The central issue in the current euro mess is the excessive borrowings of governments, with debt-to-GDP ratios in many countries now universally regarded as excessive.
Leaving aside the problem of reducing the debt to sustainable levels, the aim is to put in place a framework to avoid a recurrence. Hence the attempts, promoted in particular by Germany, to centralise fiscal policy (a 'fiscal union') so that German discipline can be imposed on the whole of the euro area. Of course, this has been attempted before, by way of the Maastricht Treaty, which in theory kept budget deficits below 3 per cent of GDP and government debt below 60 per cent of GDP. In practice, this didn't last long, with Germany among the first to exceed the Maastricht limits.
So why would it work any better next time, unless sovereignty over what must be the most sensitive element of macro-policy is ceded to Brussels (or Berlin)? The idea of firm discipline from a 'fiscal union' seems many years and many heated debates away.
There was, and perhaps still is, an alternative channel for imposing fiscal discipline on governments. If bond holders were diligent in researching and monitoring the credit risk, they would stop lending to governments which had reached the sensible ceiling of borrowing, and would insist on higher interest payments to compensate for greater risk. This is the sort of discipline that should be imposed by the 'bond-market vigilantes', whose potential power was recognised by US President Bill Clinton.
Why have the bond-market vigilantes been so ineffectual? Part of the problem is their own incompetence. Until 2009, they did a hopeless job of foreseeing the impending doom in Greece, treating Greek debt as more-or-less on a par with German debt. Of course they could argue that the Greeks hid the extent of the budget deficit, but as some of the bond vigilantes were actively involved in this concealment, they have little excuse.
The credit ratings agencies were equally blinkered, with one of them keeping Greece at investment grade even after the full extent of the disaster was apparent to all. The IMF's surveillance operation was either tardy in identifying the problems or reluctant to blow the whistle.
Perhaps the bondholders were sanguine because they anticipated that they would be bailed out. They had no good reason for this view: there is a specific clause in the euro agreement designed to prevent this. Nor is there some sacred principle that precludes sovereign defaults. Such defaults have been common enough; there was Argentina in 2001, and Iceland defaulted on its bank debt in 2008.
There seemed an opportunity in early 2010 to fix this fundamental issue by allowing Greece to default (in the form of a rescheduling). Certainly, strong mutual support would have been needed to withstand the inevitable contagion. But default would have re-established the role of risk as the primary discipline on profligate governments. Creditors who lost would be entitled to vent their anger on the credit ratings agencies, which might have sharpened the agencies' performance. The euro authorities who insisted that all euro sovereign debt should be treated as AAA for the purpose of prudential supervision, thus encouraging banks to hold excessive amounts of risky debt, might have corrected their mistake.
Instead, this robust channel for enforcing discipline seems to have been abandoned altogether. Part of the 'Merkozy' agreement reached last week promised that there would be no 'private sector involvement' in any future rescue operations: no compulsory bail-in of bondholders.
If this idea gets built into a future arrangement, it will be a truly amazing outcome. How could something so clearly at variance with the basic functioning of markets come about?
Perhaps the answer is that the eurozone crisis has seriously distorted sensible decision-making. Each of the involved parties has a good reason for supporting this aberrant outcome. The bondholders, of course, want to maximise their returns (and managed to negotiate a favourable voluntary outcome for the Greek debt). The debtor countries are very ready to avow that in future they will not default. The European Central Bank is already holding very large amounts of sovereign debt from risky countries, and wants an outcome which avoids losses. The financial institutions which underwrote the debt through credit default swaps and other guarantees favour a world of no defaults. The euro prudential supervisors would rather avoid the balance sheet carnage that would result if their banks' bond holdings incur big losses.
The IMF should have demanded a rescheduling of Greek debt when it first got involved in this mess in early 2010. It has now lost the opportunity. The short-term imperative to keep bondholders happy is overriding the longer-term need for market discipline on sovereign borrowers.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.