A European Mechanism for Sovereign Debt Crisis Resolution

Bruegel have released a proposal in relation to the resolution of future sovereign debt crises. (Since the mechanism does not yet exist and would require a Treaty change, it only relates to future debt issuance after its establishment – it has no implications for already-issued debt or any debt issues in the near future.) It has two elements:

1. A procedure to initiate and conduct negotiations between a sovereign debtor with unsustainable debt and its creditors leading to, and enforcing, an agreement on how to reduce the present value of the debtor’s future obligations in order to re-establish the sustainability of its public finances. This would require a special court to deal with such cases. The European Court of Justice is the natural institution for this purpose and a special chamber could be created within it for that purpose.

2. Rules for the provision of financial assistance to euro-area countries as an element in resolving the crisis. Should a euro-area country be found insolvent, the provision of financial aid should be conditional on the achievement of an agreement between the debtor and the creditors reestablishing solvency. The task of supplying financial assistance could be given to the EFSF provided that it is made permanent and an institution of the European Union. Lending by the permanent EFSF could also be provided, under appropriate conditions, to euro area countries facing temporary liquidity problems, as currently foreseen by the temporary EFSF.

37 replies on “A European Mechanism for Sovereign Debt Crisis Resolution”

I think Lee C. Buchheit posited that a country might decide to change the law on debt governed by domestic law to allow default if a majority of the bondholders allowed it. Is this a way for a defaulting country to deal ith existing bonds?

IIEA Event on Europe’s Sovereign Debt Crisis

Apart from that, it is worrying that a framework for default might confer a permanent advantage on larger countries that the single currency did not envisage. On the other hand, surely we have to be happy that losses will be imposes on creditors as well as tax-payers and that there will be a market friendly mechanism of effecting this.

My first para is badly stated. Substitute:

I think Lee C. Buchheit posited that a country could decide to change the law on debt governed by domestic law to enforce default. Mr Buchet suggested that a country might seek approval of a majority of the bondholders to try to preserve credibility. Is this a way for a defaulting country to deal ith existing bonds?

It is a real pity we can’t pick a date and revalue the Irish Punt from 1.27 to 1.00 against the Euro. All Irish Held Euro Debt and Deposits would decline in Euro value. The public sector wage bill , Future Economic growth prospects, Irish export competetivess would be solved.
The bond markets are practically pricing this level of revaluation into the Irish Euro every decade at the moment.
If we could find a way of getting the ECB to agree without a precedent set for the Italians.

I think it is well worth reading the paper in full, and especially the last few pages. You have the lowdown from p26 onwards (that’s in pdf terms – p25 if you look at bottom of page), but it gets interesting from p18 and then p22 on, but worth reading from 2 to 30.
The introduction says
“The creation of the ECRM would likely need to be established by a treaty. The mechanism would, therefore, only apply to future debt issuance”.
but I don’t say why that is borne out later on (the document has several authors).
e.g. p27 “The ECRM could be established either through an EU directive” and anyway, with article 48 from Lisbon, enacting a Treaty change should be possible. Maybe quickly.
I dont understand why you say “it has no implications for already-issued debt or any debt issues in the near future.” (I saw newswires saying the same thing, but I don’t know why).
The paper it seems to me has many concrete implications, here and now.

@ Ciaran

Herr Schauble said the plan would not affect the existing stuff (there could be a crossover between this plan and the general German concept). Unless it was mistranslated, but that was literally his comments verbatim.

I agree with Ciaran. Bottom of p25 and top p26:

“The provisions of a future ECRM treaty would apply to all debt issued (or contracted) by a euro-area sovereign..”

I expect this may be a fault-line between the various players trying to get to grips with this. Some mightn’t want it ‘retrospective’, but if it ain’t it won’t be of much use in the here and now.

jules Says:

November 9th, 2010 at 1:08 pm
Default is evitable unless something is done with the Euro not just for Ireland for also for some of the others PIGs including Greece. The European stability fund is just putting off the evil day. You cannot sustain interest rates of 5% + on national debt when inflation is nothing and deflating as in Irelands. Directly all the existing Irish bonds are redrawn at these penal rates the draw on the national finances will be become too much for the exchequer. Reductions of greater than about 3 €bn in national expenditure will only bring forward the day as the reducing GDP caused will kill off any chance of Ireland growing out of the problem. The only other solution that could happen is that quantative easing is used by the ECB to right off some of the PIGs and other countries debts (Germany could use to save some of its city councils some of which are in a desperate state). We need to get some sinorage on the euro and now is the time to do it after the 600 bn dollars printed by the USA. The resulting fall in the Euro would also make Irelands exports more attractive and could lead to growth. The other point is that very high debt/GDP ratios are sustainable when the country has control over its financial policies and can set interest rates AND that most of the debt is domestic so interest transfers are not leaving the country as in the case of Japan. The threshold of default is much lower for Ireland were most of the transfers will go to Saxony and the Rhur region and we have no control over our interest rates. Nothing that has happened in Ireland suggests any changes in how to deal with huge percentages of sovereign debt. 1 Default 2. Devalue by printing money or directly manipulating the exchange so the resulting growth reduces the ratio. In ten years time all that we will text book examples of how not to do things.

I do not europe is going to solve its sovereign debt crisis without printing money. In irelands case our problems were mainly caused by europes dictact that “no bank should fail” which in irelands case bankrupt the country and cost us more in two half years than all european grants and subsidies ten times over. If only we had been allowed to let some banks go as they had to in the USA, iceland and the U.k. we would not be in the mess we are in. It is up to Europe to solve it.

Isn’t the move away from the wonderful taxpayer gets shafted model going to mean bond yields generally will rise ? If -shock horror- bondwallahs have to chip in in cases of economic carnage aren’t they going to look for more yield in compensation? Finally effectively an admission that the level of risk priced into Eurozone periphery bonds pre Lehman was hopelessly low. Low interest rates have a lot to answer for.

@ Jules
You will find that there is an absolute refusal on this site to accept Europe’s role in creating this mess.
I think it’s because of Irish insularity or just the tendency of people not to look at the big picture. There is a also perverse sense of satisfaction here as people contemplate the sacrifices others will have to make.
Big picture is also counter to our narcissism.
I think Europe has a duty to sort this. But Europe does not care about the periphery. Europe is interested in Germany alone.
Angela will not have bank debts burdened on her tax payers no matter what and she does not want German banks to fail. Germany’s need for Ireland to become a debt servicing dump is huge. It will guide all policy.
The Europeans will do nothing to protect us.
When oh when will people wake up and smell the crappy German coffee and leave the Euro?
They were useless in the Balkans, they are useless now.

@ Eoin Bond, I read Herr Schaeuble (see Spiegel.de interview etc) as more suggesting a collective action clause of some sort. If you read, or have read, the Bruegel paper, there is a good comparison of the statutory with the contractual approach. Bruegel to me makes eminent sense. It gives legs to Germany’s determination to rid us of moral hazard. It could be applied, not just in Europe, but worldwide for some parts of it. And quickly. Herr Schaeuble has let the cat out of the bag, and the genie out of the bottle. Now the mind boggles.
Don’t by the way, underestimate Mr Schaeuble
This is how he dealt with his spokesperson Mr Offer, who resigned today

@ Jules, printing money might be one way out. But there is widespread agreement, even in the spendthrift states, that it is a road better not trod for the time being. Like it or lump it.
@ Eureka, Ireland – more than other state – has benefited from the largesse of the ECB, and the understanding of the European Commission (longest eurozone convergence targets). There has been a tremendous well of sympathy abroad towards Ireland. And Germany has paid a very heavy tribute to the European ideal of late. The ECB, like Germany, is every more “bailed in” to the next government getting Ireland out of a sticky corner. Please take a careful read of this recent research paper, and let me know what you think afterwards. http://www.imf.org/external/np/res/seminars/2010/arc/pdf/boj.pdf

@ Ciaran
Thanks for the paper. Great to see this analyzed to some extent.
I’m not an economist but I’m not sure about it. For example, they discount the role played by Euro membership by alluding to three countries – Denmark, Sweden and UK – these are hardly similar in terms of fundamentals as Portugal, Spain, Greece and Ireland. There is no doubt that the badly designed Euro lured banks into lending money to bad risks and lead to this crisis.
Their models are incomplete because they look at financial and fiscal factors but not political factors. The safe country and the risky country are politically intertwined to an extent that they cannot factor for. Basically the “safe country” wants to squeeze every penny out of the risky country prior to having to bail it out. However the risky country has options too that could be very damaging to the safe country- accept forced austerity and then default. The forced austerity would send a clear message to other “risky” countries that the “safe” country is not interested in political unity but rather economic predation.
Political entropy dictates that a country so disinterested in its neighbours cannot be the centre of a Union.

@Ciaran O’Hagan
What price eurobonds? With an internal/external price? Eurobondco borrows at x% eurobondco sells at y% to country x with good fiscal stability and at y+z% to country, eh, I, with poor fiscal stability?

Eurobondco effectively acts as its own insurer by using its spread to build up a reserve?

So – there is no mechanism to deal with this. Remember the policy makers are not economists
So the choice for Frau Merkel – read a Bruegal paper or
“Send Ollie to those dumb Irish and make sure they pay us back as much as they possibly can. They’ll probably default anyway but let’s make sure we’ve got as much as we can out of them first”
You decide!

Isn’t it odd that Germany’s new-found sense of moral purpose to protect taxpayers and to impose loses on creditors came two years too late for Ireland, after any loses made by German and French banks were neatly offloaded onto Irish taxpayers? Seems the Irish players at the EU poker table have terribly bad luck.

Yes, jumping into WWII metaphors doesn’t progress the debate, though the historical context of the whole EU project is always there in the background and should not be forgotten. My point is that Germany’s actions can be fully explained with reference to economic self-interest, rather than the idea that they want to offer anybody tea and sympathy. Greece was bailed out because of the huge exposure of German banks to Greek debt. During the recent stress tests the only banks not to provide full disclosure of sovereign debt holdings were German banks, citing “local laws” against doing so. How convenient. There is a game of poker going on, with move and counter-move to do with disclosures/realization of loses, and trying to shift the burden to someone else. The strong countries have both better hands and more skilful players.

Also there was never a referendum in Germany on the Euro, because if there had been one it would have lost. The lack of a proper democratic mandate for the Euro is a problem is Germany, and will lead to whatever measures are necessary to keep a voter revolt on this getting out of hand. This is guiding policy, not the welfare of other member states.

@Bryan G – “Greece was bailed out because of the huge exposure of German banks to Greek debt.”

So would that imply that once the German banks’ Irish (government rather than banks) debt has been covered/picked up by the ECB then Ireland can go hang in the wind and forget about being bailed out?


Well the timing looks very suspicious to me – there’s a first round of private debt socialization where taxpayers take up the burden, and then new taxpayer-friendly rules are brought in too late to be of any benefit to Ireland, and which will in fact penalize the weaker countries on an ongoing basis with higher interest rates. This works out very nicely for the stronger countries since their debt will now be even more in demand as a safe haven and they can take advantage of lower interest rates for their own debt servicing.

I actually think that imposing loses on creditors is the right long-term strategy, but in this case it is equivalent to shutting the barn door and hiring expensive security guards to sit outside long after the horse has bolted.

Looks like there will always be some form of last-resort/bail-out mechanism that an EZ country can use, but it will be pretty tough – e.g. from the ECB proposal

Conditions for financial support should come at penalty rates. The ECB proposes to make financial support very unattractive for the recipient government and to extend it only under preferred creditor status and based on good collateral. Adopting a mechanism of this kind would amount to implementing a permanent bail-out framework.

The Germans will look after the Irish. The point is to teach us all a lesson about credit and the relationship to money. The terrible Hyperinflation has left the Germans aware of the relationship. They survived and are stronger for it. The Irish will survive and prosper too, but no thanks to the whingers on this blog!

Greed and ignorance not only infect the government. They are buddies in every school, workplace and market. How are you going to reform them?

Don’t worry, you have decades of time before the money machine becomes a threat to the Irish Pot O’ Gold again!

Just remember that you and yours caused this mess, not the Germans!

Does this report, in essence, propose that EMU countries shall not longer be able to issue debt governed by domestic law? That is the ultimate surrender of sovereignty as far as I am concerned. Rogoff & Reinhart have shown the critical importance of having your debt goverend by domestic law in times of crisis. We need to look beyond the end of our nose on this.

[I admit I have not had time to read this report]

Hopefully the Irish authorities are actively trying to influence the shape of the future EFSF. I posted this on the Morgan Kelly thread and it garnered zero interest. It may be bad form to report, but I lack class.
It’s time to start planning for a more favourable participation in the EFSF (or whatever amended form it may take). Currently the EFSF is all stick and no carrot. If we’re not allowed to default, we’ll end up paying billions to Germany and France to cover the cost of ‘their’ guarantee.
The stick should be as it is – handing over control of a lot of economic decisions and a high interest cost. On the former, it is necessary to keep control of our corporation tax policy; all other areas should be subject to outside control. On the latter, it is necessary to deter accessing the EFSF as a preferred option.
That said, the high interest doesn’t have to flow out of the facility. With my structured finance hat on, I would suggest that most of the interest should get trapped in a loss reserve subordinate to the EFSF bonds. I would also suggest that a QE-style operation by the ECB in buying a portion (mezzanine EFSF bonds) or all EFSF bonds.
In simple terms, my suggestion works as follows: Say Ireland has to tap the EFSF for 100bn at 5.5% for ten years. Assume the EFSF bonds pay 3% and the guarantors get 1%. I suggest the remaining 1.5% is used to fund a loss reserve. Over ten years, this would amount to 15% (or 15bn). This is the carrot – i.e. if the country gets their act together and avoids a default, they get to reduce their national debt by 15bn on exiting the EFSF. The introduction of a loss reverse does not adversely affect the guarantors because in the event of default, the losses would initially be absorbed by the reserve.
The numbers I use are purely for the purpose of example. ECB involvement could make things a lot cheaper. With the Americans engaging in QE2 and the possibility of the euro becoming too strong, some QE-style programme by the ECB is worth looking at.


I noted your comment and also noted the lack of response. I would be very surprised if the Government and the Troika aren’t working on a Plan B – required if the NTMA is shut out of the market. My view is that the Government’s last remaining card is that the Troika want to keep Ireland out of the EFSF more than the Government wants to stay out.

I think we’ll just have to wait and see.

@Paul Hunt

I am probably behind the times but who or what is “the Troika” and why do they want to save Ireland from the EFSF?

If the government aren’t working on a plan B then they should be!

Point number 1. is phrased in an interesting way:

“how to reduce the present value of the debtor’s future obligations ”

Maybe the first response might be a rescheduling of the term of debt, which for fixed income securities trading at a discount to par, would mean a fall in their present value (a drop in the yield to maturity to holders which comes through in an immediate capital loss in the mark to market value of the bond).

For example, by my calculation the benchmark 2014 4% Irish government bond rescheduled to 2030 would produce a change in the price from €91 to €67. about 26% fall.

That could “save” us a bucket load, given we have issued a lot of debt at the shorter end of the yield curve over recent years – I will have to look into the proportions.

Shifting average maturity out 15 years in this way could cut €26 billion for every €100 billion we owe – in terms of “the present value of the debtor’s future obligations “


Ciaran O’Hagan should have claimed copyright on the Troika – EC/ECB/IMF.

And I expect Plan B has to be in the works, but well under wraps.

It’ll be needed. Can’t see bond investors queueing up for long-dated Irish sovs at manageable yields when they see (a) a government that will be precluded constitutionally from seeing through the proposed programme of fiscal adjustment, that lacks a popular mandate and barely has constitutional legitimacy and (b) two opposition factions – that in more mature and developed democracies are on opposite sides of the political divide – fighting furiously to be top-dog in the most likely incoming combination of governing factions.

Also, nobody has pointed out the irony that current policy is doing a very effective job of “reducing the present value of our future debt obligations”. It’s just that it hasn’t been implemented in a manner that is of much benefit to us yet!!


I agree. It’ll be a murderous 3 years in the EFSF before any respite on this front might emerge. But hey, the IMF will have fun ripping into the cosy clubs and rent-gougers.

@Ahura Mazda.
Sounds like a good template. It keeps both the profit and the loss within the system. At present it seems that the EU taxpayers take the loss, the speculator take the profits.

In fact the you should lower the rate by about 1% so that the country in trouble borrows at about 3% above ECB, with 2% going to reserve as a potential carrot, the remainderas internal profit.

About Ireland. Your €100 billion Bubble bond or Bertie Bond figure is about right. Taking MK €70 billion for the banks which is understated by the looming mortgage crisis that may come to €30 billion to sort out in a socially equitable manner.

In general not enough comment is given to solutions of the current problem and this was a major fault in Morgan Kelly’s article.

So which one of our great leaders will take Ahura’s proposal to the table. Not one. Too busy cosying up to their new paymasters.
The dail is completely of independent or creative economic thought. There the only question is to Vichy or not to Vichy?

@Ahura Mazda

Good ideas. I would hope on the political side of things that Ireland is working with the other peripherals to shape the future EFSF – collectively the peripherals have a blocking majority, or very close to it. There is no evidence of this though – there are no “Malaga” meetings corresponding to “Deauville” meetings, before the major summits. More broadly all the arguments that the USA is using regarding the problems of their imbalances with China have a direct analog with the imbalances between the EU peripherals and EU core, yet there seems to be no coordinated effort by the peripherals to try and do anything about it.

@Ahura Mazda
Yes, it’s a good idea. See my own more limited scheme above.

Combine the two and you have a mechanism to lend and to punish those who step out of line – break Maastricht rules and you pay more to Eurobondco, thereby increasing your reserve for the inevitable trouble down the line.

@ Paul Hunt,

the UK group Plan B had a hit single this summer called ‘Prayin’. Plan B and Praying sounds about right for the DoF.

@ Joseph Ryan,

I’m sure there are better ideas out there. I’m suggesting a template common in ABS. You could certainly change the percentages. In terms of funding costs, an ECB involvement could be critical. Realistically the emergency fund mechanism needs to be scalable to an Iberian peninsula-sized problem.

@ Bryan G,

Working with the other PIIGS is a good idea, though risky. Any Spanish involvement would send the Germans bananas. I’m rather modest in my suggestion – fiddling within the framework, coordinated PIIGS would have a stronger hand (though it could collapse the EU). Certainly ‘general discussions’ should be seriously evaluated.

@ hoganmahew,

Unless Eurobondco is incredibly well capitalized, Country X (with good financial stability) should be able to borrow at x% or less. Would Herr M of country X be willing to take one for the team? A sticking point might be that country X loses influence while subsidizing country I. And how is z% determined? Your suggestion is probably workable, though it would get very complex. There’s many alternatives to the EFSF. Hopefully ‘country I’ doesn’t buy of the shelf.

Are bonds not just a way to manipulate currency?
Is it possible to recoup/exceed any losses on bonds through shorting the Euro?
Is this the real play here?

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