Leverage Limits vs. the Euro Discipline Rules

Much blame has been put on the 2004 regulatory change in the US that let investment banks increase their leverage and also changed the general regulatory regime to one of more self-regulation. See my post here and the related posts.

It is interesting to compare the attention that rule change received to the amount of recent coverage I have seen (almost none) on the rule changes in the Eurozone that let member countries run higher deficits and higher debt levels than the original pact allowed.

IN 2002, France and Germany ran deficits in excess of 3% of GDP, which the original Stability and Growth Pact allowed. By 2004, Greece, the Netherlands, Portugal and Italy were also beyond the limit. See Feldstein, "The Euro and the Stability Pact.

Nothing was done to the violators.

In March of 2005, the Pact was changed to make the limits even less meaningful: see the summary summary available here.

Also see the comment at the time by the European Central Bank:

PRESS RELEASE

21 March 2005 - Statement of the Governing Council on the ECOFIN Council’s report on Improving the implementation of the Stability and Growth Pact

The Governing Council of the ECB is seriously concerned about the proposed changes to the Stability and Growth Pact. It must be avoided that changes in the corrective arm undermine confidence in the fiscal framework of the European Union and the sustainability of public finances in the euro area Member States. As regards the preventive arm of the Pact, the Governing Council also takes note of some proposed changes which are in line with its possible strengthening.

Sound fiscal policies and a monetary policy geared to price stability are fundamental for the success of Economic and Monetary Union. They are prerequisites for macroeconomic stability, growth and cohesion in the euro area. It is imperative that Member States, the European Commission and the Council of the European Union implement the revised framework in a rigorous and consistent manner conducive to prudent fiscal policies.

More than ever, in the present circumstances, it is essential that all parties concerned fulfil their respective responsibilities. The public and the markets can trust that the Governing Council remains firmly committed to deliver on its mandate of maintaining price stability.

The Health Care/Jobs Bill

It appears that the Patient Protection and Affordable Care Act has morphed into the jobs bill -- see this Reuters story.


The essence of the new initiative is that up to $1 billion (of the $10 billion set aside for "innovation" at the Center for Medicare and Medicaid Services (CMS)) will be used as grants for people who come up with good ideas to save money and improve care.

Ah, but the wrinkle is this:

"To get a grant, projects must start within six months and the program will concentrate on those ideas that spur the most hiring and workforce training, the Department of Health and Human Services said."

Here we have a perfect example of economic engineering. Give grants/subsidies/impose taxes, with a variety of specific constraints, all meant to achieve what some policymakers think is the current objective.

But what if the projects that save the most money are the ones that lay off a bunch of health care workers? Funny, but at our local hospital, layoffs are proceeding at a rapid rate. So we will have one set of incentives to lay people off and another set of incentives to hire new ones...but only in certain areas..."shovel ready health care projects."

The health care bill is starting to look like our tax code, and it hasn't even kicked in yet.

Interesting Issues on Greek Debt: Non-Participation in Exchange, and Non-Trigger of CDS

It is interesting that the 50% writedown on Greek debt applies only to privately held debt (held by banks and I guess any other private individuals or institutions) NOT to the bonds held by the European Central Bank. (I believe that any bonds held by the European Financial Stability Facility will be excluded as well). The Economist notes the matter; also see this Bloomberg story.

How this discrimination actually works is interesting. The writedown is voluntary, and will be effected by an exchange of old bonds for new ones at some time in December. It seems that anyone is free to forego the exchange, and that will include the ECB. Holding on to your old bonds, however, will put you at some risk that the terms of those bonds will be changed down the road, along the lines of squeezing minority shareholders.

Why is the deal is struck this way, to allow the ECB and other public entities to avoid a loss? There is a cost: if the public sector holders also took part in the exchange, then the Greek solvency problem could be solved with a smaller writedown. That is, if the private sector only holds 60% of outstanding Greek debt, then a 50% writedown on that is equivalent to a 30% writedown on 100% of the outstanding debt.

What would happen if the ECB had to write down the value of its Greek debt? Would that be a problem for its balance sheet? Maybe.

Another possible explanation for the discriminatory treatment is that the purchases of Greek debt by the ECB were to help the banks in the first place, and those purchases might have been at close to face value. So letting the ECB avoid the writedown and putting more of it on the banks is just ex post recognition that the banks owned all this debt in the first place.

This situation also creates the potential for some private holders to not do the exchange, essentially casting their lot in with the ECB. How that strategy will play out is anyone's guess.

The second interesting thing is that the voluntary exchange will not, it appears, qualify as a credit event that would trigger credit default swap payments. CDS would normally be triggered if timely interest and/or principal payments are not received, and I guess an exchange does not meet that test. I have often had students question the idea of "voluntary" exchange in situations where one party is under duress. In this case of a voluntary bond exchange, I must admit to thinking that the definition of "voluntary" is sounding pretty Clinton-esque. I imagine there are some European banks who bought CDs to hedge the default risk of their Greek bonds and are pretty unhappy now to see that the insurance will not pay out.

Of course, none of this is written in stone yet...the last installment of bailout money to Greece has been held up by the political turmoil in Greece after Papandreou said he would put the deal to a vote.