Athanasios Orphanides: Restoring trust in the euro area

Government debt markets are about trust. Before the crisis, all eurozone governments enjoyed the benefit of their collective trustworthiness, co-operation and solidarity in the form of favourable financing conditions that contributed to the wellbeing of Europe. Investor trust in the eurozone has been badly shaken in the past two years. The image of co-operation and solidarity has been shattered.
As 2011 came to a close, questions about the survival of the euro that would have been considered taboo earlier began to surface. Following Greece, a number of member states faced difficulties refinancing their debts or lost access to markets altogether, despite the implementation of unprecedented fiscal programmes.
What caused this dramatic erosion of confidence? Was it the result of fiscal profligacy, such as that revealed in Greece that marked the start of the slide? Was it the loss of competitiveness? Or current account imbalances? Without doubt all these were contributing factors. But the contagion that has spread to so many eurozone member states points to a broader problem: the incomplete design of the euro area – lax monitoring, inadequate enforcement of the rules and non-existence of a crisis management framework. It also points to the collective failure of eurozone decision makers to tackle this problem effectively. A failure that has been marked by a sequence of EU summits and aborted plans that have convinced some that a solution is beyond reach.
Two related decisions proved costly for the eurozone. First, following the summit in Deauville in October 2010, European leaders agreed to introduce a novel element in eurozone sovereign markets: the imposition of losses on creditors whenever a member state faced liquidity concerns. The message to potential creditors was clear: eurozone sovereign debt should no longer be considered a safe asset with the implicit promise that it would be repaid in full. Private sector involvement (PSI) was the new doctrine. Second, at the EU summits in July and October, European leaders decided to force losses on holders of Greek debt. The Greek PSI reinforced the idea that holders of eurozone sovereigns should be prepared to incur losses even under circumstances that would not necessarily trigger comparable losses for sovereigns outside the eurozone.
The decisions that raised the cost of financing in the eurozone by introducing additional risk on private investors were not without a useful purpose. The PSI risk raised (disproportionately) the cost of financing of member states with larger than projected levels of debt. Thus, it would serve as a disincentive to fiscal profligacy, thereby guarding against moral hazard and reducing the risk of future crises. Adding PSI risk could improve governance.
Unsurprisingly, as investors digested the implications of the two decisions they increasingly fled eurozone sovereign markets. The resulting contagion was evident in the deterioration of borrowing conditions for other eurozone member states after October 18 2010; July 21 2011 and October 26 2011.
The capacity to learn from mistakes is a hallmark of good leadership. As the existential threat to the eurozone became clearer, EU leaders changed tack. On December 9 a change in doctrine reversing the Deauville PSI innovation was announced. In future, the eurozone would adhere to International Monetary Fund principles. Leaders also agreed on a new “fiscal compact” to enhance governance.
Unfortunately, despite reversing the Deauville PSI innovation, investor trust has not been regained. A reason cited for this is that the December decision did not reverse the haircut on Greek debt. Rather, the eurozone leaders supported continuing the Greek PSI while stating that the Greek case was unique and would not be repeated. But can the promise to abandon the PSI doctrine in the future be convincing while losses on Greek debt are imposed at present?
Reversing the Greek PSI decision would help restore trust. Could it still be undesirable? Consistent with IMF principles, one of the reasons for imposing the Greek PSI was to reduce the interest burden on the Greek government. But a serious limitation of their application in the eurozone is that the IMF principles examine a member state in isolation, ignoring contagion effects on other states. Reversing the Greek PSI decision would ralso aise the financing cost on the Greek government, but by restoring trust in the eurozone it would reduce the financing cost of other eurozone governments. Reversing the Greek PSI would benefit the eurozone as a whole. A 30-year low interest-rate loan to Greece could accompany the reversal of PSI to keep the financing cost on the Greek government as low as presently contemplated.
The key is to restore trust.