Cost-effective Eurozone firewalls and the buyback boondoggle
This post was written by Gregory Connor
John McHale has a recent thread on the probability of a Greek default. In this thread I want to consider a different but related question. Only some of the promised Greek bailout funds are intended for funding Greek government expenditures; the rest of the funds are intended to pay back outstanding Greek sovereign bonds. Conditional upon a Greek default, how should the bond-payback-earmarked Greek bailout funds be spent by the Eurozone? Let X denote the total sum of Eurozone bailout funds intended for Greece, Y the amount earmarked for Greek government expenditures, and Z the funds available to pay back Greek bondholders. Define a disorderly Greek default as one in which a private sector involvement (PSI) agreement is not in place or is inoperative. My question is:
In the event of a disorderly Greek default, how should the EU spend Z?
There is a historical precedent for massive wastage of taxpayer funds in analogous situations. Bulow and Rogoff call it the “buyback boondoggle.” The buyback boondoggle refers to the tendency of fiscally-distressed states to demonstrate their newfound fiscal discipline by handing over large quantities of taxpayer funds to outstanding bondholders, even when there is no fiscal benefit in doing so. In reality, the payment of funds to existing bondholders by states in fiscal distress can actually lower rather than raise the future borrowing prospects of the state (see the paper above and this related paper).
Bulow and Rogoff make the now-obvious point that it is important to differentiate between existing bondholders and prospective new bondholders when emerging from a fiscal crisis. Policymakers in the midst of sovereign crises have an overwhelming urge to throw good money after bad. After a period of fiscal profligacy, politicians realize that it is important for the government to signal to capital markets that it will practice fiscal discipline in the future. What politicians can miss is that it is wasteful to throw away good money pretending that the state had such discipline in the past. In many cases the cost-efficient strategy is to fully default on existing claims, and start over. International investors are not stupid, and will in general act in their own interest, not that of existing bondholders. They can differentiate between the past and the future. (Rogoff the chess grandmaster was the first economist to see this clearly – in a chess game, you should play the board in front of you, not attempt to make amends for your bad decision four moves ago).
Also, in the current context, international investors know the difference between, say, Greece and Italy. A full default by Greece on all existing claims need not have a huge impact on Italy etc.’s borrowing prospects.
Much of the concern in the Eurozone is about the impact on European banks that are holding Greek bonds. Can Eurozone banks withstand the hit to their capital ratios if they are forced to write down Greek bonds to zero? Policymakers are actually proposing to deliberately pay off these bonds at a big premium to their fair value, partly in order to indirectly siphon money into Eurozone banks. This is a really wasteful channel to get equity into private Eurozone banks. If Eurozone banks need equity capital in light of a wipeout in Greek bond market values, they should be forced to accept direct equity injections. Anything else is extremely wasteful, since much of the funds spent overpaying on Greek bonds will leak out of the Eurozone banking system into NYC/London/Bermuda hedge funds, etc. My own suggestion is that in the case of a disorderly Greek default virtually all of Z should be spent directly on firewalling Eurozone banks, and near zero should go to outstanding bondholders.