Sovereign debt restructuring; what it may take to save the Euro project

Transcription

1 Sovereign debt restructuring; what it may take to save the Euro project Marcus Miller University of Warwick 38 th Meeting of Central Banks and Finance Ministries IDB, DC October 9/10,

2 George Soros on creditor power Newsletter 1/10/2013 EU meant to be a voluntary association of sovereign and equal states surrendering part of their sovereignty for the common good. Has turned into a relationship between creditors and debtors that is by its nature compulsory and unequal. When a debtor country gets into difficulties the creditor countries gain the upper hand. The rules perpetuate this state of affairs. This is politically unacceptable; has the potential of destroying the European Union altogether. Only the creditors are in a position to prevent this outcome. 2

3 Some history and theory To put this in context, we take a brief look at: the history of debt, drawn from David Graeber (2011) Debt: the first 5,000 years the notion, discussed in Ariel Rubinstein s Economic Fables (2012), that sometimes power and not prices may be the key to determining outcomes. Taken together, they suggest a key role for debt restructuring 3

4 Some history: Where and why was debt invented? David Graeber (2011, p 64) Mesopotamia is where the practice of loaning money at interest was first invented. Most likely, Temple administrators invented the idea as a way of financing the caravan trade. However, once established, the principle seems to have quickly spread. Before long we find not only commercial loans, but also consumer loans. 4

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6 Why debt? Costly State Verification, apparently Why did the Mesopotamian temple lenders not use profit sharing as an alternative form of (equity) finance? [They] could not normally expect a merchant returned from a far-off land to be entirely honest about his adventures. A fixed interest rate would render irrelevant whatever elaborate tales of robbery, shipwreck, or attacks by winged snakes or elephants a creative merchant might have concocted. The return was fixed in advance. Graeber, p.215 6

7 Debt default penalties By c. 2,400 BC it already appears to have been common practice on the part of local officials, or wealthy merchants, to advance loans to peasants who were in financial trouble on collateral and begin to appropriate their possessions if they were unable to pay. It usually started with grain, sheep, goats and furniture, then moved on to fields and houses, or, alternately or ultimately, family members. Servants, if any, went quickly, followed by children, wives, and in some extreme occasions, even the borrower himself. These would be reduced to debt-peons: not quite slaves, but very close to that. 7

8 Exogenous shocks-- and debt relief [Consequently] farmers, who had borrowed to plant crops and were rendered insolvent by bad harvests, fled their homes for fear of repossession and joined semi-nomadic bands on the desert fringes of urban civilization. Faced with the potential for complete social breakdown, Sumerian periodically announced general amnesties. declaring all outstanding consumer debt null and void (commercial debts were not affected), returning all land to its original owners, and allowing all debt-peons to return their families. (Graeber p.65) 8

9 Some theory: Alternative worlds - the market and the jungle In Economic Fables Ariel Rubinstein contrasts the Walrasian market-clearing paradigm with the alternative of Jungle economics. In the market paradigm it is of course initial endowments and market prices that determine allocation. But in the jungle there are no property rights: allocation depends on relative strength. MIGHT IS RIGHT. 9

10 Market and Jungle

11 Endogenous transition from Market to Jungle? Rubinstein s analysis has been criticised for treating the power relation as exogenous. But maybe the creditor/debtor relationship is one where the shift from Market to Jungle is endogenous triggered by default? Consider the following 2 period, 2 player example. 11

12 Two concepts of equilibrium in one Edgeworth Box: first Market equilibrium at M; Borrower Later Consumption M E Real interest rate Lender Early consumption With initial endowments at E, for example, equilibrium at M is achieved by a lending at interest; 12

13 Second, Jungle equilibria where the lender is satiated Subsistence level for Borrower and family Borrower Later Consumption M J J Satiation Level for Lender E Real interest rate Lender Early consumption More powerful player chooses whatever suits him; weaker gets residual 13

14 How an unexpected but temporary shock can lead to default and a switch to Jungle equilibrium Borrower Subsistence level for Borrower and family Later Consumption E Initial endowment, excluding debt M Real interest rate J E J E Satiation Level for Lender Lender Early consumption Arrow indicates debt service obligation of borrower with outstanding debt; if hit with an asymmetric shock borrower is unable to service the debt due to the subsistence constraint; 14 default leads to jungle equilibria

15 Dead-weight costs of default Jungle equilbria (as discussed above) need not be Pareto efficient Violation of subsistence constraints, moreover, will have obvious deadweight costs, with long lasting effects in an economy with production. 15

16 Bankruptcy law as means to avoid switch to Jungle equilibrium Since debtor has unchanged net worth, s/he could justifiably file for protection against the creditor who insists on the letter of the preexisting debt arrangement If the bankruptcy judge granted an automatic stay and allows extra financing, this could secure equilibrium at M. i.e. the judge acts to make the debt contract state-contingent. 16

17 Application to the Eurozone? George Soros has made the point that creditors have the strategic advantage in the Eurozone. How to use this to keep the Euro Project alive? Fiscal Consolidation as key to macro policy has failed to reduce debt income ratios; But ECB action to calm panic in sovereign bond markets has worked see next slide on OMT: What else might be done? 17

18 Avoiding shifts of equilibrium Panic leads to high sovereign spreads for high debt countries in Euro area - as Calvo (1988) had warned. ECB promises to do whatever it takes prevent selffulfilling panic by buying sovereign debt in the secondary market as Calvo recommended. OMT has helped Euro survive 18

19 Super Mario But what next? 19

20 A swap to state-contingent debt? From a theoretical perspective a substantial switch to GDP indexed debt could in principle relieve a lot of the pressure. Bob Shiller advocates the issuance of trills ; and Barr et al. in a Bank of England paper study how risk sharing via GDP bonds could reduce the incidence of crisis Attractive in principle, but not credible in short run? What about administrative alternatives, motivated by bankruptcy procedures? 20

21 For debt laden, but solvent, sovereigns Countries which are solvent but face difficulties servicing all current debt could benefit from protection as follows: (a) Extending maturities of existing debts, (b) At reduced interest rates (c) Issuing warrants to give an upside. Under such a plan for easing the position of its Eurozone partners, the creditors would be acting, in effect, like a bankruptcy judge. The case for doing so would be a common interest in preserving the Euro. 21

22 For insolvent sovereigns For countries, like Greece, that are not solvent, write down will be required And, in addition, a cram down on all creditors, including vultures The CIEPR Report recommends an ESM Treaty amendment to prevent vultures from blocking a write down. Warrants could once again give creditors an upside prospect in recovery. 22

23 In fact Plans for for substantial debt consolidation in the form of a long term European Debt Redemption Pact have been proposed by the German Council of Economic Advisers ( to consolidate much of the debt above 60%). For more details and refinements see CIEPR Report (forthcoming). 23

24 The fateful question Creditors have the upper hand and, as the history of debt indicates, this could lead to a Jungle equilibrium The operation of bankruptcy law is to restore marketstyle equilibrium - effectively by making contracts state-contingent. Germany is now in the position of powerful creditor: Will it act like a bankruptcy judge or like the king of the jungle? 24

25 Angel Merkel?

26 References Graeber, D. (2011), Debt: the first 5000 years, New York: Melville House Publishing. CIEPR (201) Revisiting the case for SDRM, Committeey on the International Economic Policy and Reform (forthcoming). Miller, M. and Thomas, D. (2007), Sovereign Debt Restructuring: The Judge, the Vultures and Creditor Rights, The World Economy, 30(10), pp Miller, M. and Zhang, L. (2013), Fiscal consolidation: Dr Pangloss meets Mr Keynes, CAGE Online Working Paper Series 159, Competitive Advantage in the Global Economy (CAGE). Rubenstein, A. (2012), Economic Fables, Cambridge: OpenBook Publishers. Soros, G. (2013), Newsletter 1/10/2013. Stiglitz, J. (2012), The Price of Inequality, London: Penguin Group. 26