Tuesday, 25 October 2011

The Euro: A Tragedy of the Commons

Imagine that each EMU country possessed a Euro printing press. Each country would accrue benefits (higher income) by printing money, whereas the costs (a lower purchasing power) would be borne by all Euro countries. The country that prints the fastest makes gains at the expense of others. In this (hypothetical) situation we are faced with a "pure" Tragedy of the Commons where there is no limit to the exploitation of the Euro resource. The currency ends in a hyperinflation and a crackup boom, in other words, the destruction of the common resource.
Although hypothetical, the example of several printing presses helps us understand the risk to the Euro. Reality is different - deficit countries run deficits and issue bonds, which is not the same as printing Euros. Banks earned a yield spread by purchasing these bonds and posting them as collateral for cheaper loans from the ECB. The loans were effectively new money from the ECB, which was used to repeat this process.
Similar to the mortgage securitization process by US investment banks, this created a “demand” for Euro government, which politicians were only too happy to supply. The incentive for politicians was redistribution. Early adopters bought electoral favors at low prices. Spending the newly borrowed money increased prices and monetary incomes across the EMU. This forced greater borrowing to finance the same lifestyle. The higher the deficits became and the more governments were forced to borrow.
There were several risks to this arrangement continuing forever.
1. Low yields - Banks needed sovereign bond yields to be higher than the ECB lending rate interest rate for this to be profitable.
2. Default risk - default was considered impossible. It was widely confused with a country leaving the Eurozone. As the euro was seen as an irreversible political project the market assumed there were implied bailout guarantees, even though these are explicitly prohibited by the EMU treaties.
3. Collateral quality - Before the 2008 crisis, the minimum rating required by the ECB was A–. This was reduced to BBB– during 2008 for one year, and then another. Finally, the ECB, in contrast to its stated principles of not applying special rules to a single country, announced it would accept Greek debt even if rated junk.
4. Liquidity risk - Government bonds are of a longer duration than ECB bank loans (1 week to 3 months, now increased to 1 year). The risk was that the ECB might refuse to roll over loans collateralized with downgraded country debt, causing liquidity problems for the borrowing bank.
5. Haircuts -The ECB distinguishes five different categories of collateral, demanding applying different haircuts. Haircuts for government bonds are the smallest, thereby subsidizing their use as collateral vis-à-vis other debt instruments. This supports government borrowing. Downgrades mean that haircuts applied by the ECB on the collateral may not allow for full refinancing.
6. Tightening - The ECB might not accommodate all demands for new loans. If a restrictive monetary policy was applied, the risk was that not every bank offering government bonds as collateral would receive a loan.
However, for political reasons, the ECB did accommodate such demands, especially if some governments were in trouble. Indeed, the ECB started offering unlimited liquidity to markets during the financial crisis. Any demand for a loan was satisfied — provided sufficient collateral was offered. Loans up to 1 year were offered. Collateral quality control was waived.
EMU leaders externalized the costs of government spending in two dimensions: geographically and temporarily. Geographically, some of the costs are borne in the form of higher prices by the whole Eurozone. Temporarily, the problems resulting from higher deficits are possibly borne by other politicians and only in the remote future.

These tragic incentives stem from the unique institutional setup in the EMU: one central bank. These incentives were not unknown when the EMU was planned. The Treaty of Maastricht (Treatise of the Economic Community), in fact, adopted a no-bailout principle (Article 104b) that states that there will be no bailout in case of fiscal crisis of member states. Along with the no-bailout clause came the independence of the ECB. This was to ensure that the central bank would not be used for a bailout.
Political interests and the will to go on with the euro project have proven stronger than the paper on which the no-bailout clause was been written. Moreover, the independence of the ECB does not guarantee that it will not assist a bailout. In fact and as we have seen, the ECB is supporting all governments continuously by accepting their government bonds in its lending operation. It does not matter that it is forbidden for the ECB to buy bonds from governments directly. With the mechanism of accepting bonds as collateral it can finance governments equally well.
There was another attempt to curb the perverse incentives of incurring in excessive deficits. Politicians introduced "managed commons" regulations to reduce the external effects of the tragedy of the commons. The stability and growth pact (SGP) was adopted in 1997 to limit the tragedy in response to German pressure. The pact permits certain "quotas," similar to fishing quotas, for the exploitation of the common central bank. The quota sets limits to the exploitation in that deficits are not allowed to exceed 3 percent of the GDP and total government debt not 60 percent of the GDP.
If these limits had been enforced, the incentive would have been to always be at the maximum of the 3 percent deficit financed indirectly by the ECB. Countries with a 3 percent deficit would partially externalize their costs on countries with lower deficits. However, the regulation of the commons has failed. The SGP is just an agreement of independent states - without credible enforcement.
Inflation and deficit quotas of independent states are difficult to enforce. Automatic sanctions, as initially proposed by the German government, were not included in the SGP. Even though countries violated the limits, warnings were issued, but penalties were never enforced. Politically influential countries such as France and Germany, which could have defended the SGP, violated its provisions by having more than 3 percent deficits from 2003 onward. With a larger number of votes, they and other countries could prevent the imposition of penalties. Consequently, the SGP was a total failure. It could not close the Pandora's Box of a tragedy of the commons which will now follow. Expect more bailouts.
Adapted from http://mises.org/daily/5331, an excerpt of Philippe Bagus’ book The Tragedy of The Euro

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