GERMANY IS RIGHT : BOND HOLDERS MUST PAY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Germany is right: bondholders must pay

By Otmar Issing

Published: December 1 2010 22:13

Miscommunication has accompanied Europe’s monetary union since the start. The economic crisis, however, has brought forth a Babel of voices. A recent example was the remark by Herman Van Rompuy, the European Union’s president, that the debt crisis would put the survival of the union in question.


Now, most observers would apparently want to put at the top of the list of mistakes the announcement that holders of government bonds issued after 2013 should take losses in the event of a sovereign debt crisis.


As a consequence, the argument goes, uncertainty was increased and the bonds of Ireland, Portugal and Spain fell. Not everyone had the same opinion, but there seemed virtual unanimity that such a statement should not have been made until the crisis was over.


I would not suggest that the announcement deserves a Nobel prize in communication. But I think the timing and core message were appropriate.


First, it seems to me of crucial importance at this stage in the monetary union’s development that if a permanent rescue mechanism is established we should also have a restructuring regime for sovereign debt that involves losses for private investors. Why should taxpayers be taken hostage endlessly by investors who enjoy the benefits of high interest rates and who can rely on being bailed out once an indebted country gets into trouble?


Default must be a credible threat – otherwise investors will have a strong incentive to buy bonds offering higher interest rates without taking into account the associated risks. We saw the consequences of such behaviour when, for a long period, the long-term interest rates for countries such as Germany and Greece hardly differed. Over many years, news about higher budget deficits and debt ratios that were far beyond the criteria set in the Maastricht treaty had no significant effect on interest rates. That encouraged countries to ignore the need for fiscal consolidation and contributed significantly to the current crisis.


Second, what about the argument that any announcement of a sovereign debt mechanism should have been delayed until the crisis was over? I would argue it was hardly premature. As long as investors can reasonably hope for a bail-out, investment decisions will be distorted by speculation about politically motivated intervention. The more markets are convinced that the EU or other authorities will support an economy in crisis, the larger will be the number of investment decisions based on such speculation – and the greater the risk of bank collapses if such support is not forthcoming. Pressure for “solidarity” will increase and “there is no alternative to a bail-out” will become a permanent mantra.


The case of Germany’s Landesbanken is a good example of what happens when the implementation of reforms is delayed. When it was announced that the phasing out of state guarantees would only become effective some years hence, the Landesbanken used their triple A ratings – which remained during the “grace period” – to issue large amounts of bonds at very low interest rates, which were invested in high-risk assets such as subprime mortgages. The results are only too visible in Germany’s Landesbanken sector today.


No doubt, designing a sovereign default scheme is a tremendous challenge. But there is a consensus that a permanent crisis mechanism is needed in Europe’s monetary union. Any agreement on a new fund – or whatever it is called – that does not include a debt restructuring clause involving private investors would be an invitation to markets to speculate on future bail-outs. It would undermine, if not destroy, the signals markets are sending about good and bad fiscal behaviour. The sanctions imposed by markets are needed more than ever because governments have refrained from strengthening the EU’s stability and growth pact, which was meant to act as a political control on fiscal behaviour.


Outline proposals for a mechanism have now been presented. It seems, however, that private investors would have to take losses only in extreme cases and after ad hoc decisions. Which authority will judge that the debt position of a country is unsustainable and that a process of restructuring has to be started? Such a regime would lack credibility and predictability. It would be based on discretionary decisions and set the stage for future political tension, uncertainty and market volatility.


The writer is president of the Centre for Financial Studies and a former member of the European Central Bank’s executive board


Copyright The Financial Times Limited 2010.