By now just about everybody agrees that the European bailout of Greece has failed:  The debt will have to be restructured.    As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.

There is plenty of blame to go around.  But three big mistakes can be attributed to the European leadership.  This includes the European Central Bank - surprisingly, in that the ECB has otherwise been the most competent and successful of Europe-wide institutions.

Mistake number 1 was the decision in 2000 to admit Greece in the first place.   The country was an outlier, geographically and economically.  It did not come close to meeting the Maastricht Criteria, particularly the 3 % ceiling on the budget deficit as a share of GDP.  No doubt most Greeks would agree with the judgment that they would be much better off today if they were outside the euro, free to devalue and restore their lost competitiveness.

The second mistake was to allow the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007.   Despite budget deficits and debt levels that far exceeded the limits of the Stability and Growth Pact, Greece was able to borrow almost as easily as Germany.  Part of the blame belongs to international investors who grossly underestimated risk on all sorts of assets during this period.  And part of the blame belongs to the rating agencies who, as usual, have been lagging indicators of European debt troubles, rather than leading indicators.  But in this case, both groups might justify their attitudes by pointing out that the ECB accepted Greek debt as collateral, on a par with German debt.

The third mistake was the failure to send Greece to the IMF early in the crisis, before Greek interest rates went to 600 basis points (see graph).  By January 2010 the need to go to the Fund should have been clear.  Rather than going into shock, leaders in Frankfurt and Brussels could have welcomed the Greek crisis as a useful opportunity to establish a precedent for the long-term life of the euro.   The idea that a debt problem of this sort would eventually arise somewhere in euroland cannot have come as a surprise.  After all, why had the architects of the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability & Growth Pact (1997) written them in the first place?   Skeptical German taxpayers believed that, before the project was done, they would be asked to bail out some spendthrift Mediterranean country.  European elites adopted the fiscal rules precisely to combat these fears.   

When the rules failed and the crisis came, the leaders should have thanked their lucky stars that the first test case had arisen in a country that met two characteristics admirably:   
(i) The Greek government had broken the rules so egregiously and so frequently that one could with a clear conscience judge that a firm stand was merited.  The only alternative was to risk establishing the precedent that even profligate governments can expect ultimately to be bailed out, with all the moral hazard headaches that precedent implies.    (ii) The Greek economy was small enough to make it feasible for Europe to come up with the funds necessary to insulate others who were vulnerable to contagion but not as blameworthy:  banks that hold Greek debt and governments such as Ireland that had tried to follow responsible policies in the period before the global financial crisis.

European leaders also should have thanked their stars that the IMF exists.   Instead of acting as if such a crisis had never been seen before, they should have realized that imposing policy conditionality in rescue loan packages is precisely the IMF’s job.  International politics is less likely to prevent the Fund from enforcing painful fiscal retrenchment and other difficult conditions than it is among regional neighbors or other political allies.   Europe is no different in this respect than Latin America or Asia.  

But the reaction of leaders in both Frankfurt and Brussels was that going to the Fund was unthinkable, that this was a problem to be settled within Europe.   They chose to play for time instead, to treat insolvency as illiquidity.  Against all evidence — despite a decade of SGP violations — they still wish to believe that they can impose fiscal discipline on member states.  Despite two decades in which citizens of Germany and other European countries have expressed clearly that they do not share their leaders’ enthusiasm for Economic and Monetary Union, the latter apparently still wish to believe that further progress to political and fiscal union is possible.  The emu has long since become an ostrich, burying its head in the sand.

It turned out that the German taxpayers had been right all along.   How, in light of that democratic deficit, can anyone think that Europe is ready for a transfer union? 

Next week’s post:   A proposal to avoid future repeats of Europe’s sovereign debt crisis.

These matters were discussed in a session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 10, 2011.  Video & slides are available, including my own comment.

[Comments can be posted on the Vox.eu site.]

My response:

I do think that measures such as the Contingent Convertible Bonds would be a useful step.  Some argue that it would be hard to know when to invoke the contingency clause.  It strikes me that this argument largely vanishes when one realizes that the clause would of necessity be invoked by the time we got to the stage of a Bear Stearns or Lehman Brothers bankruptcy. CoCos would not go very far in themselves toward comprehensive reform of the financial system, if that is the goal.  But then no single policy measure would do that.  I agree with Gillian Tett: “In theory, I think that CoCos certainly could be a useful additional to banks’ tool kits. However, in practice, the contagion risk suggests it would be dangerous to rely too heavily on an exclusive diet of CoCos for any policy ‘fix’.” 

Two related issues are of much bigger import.   First, is it a feasible goal to eliminate, credibly, the problem “too big to fail” or “too interconnected to fail,” thereby eliminating the critical moral hazard problem?  My suspicion is that this is not an achievable goal, when push comes to shove, ex post, in a crisis; and if I am right, then it is very important that we don’t return to the rhetoric of claiming “no bank is automatically too big to fail” and so fail to regulate and collect insurance from the banks ex ante.   This would just exacerbate the moral hazard problem.   Commercial banks are like river banks  in this respect.

Second, would the legislation that is offered by Senator Chris Dodd be a better approach to financial reform than alternative proposals, or even than the status quo?     While the 1,000+ page Dodd bill undoubtedly has some good things in it (the principle of a Consumer Protection Agency in lending is probably at the top of the list), I believe it would be very damaging overall. The major reason is that it would seriously undermine the power of the Fed to set fully-informed monetary policy in normal times and to respond effectively in times of crisis.  It seems that Barney Frank understands these things much better. 

Quite a few excellent economists are worried about moral hazard in financial markets.   Vince Reinhart wrote a Wall Street Journal column rebuking his former bosses after the Bear Stearns intervention: “…the Federal Reserve’s action can only be viewed as rewarding bad behavior.”  Ken Rogoff recently wrote in a Financial Times column, “it is important to be tougher in busts, so that investors and company executives have cause to pay serious attention to risks. If poorly run financial institutions are not allowed to close their doors during recessions, when exactly are they going to be allowed to fail?”   

Of course moral hazard is a serious problem that lies close to the heart of the financial market crises.   But I am not sure that I completely share the priority at this point on drawing a tougher line with the ex post bailouts. It may be futile advice.   Fixing the hole in the roof when it is raining is, after all, rather difficult.

Consider two other areas where moral hazard is an issue: commercial banks and river banks. Some economists would prefer that the government refrain from helping the victims of banking panics and river floods, respectively. The worry is that if those who overlend or overbuild do not bear the full costs of their mistakes, they will have no incentive to be more careful in the future.

But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks). It is wiser that we recognize this fact, and design a regulatory system that explicitly incorporates mandatory federal flood insurance and deposit insurance, and charges for them up front. We already do this for commercial banks. To me, the lesson of recent months is that we need to do it for investment banks and a wider range of financial institutions.

As a final tweak, I can’t help noting that central bank governors, Treasury secretaries, and chief executives who make the most noise about the evils of moral hazard and bailouts ex ante, are no more likely to stand firm ex post than others. If anything, the reverse.  I am thinking, for example, of how - ten years ago this month - it was the Clinton Administration that finally pulled the plug on continued IMF loans to Russia, despite well-founded fears of systemic contagion.   The Reagan Administration in the 1982-84 international debt crisis and the Bush Administration in the 2001-03 Argentine crisis, for all their laissez-faire rhetoric, never pulled the plug on any of the debtor countries.    When sitting in the hotseat of a financial crisis, officials suddenly discover a need for bailouts, much like soldiers sitting under fire in foxholes sometimes suddenly discover a need for religion.

[Any readers wishing to comment on this blog post:  I suggest you go to the RGE version.] 

Someone this week asked me what I thought of policy-makers who ex ante profess a free-market ideology and acute sensitivity to the dangers of moral hazard from financial bailouts, but who toss that ideology overboard when faced with a financial crisis.  The reference was to Treasury Secretary Henry Paulson’s lobbying this week in support of a rescue for Fannie Mae and Freddie Mac, the two big home mortgage agencies, following on the rescue of Bear Stearns in March.   My reply was:  “They say there are no atheists in foxholes.   Perhaps, then, there are also no libertarians in financial crises.”

There are more egregious cases than Hank Paulson of inconsistencies between ex ante promises by policy-makers not to bail out and ex post bailouts when disaster strikes.    (Indeed, some amount of change in position may even be rational for an office-holder, though I would draw the line at false statements.)    I reserve my disdain for those who go around lecturing others on the evils of bailouts, only to out-do the officials they criticized when their own turn in the hot-seat comes.  

An example I have in mind concerns the members of the starting team in the Bush Administration who had lectured the Clinton Administration on the evils of its allegedly excessive bailouts of emerging markets in the 1990s, only to engage in worse when they themselves were faced with the Argentine crisis that began in 2001.  There was no particular reason to rescue the Kirchner government.   Argentina in 2003 would have been the perfect place to refrain from rolling over an IMF program, thereby putting a limit on the moral hazard problem.   The Clinton Treasury had done this with Russia in August 1998 despite high costs in terms of systemic contagion.   Yet the Bush White House continued to push the IMF to bail out Argentina.  Apparently the failing lay in simple inexperience and lack of awareness that any such choices are always difficult.   (See pages 9-11 of my article on Managing Financial Crises, in the Cato Journal, Summer 2007.)    The Administration was very much following in the footsteps of the Reagan Administration, which talked tough at first when the international debt crisis hit in 1982 but which then participated in comprehensive IMF-led bailouts of Latin American debtors who had been pursuing far worse macroeconomic policies than the emerging market governments of the 1990s crises.  

Incidentally, before writing this blog post, I checked into the World War II origins of the sentence “There are no atheists in foxholes.”     I discovered to my surprise that this expression was intended, and is still considered, as a put-down of atheists, and that their lobby protests its use.  

Of course the proposition is not literally true; indeed some soldiers lose their pre-existing belief in God when confronted with the horror of war.   But let us stipulate that those who suddenly face death more often find religion than lose it.  What strikes me as odd is that the expression is apparently normally interpreted as meaning that people who profess atheism don’t really mean it, and that their true colors come out under pressure.     I had, apparently erroneously, thought rather the reverse.   (Indeed, Richard Dawkins argues that vast numbers of people who would no more bet on the existence of God than on the existence of the Easter Bunny, nonetheless call themselves “agnostics” rather than atheists, to avoid rocking the boat.)   

I had always taken the expression to mean that mankind’s hunger for religious beliefs comes from a desperate desire for divine intervention – or, failing that, comfort – when confronting death.  Something more along the lines “There are no unsoiled underpants in foxholes.”     I am in sympathy with the character in a novel who said “That maxim, ‘There are no atheists in foxholes,’ it’s not an argument against atheism — it’s an argument against foxholes.” 

So what’s my point?    Not to argue that governments should intervene always  (nor that they should intervene never).  The lesson for government officials is that wherever they choose to draw the bailout line – one hopes the line strikes an intelligent balance between the short-run advantages of ameliorating a serious financial crisis and the longer-run disadvantages of moral hazard — they should think through the system ahead of time.  They should take the appropriate regulatory precautions during the boom times, which correspond to the bailouts that will inevitably come during the busts.   

Long ago, the United States worked out the approximate right answer for banks:  there will always be rescue of small depositors ex post when banks run into serious trouble, and so under our system, (i) deposit insurance provides formal guarantees ex ante and (ii) banks must pay the price ex ante through reserve requirements, capital requirements, and active regulatory oversight.  What we now need to do is design the analogous sort of system for non-banks.

It should not come as a surprise to high officials that there are such things as financial crises anymore than it should come as a surprise to soldiers that there are such things as bombs.   Human nature must be accepted for what it is.   But in the case of  high officials, it shouldn’t be necessary for them to alter their fundamental beliefs when crisis strikes, in the absence of truly unforeseeable developments.