Sovereign Bankruptcy Nostalgia, August Edition

Preventing a Greek default in August might just be the one thing that rates higher on the EU policy agenda than preventing a Greek default--or so I am told by a source familiar with the policy significance of August in Europe.  Yet August is a popular month for sovereign debt crises (Mexico, Russia, Argentina), which makes it an excellent time to contemplate institutional changes that might make the inevitable sovereign defaults less painful for the debtor, the creditors, and the bystanders.  Earlier this week, the FT obliged with a wistful retrospective on the odd combination of gunboat diplomacy (c. 1820-1956) and the International Monetary Fund's technocratic attempt at a sovereign bankruptcy regime (2001-2003).  Recent German proposals for European sovereign bankruptcy piggyback on the IMF effort, but are even more firmly rooted in the conviction that just the right rule could bind policy makers facing financial cataclysm to act prudently and predictably.  I find such rule nostalgia puzzling in the wake of the disgraced no-bailout clause in the EU treaties--the ultimate in bright-line commitments--and its relations the world over.  However, the revived conversation is valuable.

To review:

• Sovereign states cannot discharge debts in bankruptcy.  There is no international bankruptcy tribunal for sovereigns.  Instead, there is a combination of conditional lending by international financial institutions, such as the IMF; informal, fragmented institutions and market practices for restructuring different categories of government debt; and qualified sovereign immunity, which makes it difficult for creditors to attach government assets even if it has become relatively easy to sue and get judgments against defaulting sovereigns.
• Sovereign bankruptcy is an old idea, going back to Adam Smith if not further.
• Sovereign bankruptcy proposals were officially considered at at least four times over the past hundred years.
• The  latest version was proffered by the IMF in late 2001, primarily as a device to overcome collective action problems in private international bond restructuring.  For pragmatic and political considerations, the proposal was very narrowly targeted--very very narrowly targeted in the end.  It was doomed in any event, for reasons best explained by Brad Setser here (published as Chapter 12 here).
• No viable sovereign bankruptcy proposal has approached the comprehensive, collective proceeding ideal of domestic bankrptcy.  Even the most ambitious plans exempted vast segments of the sovereign debt stock, such as debts owed to domestic residents and/or governed by domestic law, debts owed to other governments, international institutions, etc. etc. ... which often comprise the bulk of sovereign liabilities, particularly for poor countries.  For what it's worth, sovereigns have limited legal and political capacity to incur secured debt, and have little such debt as a consequence.

Enter Greece, Germany and Friends.  In late 2009, after a series of accounting scandals, the markets got worried about Greek debt.  By emerging market standards, Greek debt is unsustainable:  120%, on track to top 150%, of its GDP even on benign economic and policy assumptions.  The big question is whether emerging market standards are the right ones to apply.  That is a question of EU politics:  Greek debt will be paid if other EU countries are willing to make fiscal transfers to Greece, either for Greece's sake, or for the sake of their own banks, which are undercapitalized and overexposed to Greece, or to arrest contagion elsewhere in the EU.  In May 2010, the EU and the IMF joined forces in a trillion dollar facility designed to quash expectations of imminent default. 

Thus at a minimum, EU bankruptcy rules that purport to foreclose future bailouts are a price to pay for current rescue authority--much like the 2001 IMF bankruptcy exercise was a reaction to Argentina, and Dodd-Frank crisis management provisions are a reaction to 2008 (the law also tries to discourage IMF bailouts, inspired by Greece--Sec. 1501).  The challenge is to give any new no-bailout promise a modicum of credibility despite the abject public failure of those that came before.

From here, the devil is in the details, and the Germans have offered few.  An "apolitical and legally independent" bankruptcy overseer called "Berlin Club" strikes me as a contradiction in terms--just ask the Greeks.  A recent influential proposal for a European Monetary Fund is meatier.  It would offer creditors to buy their debt at a predetermined discount in exchange for claims on the EMF.  The EMF would use the debt it acquires as leverage to oversee the distressed government's policies.  I am not sure why the debtor or the creditors would agree to outsource the discount and policy-setting to this institution, how a voluntary framework would address incentives to hold out and sue (especially for non-EU creditors under non-EU law), and how much of an improvement the new scheme would be over the known and recently fortified IMF.  The EMF is a far cry from a comprehensive workout mechanism, but if it rocks the EU boat, so be it.  I see no major harm potential beyond distraction, and it might even work where--as in Greece--most of the creditors are regulated European institutions and could be swayed to participate.  However, the contraption is unlikely to be agreed in time for Greece to use.

The flaw with many recent proposals is that they fail to frame a problem in sufficiently specific terms to justify their solution.  Generalized fear of disorderly default and bailouts is enough to support a political fig leaf, but not a workable fix.  To the IMF's credit, it was quite precise in 2001-2003:  the problem was collective action in international bonds; its Sovereign Debt Restructuring Mechanism was tailored precisely to this problem.  One can argue about whether collective action in foreign bonds was the right problem to target then, but that does not matter now because it is patently not Greece's problem: most of its debt is governed by domestic law and relatively closely held by banks and pension funds.  Conventional wisdom suggests that such debt is among the easiest to restructure, by fiat if all else fails.  In fact, a restructuring blueprint has been out for months.  Put differently, Greece's real problem might not be the lack of EU bankruptcy rules, but the thin capital levels in EU financial institutions, recent stress tests notwithstanding, and the creditor governments' unwillingness to admit it and recapitalize their banks, which could in turn give rise to hopes of both policy and market discipline.  That is not a problem sovereign bankruptcy could fix--even if it were a great idea for any number of other reasons.

Comments

[Stephen Lubben]

One thing that puzzles me about German proposal is that it would seem impossible to prevent a country from simply leaving the EU if the bankruptcy mechanism is too tough, yet the entire motivation for the proposal seems to be an effort to get tough with the future Greeces and thus make a credible commitment to no further bailouts. In short, I'm not sure the mechanism can ever make the commitment credible, given the option the debtor has to exit the EU.