:47 GMT