Otmar Issing is wrong! Germany should bail out Greece without making bondholders pay!

02 December 2010

In today's FT Otmar Issing, an important German Economist and Central Banker, has published an article defending Germany's recent decision to begin putting in a place a bailout framework which includes the possible restructuring of sovereign bonds.

Until recently the Eurozone was thought to be a no-default, no-bailout system. We haven't had a default in a major developed economy since the Second World War, and for a long time the idea of an Eurozone country defaulting just didn't register on the financial market's radar screen. Up until the Credit Crisis, all Eurozone government bonds traded at around the same yields.

Nevertheless, the founders of the Eurozone were not blind to the dangers of default. They created a rule specifying that member states must not allow their budget deficits to exceed 3% of GDP, nor should their total debt rise above 60% of GDP. However, these rules were widely ignored, now even Germany violates them.

So the Germans are now searching for new Eurozone stability principles. Why does this job fall primarily to Germany? Because Germany is by far the most economically powerful state in the EU, in fact the gap between it and other states is widening rapidly. Germany also contributes substantially more money to the EU budget than other member states. Once Germany and France called the shots together, these days the Germans increasingly rule alone.

How is Germany's new crisis resolution / prevention vision shaping up? Here is what we have so far:

(a) The EU will police the collection of economic statistics to ensure member states report them truthfully.

(b) The EU will impose penalties on states running dangerously unsustainable deficits.

(c) Failing Eurozone member states will not be abandoned or forced to leave the Eurozone. Instead, the EU will bailout Eurozone states on the brink of default.

(d) Sovereign bond holders will not necessarily be protected in any bailout, which will help to cut the cost of bailouts, and ensure that governments are motivated to curb excessive borrowing by financial market pressures. Mr Schäuble said: with this measure "we ensure that solid fiscal policy is rewarded, while bad fiscal policy is disciplined by means of different spreads between government bonds”. Bond yields in Ireland, Spain and Portugal rose dramatically on the announcement (ie prices fell, reflecting a higher level of risk).

(e) Bailouts will involve some loss of sovereignty. The EU and the IMF will impose austerity programs on failing member states. 

Otmar Issing's FT article defends item (d) above. He point out that:

Without (d) German taxpayers are being asked to shoulder potentially unlimited losses, the option of making bondholders contribute to the rescue must be retained. Without (d) German is effectively guaranteeing the sovereign credit of every other member state. All bonds would logically trade at German levels, and member states would be even more likely to get themselves into difficulty, enjoying themselves on a German Platinum Card with no limits and rock bottom rates.

A powerful argument - but wrong!

Fickle investors and worthless credit rating agencies can not provide either efficient or rational discipline. Outsourcing the EU stability mechanism to financial markets is a very bad idea. What we really need is a single market in Eurozone government bonds, backed collectively by all member states, ensuring the lowest possible interest rates for everyone, leveraging economies of scale.

Otmar Issing is right about the need for discipline, but wrong about the technique. How do you give a child a credit card safely? Simply say: "If you abuse this card you're grounded!".

In other words sovereignty is the proper discipline, not financial market pressure. Germany must develop a discipline mechanism which centres around (e) not (d).

In fact, Eurozone sovereign default wasn't off the financial markets radar up until 2008 purely because traders are mindless lemmings, but also because Eurozone sovereign default really is a very bizarre idea. Despite what the liberal economists over at the FT say, there is in fact absolutely no need for a rich country like Greece to default on its debt.

Greece is not Africa or Argentina. Have you seen the property prices in Mykonos? Did you know that an estimated two-thirds of Greek doctors report incomes under 12,000 euros a year, the threshold below which no income tax at all is charged in Greece? What do tax evading Greek Doctors do with their money? Buy houses in Mykonos of course. Or perhaps you think that 66% of Greek doctors really do earn less than 12,000 euros a year? In which case you may be surprised to learn that in Greece the average state railroad employee earns 65,000 euros a year! Still income isn't everything, Greek public sector employees also enjoy some of the most generous pensions in the Eurozone. In a world ranking of GDP per Capita Greece comes 24th, miles ahead of Argentina, and if we add the thriving black economy some claim Greece is richer than Germany.

What I am trying to say is that Greece's debts, high as they are, are not unrecoverable. The problem is not debt, simply absolutely appalling government and widespread corruption. There is ample money in Greece, the government just needs to confiscate it - eg by punishing tax evaders or nationalizing real estate. There is no need for Greece to steal from foreign creditors, there is a pile of ill gotten gains in Greece already.

So the EU needs to deprive the Greeks of sovereignty, putting the country under technocratic EU management until such time as it is cured. This is both the moral and the utilitarian choice. Why moral? Because it is the Greeks who are undeserving, not the German taxpayers the Greeks want to bail them out, nor the Chinese taxpayers the Greeks want to default on. Why utilitarian? Because it the best way to fix Greece, it sets an example to other member states, it minimizes EU borrowing costs, it does no harm to foreign creditors, it protects the EU's reputation.

Watching the EU repeatedly shoot itself in the head is deeply depressing. The problem with democracy is that the people who get elected are not creative thinkers, they are slaves to public opinion. The unelected specialists who advise them get caught in the same trap, because they have no power themselves, all their decisions must be approved by their mindless masters. Over time this tyranny of mindlessness purges the government of all intelligence, it becomes a monopoly of mindlessness that can only be toppled by revolution. Lord Turner of the FSA is a rare example of a radical thinker, but that's only because he was woken up by the credit crisis. Like the FSA a few years ago, the EU is sleepwalking to disaster. The question is: when will Angela Merkel have her Lord Turner moment? Turner abandoned his mindless ideological obsession with laissez-faire. Now Merkel needs to abandon her mindless ideological obsession with democracy and national sovereignty.

Dear God, please help the Germans remember that the major lesson of European military conflict, is not the sanctity of sovereignty, it is the impossibility of sovereignty, and the sanctity of wise governance. This is evolution, it is the will of God that the incompetent be ruled by the competent. Looking at the big picture progression of European history, sovereignty has never worked, nor can it ever work, especially under democracy.

Germany is, and has always been, fated to rule Europe. By refusing to step up to her responsibility, Germany endangers us all. Long ago the liberal populist Frederick III ended elite German rule, and set the country on the chaotic path which culminated in the psychopathy of Hitler. Today chaos reign again, and if the German elite fail to make the tough rational choices which cure European incompetence, populist tyranny will rule again.