The Greek bailout: wasted money

If you ask a frog to come up with a plan for draining a swamp, you are likely to end up with a proposal for more flooding.

That is the conclusion of Harald Hau, finance professor at Insead. the bailout is unlikely to end the problems with Greece and the eurozone. Why did the EU made such a bad deal ? Professor Hau argues:

In principle, governments should have been in a very strong position. Private default can end in the liquidation of a company, but a country cannot be liquidated. This puts private creditors in a very weak position when it comes to negotiating with a government and empowers the latter. But why was this not the case in the current debt crisis?

• Bankers and many journalists convey the impression that we face a choice between a full sovereign bailout and a catastrophic banking crisis.
• ECB executive board member Lorenzo Bin Smaghi even suggested that any talk about private bail-ins would increase the costs for the taxpayer.

Such assertions confuse more than they clarify, because they ( falsely ) suggest that there was no alternative.

The banking sector is the weak spot of any restructuring plan involving sovereign default. Here, direct bank support through bank recapitalisation is a much more effective and cheaper solution than a full guarantee of sovereign debt.

The taxpayers could get bank equity in exchange for their money. If this crisis is like others, there is a chance that share values recover and taxpayers break even in the long run. The 2007-2009 crisis has shown that governments are indeed able to contain a banking crisis by resolute action like forced recapitalisation and temporary nationalisation of banks.

The better prepared we are for such an event the smaller will be the impact on the economy. Europe's governments have had plenty of time to prepare over the last year, so why was such a solution not even considered?

The reasons are political. Such a solution would have upset powerful vested banker interests, even though it would have imposed the costs on those most responsible for the massive credit misallocation.

A strong negotiating position of politicians confronts two important obstacles:

First, the finance ministry and banking authority typically lack competence and information in order to prepare contingency plans for bank recapitalisation.

There is an acute skill shortage in the finance ministry and what talent there is meets a wall of secrecy put up by an uncooperative banking sector.

Secondly, the strong lobbying power of the banking sector deters politicians from preparing in advance and taking risks in favour of the taxpayer.

Conflicts of interest between the politicians and the bankers are rampant.

After the disastrous risk-management performance of many bankers revealed in the 2007-2009 banking crisis, it is surprising that the same people still enjoy great influence in the policy process. The consequences are predictable.

If you ask a frog to come up with a plan for draining a swamp, you are like to end up with a proposal for more flooding.

Bankers were asked to come up with a plan for private-sector involvement under the leadership of Ackermann and the Institute for International Finance; what they came up with was a plan for more support.

We would never ask the tobacco industry to work out a new public health policy.

A further problem is the fragmentation of political power in Europe. This prevents the political authority from taking a strong negotiating position against the sovereign-debt creditors. In 1982, when the US faced a sovereign-debt crisis brought about by US banks’ lending to Latin American nations, US finance minister Baker rejected private-sector demands that the US taxpayer bail out of creditors. While this seems similar to the position of German Chancellor Merkel, her position is much weaker.

Lastly, the ECB played a very obstructive role in preventing any effective bail-in of private creditors. This strengthened the “hostage taking” of the political authorities. At times, ECB board members gave the impression of being themselves captured by the financial elite of their home country. The ECB severely damaged its own reputation by siding so strongly with creditors and bankers rather than defending Europe's taxpayers and citizens.

The EU will gain real credibility and start to solve the crisis when real and structural changes are made to the current economic and monetary system of the eurozone.

The following measures are urgent:

1. Renew Maastricht and add Golden Rule

The Maastricht Treaty is the basis of the EMU and the eurozone. There was no rule for budgetary solidarity in this Treaty, however clear budgetary targets. Maximum 3% of GDP deficit (in a downturn, balanced budget across the cycle), and maximum debt to GDP of 60%. This should be reconfirmed, and a new rule should be added.

Deficits should not be allowed for current public expenditures, only for capital expenditures (public investments). This so-called "Golden Rule" has been applied in some emerging countries (eg. Brazil). The result is that emerging countries have sounder debt situations than the developed economies.

Indeed, the debt crisis is not limited to the EU, as the ongoing "debt ceiling" debate in the US clearly illustrates.

2. Create a European Bank Liquidator

The EU should be able to close down insolvent banks. Banks should be orderly liquidated when they are in insolvency. Today, we continue to poor money in bailouts of souvereign debt, to save banks. This is a very inefficient way to solve a banking crisis. On top of that, by giving money for free in the banking system, and by bailing out countries, we keep unwanted systems like huge bonus schemes and a shadow banking system alive.

Some banks should become smaller, some zombie banks should be closed down in an orderly fashion. A European Bank Liquidator could perform such a role.

3. Create a Southern Eurozone linked with the existing Eurozone

The EMU is heading into the same direction as the European Monetary System. It has been shown once and again, that it is impossible to keep very diverging economies and countries in the same monetary zone. The countries could however remain in the same system if at least two zones were to be created. This was one of the lessons of the EMS: the system needed flexibility to keep all currencies together.

As described by Alfred Steinherr in the Globalist:

it would be beneficial to contemplate the creation of a second monetary union, perhaps called SEMU, or South EMU. Based on their own common economic traditions, such a grouping of countries may aim at an inflation target above 2%, or it may find it more convenient not to have an inflation target, but an exchange rate target with respect to the North EMU.

This is not new, and we have suggested this on many occasions in the past.

Some EU leaders continue to argue that this is impossible, but that is not true. The problem with the current Greek bailout is that it doesn't add any oxygen to the Greek economy. The Greek economy cannot compete with the euro as a currency.

The euro is not a life jacket, it has become a straight jacket for the southern countries.

The main visual of this article, shows which countries are to be part of the southern and northern euro, and which countries are borderline.

4. Enforce independence of ECB and make it gold based

The world central banks should make a profound reflection of their roles and mistakes over the last twenty years.

I personally believe that they have gone too far in their believe that they could manage the economic cycle. In this process, they have created numerous bubbles (credit bubble, property bubbles, derivatives bubble etc), and they destabilized the monetary system.

The ECB should lead in this reflection, and enforce its independence. Politicians have forced the ECB to buy toxic debt from the periphery. This is a catastrophic event, as it has eroded the balance sheet of the ECB.

ECB-president Trichet and others talk a lot about credibility. But credibility does not come by words, it follows actions. The ECB should regain credibility by showing discipline. Controlling the money supply remains one of the most important targets in this process. The ECB could go further, and reassess the possibility to install a link with targets that cannot be manipulated by politicians, economists or statisticians. Gold serves that purpose, and it has been its most important role over the last 5000 years. This does not mean that central banks have to become 100% gold based, but the link should be reinforced not further weakened. The gold sales by all the central banks in the developed countries of the last 20 years have been a big mistake. This has been just another example of the folly of the modern bankers.

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