Free Markets, Free People

Will Eurobonds Work?

(Originally posted at Risk and Return)

I have been skeptical and so is James Bianco:

The problem in Europe is simple – they created a common currency – the euro. For years, the market erred. It thought that meant that every sovereign debt had the same rating as Germany. I was buying Greek bonds. I was buying Irish bonds. I was buying Italian bonds. But I thought I was buying German bonds. Then, a couple of years ago, I had an epiphany – no, I was not buying German bonds; I was buying Greece, Italy, and Ireland, or whatever, not Germany.

Those countries, recognizing that they could borrow into infinity because everybody thought they were lending to Germany, pretty much did that and expanded their welfare states to the point where they cannot pay their debts.

Germany has disappointed everybody with its intransigence, its unwillingness to “get with the program,” and endorse massive ECB bond buying and Eurobonds. Their reason? They believe they will be stuck with the bill. Of course, they are right, they will be:

If a Eurobond market comes with with strict discipline/rules on borrowing and paying debt back, it might work.  Unfortunately no one will agree to a Eurobond market with strict discipline/rules.

If a Eurobond market comes with no discipline/rules, then it is just another way to trick the market into thinking they are buying German Bunds.   It will “work” for a while as the crisis will ease until everyone borrows too much money and then comes back much worse.

I am not even sure it will work more than a few days at this point, but maybe. Either way it is not a solution, but a stop gap at best. It is also a stop gap that should not be attempted unless an actual endgame is in sight:

So how do you fix the Euro crisis?  Unfortunately there are only three solutions and all are distasteful:

  • Call off the union and go back to legacy currencies.  This destroys the banking system who will be paid back with devalued/nearly worthless currencies.
  • Massive austerity.  This option is very unpopular among the electorates and will cause a bad recession/depression.
  • Fiscal union.  This is a nice way of saying Germany finally wins WW2.  Is the rest of Europe now ready to take orders from Berlin?  Didn’t they fight two wars to prevent this?

The only reason ECB printing keeps being mentioned is because the three options above are untenable and money printing is the only other thing they can think of.  Money printing does NOT fix anything, it just makes the problem better for a while until it comes back worse than before.

This dovetails with my analysis in The German Dilemma that their are no good options from the German perspective, and in fact fiscal union is far more problematic than commonly realized:

Full Fiscal Integration: Since all other solutions put in place circumstances that are unstable and merely kick the can down the road, the fundamental flaw in the Euro needs to be addressed. That is the lack of a unified fiscal policy. The answer then is the end of sovereignty, the creation of a US of Europe. An obvious objection is that Germany wants to be a sovereign nation. We’ll skip this niggling little detail, but even if they didn’t want to remain sovereign do they want to harmonize laws and economic policy with Greece and some of the other PIIGS? West Germany just  integrated with East Germany and the experience was traumatic featuring massive transfers to East Germans. The PIIGS will still not be competitive with Germany. That means internal adjustments (internal devaluation or austerity) to allow them to become more competitive for the PIIGS’ or massive transfers. Thus unifying the Eurozone under a single fiscal policy means massive transfers from Germany to the PIIGS to harmonize the welfare states and unify the debt and avoid austerity throwing the entire Eurozone into depression. Germans will pay for the debt in one fashion or another.

Cullen Roche points out that in the US we don’t worry much about the need for internal transfers between states to keep the system sound.  Today that is true, though it has led to large conflicts in our past, playing a role in civil unrest, uprisings, the conquest of a continent and near destruction of its former inhabitants and the Civil War. Our unity was easier to envision and still born of blood and tragedy.

I am not saying unification of Europe would lead to such tragedies and conflicts. However, we need to ask if Germany (or really all the countries) want to make the internal transfers that make such a system work? Germans would pay a great deal, Greece and the other PIIGS would suffer internal austerity to the extent that they contribute to the economic re-balancing. Do Europeans, or most importantly the Germans, view themselves as a people who will be responsible for paying all the bills to integrate the Greeks and others?

Are Europeans ready to think about their home countries in the same way Texans think of Texas? Their state, but completely subordinate to the US? Will they be able to secede? We answered that question in the US with a war of incredible savagery and destruction. My guess is a unified Europe would be far less stable. They will not choose a civil war comparable to the US, but instead countries leaving over time as well as never entering the union. That leaves us with all the problems we have now still being there. Without a European populace overwhelmingly in favor of a true union this will not work. We would be faced with a PIIGS like crisis with every election and the possibility of secession in each of the former countries.

The necessity of creating a union where there is no possibility of secession, where citizens are more loyal to the European sovereign entity than their own countries is incredibly unappreciated. Half measures will not work. If Texas were to get upset about staying in our own Union it would not matter how overwhelmingly popular the idea of leaving was in the Texas legislature, the US military will ensure that Texas stays a subordinate state. We decided that issue in 1865 at the cost of well over 600k casualties.

If a similarly firm enforcement of Eurozone union is not agreed to (and setting aside a war to force union) then why should the market assume the system will remain intact? Why consider the bonds issued by the various states, or the Eurozone as a whole, deserve a AAA rating?  My belief is that eventually the Eurozone will suffer other crises as states face local elections that wish to leave for one reason or another. Critically Eurobonds and fiscal Union make it easier for countries to leave, since the debt will be the Eurozone’s, not theirs. They can leave and stick the remaining members with the bill. That is an incentive which virtually ensures instability.

Treaties don’t matter if there is no enforcement mechanism, and all enforcement mechanisms at the end of the day have to have a credible belief in military force behind them to matter. Otherwise those who wish to exit can just thumb their noses at whoever stays behind. Has there ever been a successful union where the underlying members could leave? Not that I am aware of.

There are no good options, only more or less realistic ones.

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17 Responses to Will Eurobonds Work?

  • The ultimate irony of it all is that it took 65 years after the fall of the Third Reich, but alas, all of Europe is now being controlled by Germany.

  • All of this, every bit of it, and the problems in our nation as well, are caused by the biggest failure of the left centered way of thinking. Not the idea of a welfare state, not the idea of big government, or high taxes or meddling in the market place.

    Bad as those ideas are the huge failure of modern thinking is the mistaken idea that debt does not matter. I remember having a professor in college who said those very words, the debt does not matter.

    But debt does matter, it matters a whole lot. Debt, not just government debt, but corporate and private debt as well, Debt is bad. I don’t know any other way to put it. Debt is like nuclear fission. It can be harnessed and used as a tool if you are very very careful, but it can get away from you and cause enormous harm.

    We have to convince the public that they have been lied to for decades and that debt should be discouraged, never made easy or cheap. Debt is at the core of every single recession and crises.

    Debt is bad.

    • @kyle8, Corporations operating on debt is pretty much a Wallstreet requirement. There are two basic reasons. The first was the leveraged takeover mania of the 80’s. Basically, if a company was capital rich, it was taken over stripped of its capital and either gutted entirely or forced to function on debt instead of capital. Or, as a defensive move, a company’s capital was put out of reach by the owners. It was tied up so that a leveraged buyout payoff would have been slow. Or, simply the capital was bled off to shareholders or by board of directors with the thinking, if it isn’t us, its going to be someone else.

      If you don’t operate that way, you will eventually. Imho, the whole publicly traded stock ownership model for companies is horribly flawed.

      • @jpm100 @kyle8 Why hasn’t that happenrf to .. say, Apple ?

        • @Neo_ @jpm100 @kyle8 Well, I think it is an exaggeration that it is inevitable, but it may happen to Apple. Size however is an impediment. Huge companies are harder for outsiders to threaten with ownership changes.

        • @Neo_ @kyle8, their market cap exceeds the payoff of such a venture. By far.

    • @kyle8 I am glad you mentioned private debt. The accumulation of enormous private liabilities generally has been what has led to initial crisis. The government’s attempts to paper over the crisis then leads to sovereign crisis. This begins with a willingness to allow financial institutions to lever up. Wonderfully this has been noted by both Mises and Minsky, so it is not necessarily a left right issue. Both left and right should recognize the issue of allowing financial leverage in excess (or even allowing fractional reserve lending or its modern equivalent at all.)

    • @kyle8 Operating on debt … “it’s like lasing a stick of dynamite”

    • @kyle8 Debt is bad.

      Except it isn’t. As you noted, debt is merely a tool to be used properly. What really is bad is longstanding, unsustainable debt that far outstrips your ability to pay.

      • @The Shark Let me know when you find the society which has never been burned by excessive debt.

    • @kyle8 Cheney famously said deficits don’t matter – lefties love throwing that quote around.

  • “If Texas were to get upset about staying in our own Union it would not matter how overwhelmingly popular the idea of leaving was in the Texas legislature, the US military will ensure that Texas stays a subordinate state. We decided that issue in 1865 at the cost of well over 600k casualties.”

    If either through an amendment to permit it specifically, or any state generically to leave the union by unilateral act of that state legislature, their would be no such repercussions.

    • @tom perkins I sincerely doubt that. In fact, the financial disruption of such a move would be catastrophic unless they stayed on the dollar, and even then likely severe. Thus due to the economic interests of the rest of the Union some price would be exacted even if secession would be allowed. If they stayed on the dollar Texas would have many of the same issues we are seeing in Europe eventually and they would be faced with the choice of rejoining the Union or leaving the dollar. Default, bank runs and other economic disruptions would follow in its wake if they left.

      • @Lance Paddock @Tom I was referring to the military repercussions Dale referenced. I have little reason to think they would stay on the dollar.

        • @tom perkins @Lance @Tom First, just to clarify, I am the guilty party, not Dale. I was saying that yes, the military repercussions would occur, and the financial repercussions are a large part of why. Re-denominated debts are extremely unpopular with creditors for obvious reasons. Of course, that is also why it will never happen. It is not only financially catastrophic, it is hopeless. In Europe’s case it wouldn’t be hopeless because the military wouldn’t be used, and therefore no nation would feel bound to the union if it became discomforting. Thus no one would find the currency credible. This is one of the reasons the Euro was never a potential replacement for the dollar as a reserve currency. If the currency union isn’t credible the currency union fails as yields have to be extremely high to cover the exit and default/devaluation risk.