It is always good to read up on Willem Buiter’s papers in times of crisis. For instance his 2005 paper with Anne Sibert: How the Eurosystem’s Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone. First of all, it is good to know that Willem Buiter is also fallible:
Another reason for a common default risk premium throughout the EMU could be that the political arrangement called EMU implies that the government of any EMU member country threatened with default would be bailed out by the collective called the EMU … We reject the implicit and intentional bail-out guarantee explanation of the uniform (low) sovereign default risk premia in the Eurozone. … There is not one iota of evidence that the sovereign debt of all 12 Eurozone countries … is, or is perceived by anyone in a position of fiscal responsibility and authority in the EMU, to be a collective responsibility of the Eurozone …
Oh well, the financial crisis was also inconceivable to most observers. What is more interesting is their suggestion that something else might explain the much too narrow spread between German bonds and the bonds of countries with much higher default risks:
Despite significant fundamental differences among the default risks associated with the euro-denominated debt issued by the 12 national governments of the Eurozone, all these euro-denominated sovereign debt instruments can defacto be used as collateral in Eurosystem Repos on the same terms as the default risk-free debt certificates issued by the Eurosystem itself.
They suggest to use haircut policies more aggressively. As a short explanation: when a central bank accepts a bond as collateral for refinancing operations, it usually calculates the market value minus a valuation haircut, as the final value of that collateral. By failing to use this tool appropriately, the ECB sent the wrong signal: suggesting that default risk was equal across all government bonds, which it clearly wasn’t.
That proposal could be extended (in the spirit of Markus Brunnermeier) to create an ECB-induced counter-cyclical fiscal and regulatory policy. Let’s assume the ECB monitors inflation and credit in a given country to assess whether the economy in that region is overheating and/or bubbly. In practice, the indicators would be more sophisticated than that. But both suggest clearly that something was terribly wrong – at least in retrospect (data: Eurostat):
Spain increased the volume of credit 5-fold since the end of 1997, Ireland 6-fold, Portugal 4-fold while France and Austria doubled theirs. In Germany, the volume of credit hardly increased at all for reasons explained elsewhere. Inflation provides another clear indication that the economic development in some places in Europe was unsustainable – which should have been clear that the time as well:
So imagine the ECB had introduced a haircut policy on government debt that was related to such overheating/bubble measures: when your country overheats, your government’s bonds take an extra valuation haircut when checking in at the ECB hotel. This would have made these governments’ bonds less attractive and might have induced governments to take a more restrictive fiscal policy and regulatory stance in the build-up of the Euro crisis. To take this proposal to the extreme for the sake of argument: if inflation is more than 0.5% above target, or credit above a resonable level of GNP, the bonds of that country become ineligible as collateral at the ECB.
What would have happened to bond prices? It remains an open question whether bond prices would have dropped sufficiently to induce a counter-cyclical fiscal or regulatory response. But banks would have been forced to use other instruments as collateral, making them a little less vulnerable to a solvency crisis in their home country. Could that be a contributing factor to the Eurozone’s future stability? Let me know what you think.
Of course, the proposal is politically difficult to implement, but it has one advantage: because it punishes inflationist countries, the Germans will love it.
HT: Markus Brunnermeier