Since its conception, the European Union has always been about reconciling seemingly irreconcilable positions among its members. In the current environment of the peripheral euro debt crisis, there is one such deadlock on the question of how dearly should the so-called peripheral euro countries pay to serve their debt compared to the so-called core countries. More or less openly the first set of countries says there should be no extra charge while Germany insists that there should be a substantial penalty (that is the idea behind the German proposal that holders of sovereign debt should share the cost of any future restructuring of debt). In market terms this is the issue of the “spread”, the difference of yield that sovereigns other than Germany would have to pay compared to the German bunds (federal bonds). Is there any way to bridge these two positions? I believe there is, if we dig under their surface.
The problem is a result of the fact that no group of countries can have the same currency (“no exit clause)”, no default and a yield spread other than zero at the same time. If there is neither currency nor default risk, investors would rush to buy peripheral euro bonds pushing their prices up and their yields down. That is what actually happened until early 2008 when the world was already deep in the current financial crisis, i.e. until just after the Northern Rock and the Bear Stearns episodes. For Greece it meant a yield spread very close to zero (20-30 basis points).
So, the peripheral countries enjoyed low actual yields because the benchmark Bund yields were low. That was a major part of the promise on the way to the euro in the 1990’s. The side-effect was that borrowing was cheap and the governments had an incentive to add up to their debt rather than curtail it. A government needs just 3 billion more euros each year to service a 100 billion euros added debt at a 3% yield while it would need to find 6 billion euros if the yield was at 6%. Alternatively it would pile up only 50 billion euros of new debt to keep the new budget burden to 3 billion euros. It was only a matter of time to find ways to mask it up. And, as the Maastricht Treaty focused on GDP ratios, new debt could pass unnoticed under high nominal growth rates (i.e. real growth plus inflation). New debt was fuelling both real growth and inflation, making it appear bearable as a percentage of the GDP.
So higher yields would force peripheral countries to become more prudent and borrow less. Given that bund yields are and should remain low, the only way to achieve that is by changing the mix of the above triad. In order to have a positive yield spread you should either drop the ‘no exit’ clause (add currency risk) or allow for the possibility of a default – orderly or disorderly. Between two evils you choose the lesser one, the orderly default procedure, or so it goes.
The underlying idea is that as less credible companies borrow at higher interest rates compared to the more credible ones, the same should apply in a monetary union between less and more prudent countries. But, lower rates were a basic promise to the South ahead of the creation of the euro zone. They gave up monetary and foreign exchange policy to a supranational authority in order to rip the benefits of cheaper borrowing not only for the sovereigns but eventually for the private sector, too. There is little reason for the peripheral euro nations to remain in the monetary union if they have to consistently pay higher yields.
Moreover, a country is not a company and a monetary union of 16 countries behaves differently than a universe of hundreds of thousands of companies. At anytime a relatively small number of companies go into default and a much greater number of them don’t. In contrast, sovereign defaults are rare but large impact events.
So, the incorporation of an orderly default procedure into a monetary union would either turn this procedure to self-fulfilling or will itself become an empty word. An orderly default procedure requires an eventual materialization of such default risk in order to be credible. Risk that never materializes is no risk, and there can be no premium for something non existent. So either the peripheral countries will be conducting regular haircuts or yield spreads will sooner than later move close to zero once again. With no default episodes, the market would need no much time to get convinced that there is no risk, spreads will dramatically narrow and we would start all over again. In the meantime, it would be a playground for speculators and the peripheral countries would pay a substantial one-off penalty. This is exactly what had happened in the short-period before and after the introduction of the euro, when they had to borrow at a spread over the bunds which was soon eliminated. Then we will start all over again with governments having intensives to add up debt until the next unrelated liquidity crisis that would mutate to a solvency crisis and a sovereign debt crisis. This is how the ‘no bail-out’ clause worked and there is no reason for a different turn out of the orderly default procedure, which is in essence an effort to fine tune the same idea. Which means that once again the yield spreads would remain far longer at either the very low or very high levels rather than in the presumably virtuous in-between area.
So in order to have a positive yield in a monetary union with a no exit clause you need not just a probability of default but a mechanism of regular default, or even better, of continuous restructuring/haircut. Is there anything close to that? I believe, there is and it is well tested in financial history. Amortization, paying interest and principal through regular instalments, can also be seen as a mechanism of continuous debt haircut, yet with another name.
This might seem as an unconventional way to describe things but let’s think about it. In an amortizing loan the principal – or part of the principal – is paid down over the life of the loan through payments that are higher compared those of an interest-only loan, which has to be rolled over at its maturity. It is the equivalent of paying a higher yield for a given period of time and then defaulting on the principal. But this procedure doesn’t carry the stigma of default and is also predictable with the added benefit of eliminating speculation.
Such an instrument would have the benefit that would neutralize the incentive to pile up debt in a low rates environment and will force peripheral borrowers to save. Because, amortization, in a way, is a forced saving procedure. Eventually, the peripheral countries will be able to lower debt levels, yet not without pain or without fiscal consolidation.
This concept could enhance the idea of a European bail-out fund, such as the one proposed recently by Peter Bofinger, Henrik Enderlein, Tommaso Padoa-Schioppa and André Sapir, and endorsed by Jacques Delors, Joschka Fischer, Romano Prodi and Guy Verhofstadt. Such a fund should be able to borrow at low rates benefiting from current favourable conditions in the bond market. However, the idea that it should pass these low rates on its borrowers with a minimum service charge, as suggested by the authors, was not welcomed in Germany not only because it incorporates moral hazard but also because it doesn’t address the roll over problem. With amortization, the bailed-out country will eventually need to search for less capital in the bond market, bringing the graduation day closer. Of course, the devil lies in details. The percentage of amortization and the duration of loans should be at macroeconomically and politically viable levels for both sides.
Moreover, the concept of amortization of sovereign debt might also have a useful application into how to finance temporary deficits during an economic slump and making sure they will be temporary with no need to be rolled over perpetually, or developing new tools to finance the public sector.
So, introducing amortization into sovereign borrowing bridges the German demand for prudence with the Euro zone periphery demand for fairness and could be a typical exercise of finding a workable compromise to make EU move ahead.