Euro breakup: Who cares about accounting losses?

With the "Merkel memorandum", The Economist has joined the rows of other commentators on the cost of a euro breakup. The costs are quantified as accounting losses on bailout loans, ECB's bond holdings and Target2 balances, and possibly bank bailouts. Is this all the euro crisis is about? Hardly. The numbers the Economist bases its argument on are accounting losses and fall short of the cost-benefit analysis it claims to be. Here are a few arguments why Frau Merkel will not be impressed by accounting losses:

Losses on bailout loans. It is correct that the paid-out loans may not be repaid as scheduled, prompting Eurostat to reassess their recording as financial investment by creditor countries. But creditor countries could find ways to avoid taking an accounting losses, such as by rescheduling the loans. As the paid-out loans are already funded, a breakup does not increase creditors' gross debt. With debt and deficit not heavily affected, what to fret about these accounting losses? 

SMP losses. It is correct that exiting countries may restructure their government bonds, reducing their face value. But ECB has bought most bonds at prices below their face value, making it unlikely that the accounting loss is as large as the full exposure.

Target2 losses. It is correct that the central banks of exiting countries are likely to become insolvent and may trigger an accounting loss to ECB. But, as with accounting losses on bailout loans, why to fret about it? ECB has large reserves and considerable earning power, and---like other central banks---could remain effective despite being balance sheet insolvent.

Therefore, Frau Merkel will not take interest in accounting losses. She will look at accounting losses in the same way as in other policy areas. And so may her electorate. Who cried out about EUR200 billion or so in subsidies spent on nuclear energy since 1950 when Frau Merkel decided to accelerate the phase-out of nuclear power generation?

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ECB's Securities Market Program is fiscal action in disguise

The ECB's Securities Market Program (SMP) is, as shown by last weeks resignation of Jürgen Stark, controversial. One striking argument in favor of intervening in sovereign markets is the analogy to a lender of last resort (LOLR), a liquidity backstop central banks provide to banks (see Paul Grauwe's VOX contribution). Yet, I think a stringend application of the analogy points to something else than the SMP as currently implemented. Here are my points:

(i) Prevent self-fulfilling runs. The LOLR function is intended to prevent the collapse of systemic institutions that are vulnerable to self-fulfilling prophecies. In other words, banks are given a backstop because they are believed to be vulnerable to irrational bank runs. Does the analogy hold to self-fulfilling sovereign debt crises? Secondary market purchases do not provide liquidity to the issuer, but keep their secondary market yields low as to help them issue cheaper. To the degree that the SMP enables deficit financing as buyers on the primary market sell the next day to the SMP (something that may well be going), the SMP undermines Art. 123 of the Treaty which forbids deficit monetization. Once the issuer cannot access primary markets, he has no reason to care about gyrations of secondary markets. A stringent application of the analogy would open the refinancing windows to sovereigns, which however is ruled out by Art. 123 of the Treaty to avoid the monetization of deficits.

(ii) Avoid systemic crises. The LOLR backstop is mainly justified by the systemic nature of banks. They are thought to be the backbone of the economy. During the crisis, backstops were extended to other entities that were thought to be systemic, such as automobile manufacturers. But how systemic are sovereign bond markets? Peripheral sovereign bonds have largely lost their benchmark function vis-a-vis local issuers, which trade "through" the sovereign curve. Again, no reason to worry about gyrations of secondary markets.

(iii) Liquidity support. The LOLR is providing liquidity, not solvency support. To that end, the central bank uses collateral rules and can (in many cases) provide further emergency liquidity to solvent institutions, with a supervisory body in charge of monitoring the debtor's solvency. In case of insolvency, a systemic but viable debtor could receive a capital injection from public coffers, but not from the central bank but the fiscal. How does this compare to the SMP? The ECB has no clearly communicated guidance about the solvency of the sovereign debtor. There is no institution supervising sovereigns in the euro area, or an explicit or implicit recapitalization assurance or collateral.

While the analogy in principal is appealing, it seems neither the conditions nor the instrument are defined the right way. Sticking to the analogy, the ECB could also buy corporate bonds and provide liquidity support to pension funds and other investors in the sovereign bond markets!

To make the SMP work in an analogy to the LOLR, the ECB (or another watchdog) would need to develop and apply a threshold of solvency, receive fiscal guarantees towards maintenance of the debtors' solvency, and (after changing Art. 123 of the Treaty) buy on primary markets or open the refinancing window to sovereigns. Shifting any losses to the fiscal would reshape the SMP into a pure liquidity operation of unlimited dimension, which the enhanced EFSF or ESM is lacking.

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