THE EUROPEAN MONETARY FUND ? : DISCIPLINARY MEASURES / THE ECONOMIST ( RECOMMENDED READING )

Economics focus

Disciplinary measures

Feb 18th 2010
From The Economist print edition

In a guest article, Daniel Gros of the Centre for European Policy Studies (pictured left) and Thomas Mayer of Deutsche Bank argue the case for a European Monetary Fund

THE difficulties facing Greece and other European borrowers expose two big failures of discipline at the heart of the euro zone. The first is a failure to encourage member governments to maintain control of their finances. The second, and more overlooked, is a failure to allow for an orderly sovereign default. To address these issues, we propose a new euro-area institution, which we dub the European Monetary Fund (EMF). Although the EMF could not be set up overnight, it is not too late to do so. Past experience (with Argentina, for instance) suggests that the road to eventual sovereign insolvency is a long one.

The EMF could be run along similar governance lines to the IMF, by having a professional staff remote from direct political influence and a board with representatives from euro-area countries. Just as the existing fund does, the EMF would conduct regular and broad economic surveillance of member countries. But its main role would be to design, monitor and fund assistance programmes for euro-area countries in difficulties, just as the IMF does on a global scale.

Guilt payments


For its initial funding the EMF should be given authority to borrow in the markets with the full and joint backing of all its member countries. Going forward, however, a simple funding mechanism would also limit the moral hazard that potentially results from the creation of the fund. Only those countries in breach of set limits on governments’ debt stocks and annual deficits would have to contribute, giving them an incentive to keep their finances in order. (Basing contributions on market indicators of default risk does not seem appropriate since the existence of the EMF would itself depress credit-default-swap spreads and yield differentials among the members.)

Countries could, for instance, be charged an annual contribution of 1% of their “excess debt”, the difference between their actual level of public debt and the limit of 60% of GDP agreed on as one of the Maastricht criteria for euro entry. A similar charge could be levied on governments’ excess deficits, the amount exceeding the Maastricht limit of 3% of GDP. Under these parameters the EMF would have accumulated about €120 billion ($163 billion) over the past decade, enough to cover the likely costs of rescuing Greece. These levies are not so big that they make it impossible for offenders to get to grips with their finances. Under this scheme the Greek contribution to an EMF would have been 0.65% of GDP in 2009.

Any member country could call on the funds of the EMF up to the amount it has deposited in the past (including interest), provided its fiscal-adjustment programme has been approved by the Eurogroup of euro-area finance ministers. Any call on EMF funds above this amount would be possible only if the country agreed to a tailor-made adjustment programme supervised jointly by the European Commission and the Eurogroup, and on condition that the EMF ranked ahead of all other creditors.

The EMF’s other job would be to deal with the aftermath of a sudden withdrawal of market funding from a euro-zone government. The strongest negotiating asset of a big debtor is always that default cannot be contemplated because it would bring down the financial system. Few now doubt that euro-area countries would step in and pick up the bill were Greece’s deficit-reduction programme to fail. To eliminate the moral hazard this presumption creates, among profligate governments and reckless investors alike, it is crucial to create mechanisms that minimise the disruptions caused by a default.

One simple answer is to draw on the successful experience of the Brady bonds that were used to deal with the impaired debt of Latin American countries in the 1980s. A default creates ripple effects throughout the financial system because all debt instruments of a defaulting country become, at least temporarily, worthless and illiquid. If a euro-area country loses access to market financing, the EMF could step in and offer all holders of debt issued by the defaulting country an exchange against new bonds issued by the EMF. The fund would require creditors to take a uniform “haircut”, or loss, on their existing debt in order to protect taxpayers. The EMF could, for example, tie its guarantees to the 60%-of-GDP Maastricht limit on debt, so that creditors of a country with a debt stock of 120% of GDP would face a 50% haircut.



The losses to financial institutions would be limited and certain, reducing the risk of contagion. The EMF would only exchange debt instruments that had been registered with it beforehand. That would provide a strong incentive for transparency, because the counterparties of derivatives designed to conceal the true state of public finances would not have the option of converting their claims.

Having acquired bondholders’ claims against the defaulting country, the EMF would allow the country to receive additional funds only for specific purposes that the EMF approved. The new institution would provide a framework for sovereign bankruptcy comparable to the Chapter 11 procedure for bankrupt companies in America. Without such a process for orderly bankruptcy, the euro area will remain hostage to any country that is unwilling to adjust and threatens a systemic crisis if help is not forthcoming.

In-house solution

Setting up a European Monetary Fund is superior to the option of either calling in the IMF or muddling through on the basis of ad hoc interventions. The IMF has no mechanism for allowing orderly default, and ad hoc decisions typically have to be taken hurriedly, often over a weekend when the pressure in markets has become unbearable. It should not come to that with an EMF.

Closer surveillance (supported by pre-funding requirements based on the laxity of public finances) should lead to sounder fiscal policies. Perhaps more importantly, there would be less reason for turbulence in financial markets as the procedure for an orderly sovereign bankruptcy would be known in advance. Of course, a defaulting country may regard such intrusions as an unacceptable violation of its sovereignty. A euro-zone country that refused to abide by the decisions of the EMF could choose to leave the EU, and with it the euro, under Article 50 of the Lisbon Treaty. But the price of doing so would be very great. That is another reason to think that the EMF would address today’s moral-hazard problem, whereby bond markets and Greece are both assuming that they can count on a bail-out in the end.

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The full paper on which this article is based can be read here : http://www.ceps.eu/book/towards-european-monetary-fund

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