The euro zone’s terrible mistake

Dec 5, 2011

Felix Salmon

The FT is reporting today that the new fiscal rules for the EU “include a commitment
not to force private sector bondholders to take losses on any future eurozone bail-
outs”. If this principle really does get enshrined into some new treaty, it will be one of
the most fiscally insane derelictions of statesmanship the world has seen — but it
certainly helps explain the short-term rally that we saw today in Italian government
debt.

Right now, the commitment is still vague:

Ms Merkel agreed that private sector bondholders would not be asked to bear some
of the losses in any future sovereign debt restructuring, as she had insisted this year in
the case of Greece’s second bail-out. However, future eurozone bonds will still include
collective action clauses providing for potential voluntary rescheduling of private
debt.

Ms Merkel said it was imperative to show that Europe was a “safe place to invest”.
You can safely ignore the bit about collective action clauses. They’re part of the
sovereign-debt architecture now, and taking them out would be far more trouble than
it was worth: they have to stay in, no matter what. The important thing is that they
won’t be used — because if no one’s going to ask bondholders to bear any losses,
then they won’t have any proposals to agree to.

The impetus for this completely insane policy seems to have come from the ECB,
which genuinely seems to believe that bailing in private-sector banks, in the Greece
restructuring, was the “terrible mistake” which caused the current euro crisis. Talk
about confusing cause and effect: it was Greece’s fiscal disaster which caused the
restructuring and the necessary bail-in.

To understand just how stupid this is, all you need to do is go back and read Michael
Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks
and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the
euro. That only served to put a positively evil debt burden onto the Irish people,
forcing a massive austerity program and causing untold billions of euros in foregone
growth, while bailing out lenders who deserved no such thing.

Are we really going to repeat — on a much larger scale — the very same mistake that
Ireland made? Does no one in Europe realize that this is the single worst thing they
can do?
Markets reflect underlying realities, and up until now, the realities have been clear.
Europe’s periphery is sinking under the weight of too much debt, and the result will
be inevitable pain for private-sector creditors. The best case scenario is that those
countries bite the bullet and restructure their debt now, since to delay is to make any
restructuring much more painful and expensive than it needs to be.

The worst case scenario is that the EU kicks the can down the road with one new
bailout facility after another, until it eventually gives up throwing good money after
bad and imposes the restructuring which was inevitable all along. In that case, as one
hedge fund manager was explaining to me last week, private sector creditors get
devastated: because the EU and the ECB and the IMF won’t take any losses on their
loans, all of the haircut, pretty much, will have to be borne by a private sector which
accounts for only a fraction of the debt. So the private sector could end up with very,
very little indeed.

Now, however, Angela Merkel has come up with another plan. The details aren’t
clear, but it seems to involve the EU guaranteeing the debts of its member states.
Why this is acceptable while eurobonds aren’t acceptable is a mystery: a multi-trillion-
euro contingent liability is hardly preferable to a couple of hundred billion euros of
real liabilities. But there’s eurologic for you.

The immediate result of this plan is that everybody will rush into the highest-yielding
bonds in Europe, which is exactly what seems to have happened today. The other
effect of the plan, however, is that every country in Europe is now effectively
guaranteeing everybody else’s debt. Which is more than sufficient to explain why S&P
is minded to downgrade every country in Europe, up to and including Germany.

In order for markets to work, lenders need to suffer when they make bad lending
decisions. If the Europeans didn’t learn from Ireland, couldn’t they at least learn from
the Fed’s much-criticized decision to pay off all AIG creditors at 100 cents on the
dollar? Blanket guarantees at par are pretty much always a really bad idea — and this
one, if it comes to pass, will be the biggest one yet. It won’t end well.