by Don Alexander, MBA
Associate, RSD Solutions Inc.
“An error does not become truth by reason of multiplied propagation, nor does truth become error because nobody sees it.” (Gandhi)
The point is that the emphasis of Eurozone policymakers focus on a stop gap liquidity facility rather than solvency can have long-term consequences. This is illustrated in the following communiqué (The Future of the Eurozone (VOXEU, Konrad & Zschapitz, June 10th)) on the outlook for the Eurozone.
A year has passed since the initial bailout of Greece. The Eurozone is still on life support, the authors argue, including the view that Europe’s policymakers have got their strategy desperately wrong. The failure to modify the Stability and Growth Pact to account for macroeconomic imbalances is a move in the wrong direction. They treat the bailout as a temporary liquidity problem and not a solvency issue, which will ultimately increase the costs of the policy error.
The authors note two options, which while considered, are not deemed viable. The first would be the reversal of the socialization of private sector debt and funding from other ECB members to finance budget deficits – a return to national fiscal responsibility. The economic cost of restructuring would have a large economic cost to all countries. A second alternative is the use of “financial repression.” This is when governments adopt measures to channel funds to themselves that may go elsewhere in unregulated markets. This method is particularly effective at liquidating excessive government debt. However, from an economic efficiency standpoint, it makes little sense for banks to use their funds to invest in government bonds unless it is part of their shareholder mandate.
Reinhart and Sbrancia (2011) characterize financial repression as consisting of the following key elements:
- Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
- Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market.
- Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
- Government restrictions on the transfer of assets abroad through the imposition of capital controls.
The authors consider following the current option of intergovernmental transfers as a means to avoid debt default or restructuring. However, the sums required to make this viable would not be considered acceptable to taxpayers. The most likely outcome is a breakdown of the Eurozone prior to reaching an endpoint as policymakers focus on stop gap liquidity facility rather than deal with the solvency issue. One possible reason for this breakdown is a rise in political tensions among member countries. A second, more likely outcome is a breakdown in the Eurozone as political tensions increase and investors lose confidence in the sustainability of the Eurozone as a whole.
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