A few months ago, we were anxiously discussing whether governments should bail out banks. They did. And then they went into the business of bailing out car companies, just as central banks – a branch of government – started to lend directly or indirectly to the private sector. And now we start discussing whether governments should bail out… governments within the euro area.
This is less revolutionary than it seems. After all, this is exactly what the IMF does and there is a long history of bilateral aid, some of it in emergency conditions. What is striking is that government bailouts are explicitly banned in the Maastricht Treaty. Of course, any piece of legislation can be circumvented and, surprising as it may be, rumor has it that the German government is already exploring clever ways to do so. When we remember that the no-bailout clause of the Treaty was a German request, we realize how desperate the situation is. Should we, indeed, cut our right arm after having cut the left one?
It may be surprising that governments – which routinely help each other via the IMF, the World Bank and other international organizations – have found it necessary to introduce the no-bailout clause within the euro area. One could have imagined the opposite, that intra-European solidarity is upped as the European Union becomes “ever closer”, in particular as countries decide to share the same currency. In some way it did, through the development of the Regional Funds, explicitly designed to redistribute income from richer to poorer regions. So, why then, the ban on mutual government assistance?
The answer is pretty obvious: moral hazard. If a government knows that, under some circumstances, part of its expenditures will be paid for by other governments, then sooner or later it will take advantage of the arrangement. Given European governments’ long history of dubious fiscal discipline, there is every reason to imagine that this would happen sooner rather than later. The seriousness of the moral hazard issue is hardly controversial. Indeed, all international loans are subject to strict conditions or rules designed to mitigate moral hazard. But that does not explain why the situation is so acute within the euro area that it requires a special clause.
The answer must be that moral hazard is compounded by the sharing of a currency. The fear is that a country’s default would trigger a number of particularly harmful reactions that would spare no other euro area member country. For example, a default by the Greek government could lead international investors to run on other government debts. In fact lists are already widely discussed in banking circles, spilling into the media and blogs the world over. A default, or a string of defaults, could lead to massive capital outflows, weakening the euro and creating the risk of inflation at a time when the ECB is fighting the recession. Already fragile banks may suffer significant losses and tilt over into outright bankruptcy themselves, dragging each other below the floating line. But bankrupt governments cannot bailout bankrupt banks, even less carry on counter-cyclical policies. The only solution, then, would be massive money creation and its eventual outcome, massive inflation. Since price stability is a fundamental objective of the Single Currency, this scenario was felt as impossible to even contemplate, hence the no-bailout rule.
As is well-known from the rules vs. discretion literature, any black-and-white rule runs the risk of being extremely counter-productive under some circumstances. When the unexpected happens, the temptation to renege becomes huge. Here we are. The question, then, is whether the costs of reneging exceed the costs of upholding the rule. The answer is by no means obvious.
Bailing out one or more governments does not have to be financially costly to the lenders if they charge the market rate. This, presumably, is what lies behind the idea of issuing EU bonds. The cost, therefore, comes mainly from the moral hazard side. This would undoubtedly require the adoption of a strong version of the Stability and Growth Pact, since the current one, which replaces a previous version that failed, clearly did not succeed in pushing many countries toward fiscal discipline.
Given the many limitations of the pact, strengthening it would be a real cost in the aftermath of the crisis. To realize how counterproductive the pact can be, it is enough to observe how the Commission is too paralyzed by its desire to uphold the pact to play any constructive role in encouraging a coordination of fiscal policies. Better solutions, which focus instead on national institutions, are possible but unlikely to be considered after a bailout. The alternative to a strengthened pact is exacerbated moral hazard, which could eventually sap the monetary union.
Letting member-state governments default could create havoc of untold proportions, as noted above. Or could it? When they wrote the no-bailout clause, the Maastricht Treaty Founding Fathers were clearly impressed by the New York City affair of the 1970s. The City informed the State of New York that it was about to declare bankruptcy and would do so unless bailed out. The State informed the Federal Government that it too would default unless bailed out, which could destroy Wall Street and the US financial system. The Federal Government responded to the State of New York “please default”, a message that was then passed on to the Mayor. No one defaulted. And then, after the City had made substantial progress, the Federal Government provided a loan on which it subsequently made good profit. Even better, the City of New York has since become fiscally disciplined.
The no-bailout clause is much better than the Stability and Growth Pact provided that it is enforced when it is needed. T’is the time.
Much as it was necessary to let Lehman Brothers go down the pipe before bailing out the remaining banks, it may be necessary to let a profligate government default and ask for IMF assistance before punching a hole in the no-bailout clause.
Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate where you can find further discussion, and where professional economists are welcome to contribute their own Commentaries on this and other crisis-linked topics.