Sovereign debt, government myopia, and the financial sector

Viral Acharya and Raghu Rajan provide an explanation as to why sovereign defaults are rare events in this VOXEU article.

33 replies on “Sovereign debt, government myopia, and the financial sector”

Source being used Source: “European stress test data released in June 2010”

That is a bit prehistoric in terms of what is happening now.

@ Robert Browne

Herewith a link to another freshly minted Bruegel paper which meets your point.

It seems to me that it is the job of academics to think the unthinkable and to take the risk of appearing naive in the process. The authors of the more recent Bruegel paper, for example state the following;

“The core reason for these failures is the absence of a fiscal union with corresponding authority over fiscal, structural and banking policies”.

What they should say is that the core reason is the political unwillingness of the countries involved to create such a fiscal union. The question then, given this unwillingness, is whether the proposition that, without fiscal union, the euro must fail. This is far from proven. The value of the most recent Bruegel paper is that it analyses the problems correctly and provides a menu of decisions from which, if a sufficient number of items are taken, the euro might yet succeed.

All the rest, including the proposals on treaty change which are promised in the next few days by Merkozy, and which deal with no problem in particular, can only be viewed as political face savers for those involved.

The key question is the nature of the institutional structure within which the new decisions will apply. The most recent statement by the French prime minister contains the fatal word “inter-governmental”. If the larger players insist on this, the euro is indeed promised a very doubtful future.

Simon Johnson has a good article in the NYT on too big to fail banks and contagion where he quotes Richard fisher of the Dallas Fed..
““Invariably, these behemoth institutions use their size, scale and complexity to cow politicians and regulators into believing the world will be placed in peril should they attempt to discipline them. They argue that disciplining them will be a trip wire for financial contagion, market disruption and economic disorder. Yet failing to discipline them only delays the inevitable – a bursting of a bubble and a financial panic that places the economy in peril.”

Seems to me that the guys are confusing cause and effect. They claim the effect of defaulting on sov debt is short lived as the markets seem to be mainly forward looking. They then propose another theory as to why govts don’t default.

However the reason why markets tend to shrug off defaults is precisely because they tend to be rare events and are usually only undertaken in extreme circumstances. If defaults were more regular and were seen to be optional or unreasonable, we would probably find that the markets would be less forgiving and it would take the defaulting nation longer to recover. This is alone is sufficient reason why there are so few defaults.

Markets are forgiving to the extent that excess money formation in one large economy (in this case, the US$ as the world’s base currency) creates an excess of “savings” looking for yield. That is not the case today. Now we have a western/ rich world eating up capital and desperately trying to recap banks that blew up with excess lending, leverage, and unknowable quantities of derivatives exposure.

The paper is too simplistic IMHO. It seems to me that governments don’t default on foreign obligations because, like addicts, they are invariably hooked on foreign capital inflows. They need the flows to maintain the pretense of decent living standards. The flow problem infects the stock problem and visa versa.

When they “Go” it is usually because flows stop, then the realization hits that we have a stock problem. The arguments around default can then begin.

I don’t think historical data on defaults is much use. The financial sector has never been as big as it is now. The ongoing breakdown of 2008-201x wasn’t caused by war or a political dispute. It was generated entirely by the financial sector which is essentially out of control.

The Greenspan put was replaced by the Trichet put and now they want a replacement.

@ Ceterisparibus

One could take it further and say that Sarkozy has accepted that the German position on the two nominally core issues, the role of the ECB and the issue of euro bonds, is immovable. But that does not mean, it seems to me, that it is game over.

The countries of the EZ have gone from pointing the finger at one another as to who is to blame for Greece, and subsequently Ireland and Portugal, falling into the hole to the point where they have now all realised, even Germany (the only first-class passenger on the Titanic, as the FT commented), that all are in the hole together. The discussion has turned from finger-pointing to the question of how to get out of the hole in which the EZ now collectively finds itself. The bond markets will remain on strike until it answers it.

The Bruegel paper provides a handy reference list of objectives to be addressed which can best be categorised according to their chance of being realised politically.

On treaty change, as the issue is largely irrelevant, little time need be devoted to it other than in terms of the institutional power-shifts that may result.

On the various technical improvements – short of a fiscal union – that are needed, these could easily be accommodated within the existing treaties. What is missing is the political will to implement them, not treaty provisions. As time is running out, there is a strong chance that proposals tabled by the Commission will have to be run with.

Bringing forward the implementation of the ESM, as sought by the Commission, would also send a strong signal to the markets but the issues relating to PSI will first have to be clarified. This must go much further than stating that Greece is an exception while insisting on treaty texts which anticipate that this is unlikely to be the case.

Lastly, there is the issue of what the ECB will decide to do “independently” in order to hold the fort while the politicians belatedly get the house in order. The Reuters report hints at one possibility.

“In one possible response, people familiar with the matter said the ECB is looking at extending the term of loans it offers banks to two or even three years to try to prevent a credit crunch that chokes the bloc’s economy”.

It is not for Merkel, or any other leader, to describe Commission proposals as inopportune. The ECB is not the only body that acts in complete independence. Such language displays a deplorable lack of respect for the institutional functioning of the EU which has been a hallmark of the Merkozy era. Events are conspiring to show that the EU cannot function on such a basis. Any credibility the two leaders had is now in tatters following the failure of the German bond auction and the effective loss by France of her triple A status.


Treaty changes are not a simple as you portray…if it does come to choosing one of barrosso’s options, an outcome extremely unlikely given the German stance as reiterated again today by Dr Merkel. As she pointed out, financing costs would converge across the Eurozone and German costs would soar. It is likely that she was playing a political game in using this argument to bring the German citizen firmly onside. This rhetoric seems to have diverged from her previous utterances regarding Eurobonds at his point in time being ” incredibly inappropriate”. I get the feeling that she is preparing for a departure and has convinced Sarkozy that she will do it…hence his about face today.

From Der Spiegal
“Angela Merkel’s response could hardly have been clearer. European Commission President Jose Manuel Barroso on Wednesday presented a study outlining the possible forms euro bonds could take — whereupon the German chancellor found unusually unambiguous words in response. The proposal, she said, was “extraordinarily distressing.” She also called it “inappropriate.”

The reaction was unusually firm for Merkel. She has become notorious in Germany for shying away from positions that can’t be wriggled out of later. But when it comes to pooling the debt of all euro-zone member states in the form of euro bonds, she has long been firm in her rejection. In December 2010, for example, she said “the euro zone needs more harmony and competitiveness rather than common euro-zone bonds.” In September, she called euro bonds “absolutely wrong.” Wednesday’s outburst, in other words, should not come as a surprise.”

Der Spiegel updates on ‘she is’ and ‘she isn’t’ just posted on previous thread …

@ Ceterisparibus

The issue is not what Barroso proposed but his right, or rather that of the Commission, to do so. In the case of euro bonds, all the Commission has done is to launch a consultation document, the Green Paper, which it is fully entitled to do.

Barroso has not proposed, on behalf of the Commission, as far as I know, any changes to the treaties (which he would be entitled to do, as would the European Parliament, under the Lisbon Treaty – Article 48.2 TEU).

The only agreed imminent change that is required to the treaties is to Article 136 to allow Germany to sign up to the ESM – a rather odd requirement on the latter’s part – and this is to be adopted under the so-called simplified decision procedure under Article 47.6 of the TEU. While subject to every country’s constitutional requirements, the government has already indicated that it does not think a referendum will be required. No doubt, someone will find reason to disagree with this view. (Some confusion crept in in the most recent public comment by the Taoiseach as between the EFSF and the ESM).

As to your comment that Merkel “is preparing for a departure”, I would ask; from what?

I suggest that you read through the Bruegel paper to get an idea of the institutional cat’s cradle that Merkel and her advisers have succeeded in creating with regard to resolving the euro crisis and to which she now wishes to add.

@ Ceterisparibus

Even the Dutch are now getting worried. That says a lot!

In the list of to-do items, that of bank re-capitalisation looms large. El-Arian thinks it has to be the idea first mooted by Lagarde some months ago, to general uproar, of forced re-capitalisation. The Bruegel paper also has some practical ideas.

+1 ….

She said from the beginning that we are playing with the fundamental wiring of capitalism. She fundamentally disagrees that a common Eurobond or that ECB printing will solve the problem. In fact, these are likely to make the problem worse for the “real” economies of Europe. It’s back to “liquidity” or solvency. If the problem is exclusively one of liquidity, then euro bonds and ECB action would work, but if it’s one of solvency too, then they only make the problem wise, because they transfer risk to those who, while so,vent now, cannot bear the extra burden.

The reality is that Europe’s periphery cannot continue to live beyond it’s means. In fact, the periphery has accumulated so much debt by living beyond it’s capacity to produce, that it is now beyond rescue. Add US bank derivative nonsense on top, and it becomes clear that NO sovereign entity can save the debtor.

In the end the creditor gets burnt too, and the Anglo (read debtor) countries are very keen to point put he losses that china and Germany will suffer if they let the debtors fail. They refuse to acknowledge that the debtor countries have had their way for so long now, that it is currently impossible to save them. Germany’s choice is a) step in and “save” the debtors but then implicitly stand by existing debt levels or b) refuse to save them, suffer an enormous hit to banks and to demand but at least survive and hold the capitalist system intact.

What would any of us choose in this scenario? I say let them fail.

Barosso may not have said anything about treaty changes but two of the options he proposed definitely require treaty changes and the third may.
The Bruegel paper proposes a finance ministry with veto powers over sovereigns and therefore requires fundamental treaty changes which will never get passed, especially in Ireland.
My point is that proposal that will likely take a long time to implement or even get the requisite consent for are useless in the current crisis.
The credit markets are seizing up and big companies are being affected across Europe. I see today that the financial regulator in Russia is restricting his banks in their dealings with European banks.
Contagion is spreading everywhere and the powers that be can only propose schemes that are incapable of being implemented in any reasonable timeframe.

As for my comment the death, the Fatherland will be the first priority.

““Invariably, these behemoth institutions use their size, scale and complexity to cow politicians and regulators into believing the world will be placed in peril should they attempt to discipline them. They argue that disciplining them will be a trip wire for financial contagion, market disruption and economic disorder. ”

Nature has viruses and pandemics for this sort of thing.

The latest from Jeremy Warner …

“No, what this is about is the markets starting to bet on what was previously a minority view – a complete collapse, or break-up, of the euro. Up until the past few days, it has remained just about possible to go along with the idea that ultimately Germany would bow to pressure and do whatever might be required to save the single currency.
The prevailing view was that the German Chancellor didn’t really mean what she was saying, or was only saying it to placate German voters. When finally she came to peer over the precipice, she would retreat from her hard line position and compromise. Self interest alone would force Germany to act.
But there comes a point in every crisis where the consensus suddenly shatters. That’s what has just occurred, and with good reason. In recent days, it has become plain as a pike staff that the lady’s not for turning.”

Worth reading whole article

@ Ceterisparibus

With all due respect, you need to sort out a few things. A Green Paper, by definition, contains no proposals. The Bruegel paper is just one among many and I have already said that it is politically unrealistic in many respects. But it is useful because not a single significant element, it seems to me, other than in relation to PSI, is missing.

As hitherto, Merkel may be conceding while trying to hide from her disabused electorate that she has done so. Underlining the independence of the ECB and saying that there will be no proposal to change its mandate is, in one way, stating the obvious but might also be read as saying that it is free to act in the manner it considers the most appropriate.

Of course, there is the prospect too dreadful to contemplate that she has no idea what she is doing.

We will see!

And this report from the telegraph says it all

“After a clearly fractious meeting, Nicolas Sarkozy tried to crush the doubts Fitch cast over France’s AAA rating on Wednesday. “[Fitch] said the AAA rating of France is stable – maybe that translation has not crossed the Rhine river,” he said.
But after the summit, Mr Sarkozy had been forced into submission. “We all stated our confidence in the ECB and its leaders and stated that in respect of the independence of this essential institution we must refrain from making positive or negative demands of it,” he said.
He added that proposals to change European treaties would be presented ahead of the EU summit on December 9. Italian premier Mario Monti pledged to balance the budget by 2013 – but failed to prevent the country’s 10-year bonds closed in the danger zone again at 7.13pc.
As stock and bond markets lurched, there was bemusement about Germany’s stance. Christian Schulz, an economist at Berenberg Bank, told reporters: “Unfortunately, we are in the paradoxical situation where we are pinning all our hopes on a new catastrophe for Berlin finally to move.”
Luxembourg’s foreign minister Jean Asselborn said in an open letter to Germany’s Handelsblatt: “If you, dear Chancellor, do get your wish… please do not forget the risk that the EU will implode.”



“No, what this is about is the markets starting to bet on what was previously a minority view – a complete collapse, or break-up, of the euro.

The FT at the weekend said the markets had priced in a 25% chance of breakup. Yields would have to go way higher to shift this significantly. The Torygraph would love it if everything fell apart of course. Like the UK system for care of the elderly.

with equal respect, whether those proposals are contained in green, pink or blue papers is irrelevant.
My point is that they are unrealistic.
As you can see from the post above, Sarkozy has said the proposals for treaty changes will be published before the summit on the 9th December.
If referenda are required in some states then it is highly likely that some of the proposals will be rejected.
In the meantime, the markets will act and credit will freeze..where it has not
already done so.
And as for Mickey Noonan’s comment that we are fully funded…I think he is delusional. If the markets seize..where is he going to get the next tranche.
Also reported tonight that the Americans are getting out of Europe as quick as they can.

@The German FDP

Humbly suggest you might leave the coalition on Black Friday – hence, possibly saving Europe.

Herr Kohl to facilitate a Grand Coaliton; item #1: change constitution.

Interim measure for ECB to be delegated unlimited emergency power, for a reasonable period of time, to stabilize EZ bond market.

Monday is then another thanksgiving day.

@ Ceterisparibus

If you read what I say you will note that we are not that far apart. My criticism is of the undermining by Merkel, like of so much else, with the deluded cooperation of Sarkozy, of respect for the institutional structure of the EU. I have expressed no view on the issue of euro bonds other than that it is effectively off the table.

As to the imagined panacea of treaty change, Merkel’s standard response, as I have also said, it is irrelevant to the immediate problem. So we are in agreement on that point.

As to the comment by our esteemed Minister for Finance, I agree entirely. Indeed, I said on another thread some time ago that the risk of cold turkey for Christmas was real.

But not to worry! As part of Ireland’s contribution to the general merriment, the politics of Ballymagash have been exported to Strasbourg. When ignorance is bliss, tis folly to be wise!

P.S. I find it hard to take the Daily Telegraph seriously as a source of comment on EU matters.

“Also reported tonight that the Americans are getting out of Europe as quick as they can.”

They’ll be straight back in if there’s a deal that sticks. It’s all about beating the benchmark for these bond portfolio managers.

According to that FT article, 4 Dutch economists wrote to the Dutch PM telling him to cop on.
The business community across Europe needs to get the finger out as well.
This is no time for orthodoxy.

“the lady’s not for turning” and separately, “I hope she knows what se’s doing”

I hope so too, and I hope and pray that she knows what she is doing. In recent posts I had hoped that she would run to the edge and then step in to prevent catastrophe. Now I am less certain, i hope and believe that she is more informed and intelligent than I am. She understands the balance between liquidity problems and solvency and has decided which is th problem.

If it is, indeed, a solvency problem (which I suspect is the case), then we are facing a massive shitshow and there is nothing we can do to prevent it. She will be right to let it go, even though she will go down in history as a disaster.

Ireland HAS to prepare for the worst. Isn’t it doing this? It needs to reach put to the ddiaspora and create alternative sources of funding to tide it over the interim, while it eases it’s expense account downwards. Right now it looks like the government is sitting passively while events swirlmaround it, but we are close to the point of ” every man for himself”. Why are they not acting with preemption?

from DOCM’s late nite ECB [not LBS …

The sovereign debt crisis and the future of European integration
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB,
at the Oxford University European Affairs Society,
24 November 2011

I have three main propositions.

First, membership of EMU entails much deeper policy changes than were originally realised. In 1991, Hans Tietmeyer, the former President of the Bundesbank, remarked that “monetary union is not just a technical matter. It is in itself, to some extent, a political union”. What has become clear is that countries that adopt the euro as their currency are required to adjust fundamentally the way in which they conduct their economic and financial policies. At the same time, ensuring overall stability requires far-reaching coordination in economic and financial governance. It would be difficult to understand that in the world’s second largest monetary area governance is outsourced solely to the markets and ratings agencies. Effective governance of an economic area of such importance requires much closer economic and financial union.

Second, in response to the crisis, a much more radical change in euro area governance has taken place than many observers seem to acknowledge. Europe tends to reform incrementally, at times creating frustration at the pace of change. But those increments now add up to a fundamental overhaul of its economic management. The reasons this has not been more effective in calming the crisis are complex, but communication stands out among them: In “selling” their reforms, euro area authorities are forced to walk a tightrope between the expectations of national electorates and financial markets, and risk satisfying neither. The only solution to this democracy-market dialectic is, again, much closer economic and financial union.

Third, and contrary to a strand of current thinking, the Treaty prohibition on monetary financing is supporting rather than threatening euro area integration. In the euro area, the central bank is “doubly removed” from the political systems of individual countries: it is not only constitutionally independent, but also elevated to the supranational level. Euro area governments cannot expect the ECB to finance public deficits. As a result, they must be commensurately more ambitious in their economic policies and more disciplined in their management of public finances to support their debt levels. Moreover, given the prohibition on monetary financing, having a banking sector which can support growth and provide adequate financing to the real economy in Europe requires a stronger regulatory and governance framework, so as to prevent negative feedback loops between banks and sovereigns. By forcing policymakers to focus their reform efforts on the right priorities the monetary financing prohibition offers an incentive to closer economic and financial union.”

Just a little reminder: Irish Sovereign saddled with a BankingBust of ~45% GDP which the empirics of economic history would tend to strongly suggest is unsustainable. On the fiscal – not a bother … The Irish debt crisis in not a true sovereign crisis – but a banking crisis.


Acknowledging emergency liquidity flows, may we please have a speech on:

The European Banking Crisis, the Neglect of Capital Flows, the Lack of EZ wide Bank Resolution Mechanisms, the Suspension of the Norms of what used to be known as Capitalism through Socialization of Financial System losses on European Citizens, and what, if anything, might be done to alleviate the present mess in all these areas.

Also late nite, WSJ

It’s a risky move. If too many borrowers with negative equity “strategically default,” the cost becomes huge for Irish banks, which would then have to turn to the government for more help—in effect, household debt would be transferred to the government.

“At a macro level, a debt-forgiveness scheme makes sense because people will be consuming rather than paying their debt,” says Philip Lane, professor of international macroeconomics at Trinity College Dublin. “But the scheme has to be surgically targeted so only the people most in need use it.”

Underlying all this from a core perspective is how do you keep the PIIGS feet to the fire so as they deal with their lack of competitiveness and over generous entitlement programs.

One way to make sure that they do not deal with their systemic problems is to let the ECB continue doling out short term funds and to make matters worse follow up with an assured flow of medium to long term funds.

The countries now in trouble including our own have a history of cronyism, nepotism, and simple plain unvarnished bad governments. There is still a lot of the Dev mentality in Ireland as in we can erect barriers and hide behind them, we are special and do not have to make an effort to find out what we are doing wrong. Friction free commerce and government acting in the long term interest of the people, that’s alright for foreigners, we need to be coddled on a daily basis.

In the same way that the Germans strive to get production out of their unemployed they are looking at the under producing governments and asking themselves how can they be induced to become efficient. The answer is, not by throwing money at them but by forcing them to get down to business and prove they are seriously dealing with their problems before they get any more funds.

The countries now in trouble including our own have a history of cronyism, nepotism, and simple plain unvarnished bad governments.

I have been reading Private Eye for 15 years. The UK is no better. I read the New York Review . The US is rotted through with corruption . Germany probably is too.

we can erect barriers and hide behind them, we are special and do not have to make an effort to find out what we are doing wrong.

It is the same in the ECB.

Friction free commerce and government acting in the long term interest of the people, that’s alright for foreigners, we need to be coddled on a daily basis.

Wait until the oil runs out. No economy is run in the interests of our descendants.

Following Bklyn_rntr’s comments above, it seems to me that the Germans are suggesting that default will have to happen and they may be right.

This is possibly not so bad for Ireland as it can compete within the EZ, and so has a relatively good chance of getting back into the bond markets quickly.

Notwithstanding the chorus for massive ECB intervention, we should consider that the Germans may be right.

The question is whether they can be right without destroying the whole kit and kabooble. ECB backed IMF programmes would be a start, but we also need a functioning banking system.

Any reform of the banks will take a long time to implement and may not be achievable at all unless it is backed by a credible EU-wide bank resolution process.

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