Solving the sovereign debt crisis
On September 5th 1661, Louis XIV ordered D’Artagnan and his musketeers to arrest Nicolas Fouquet, the “Surintendant des finances”, for the capital offences of embezzlement and crimes against the state (or Louis XIV as it was known in those days). Fouquet was accused of ruining the king through exorbitant interest rates on sovereign debt as well as diverting some of the financial flows from lenders to the royal coffers into his own pocket.
Fouquet defended himself well though, and after a three-year trial was exiled rather than executed. However today he’s mostly remembered for parties that even the Sun King found a tad extravagant (although Louis did build the Palace of Versailles as a bigger, blingier version of Fouquet’s château at Vaux-le-Vicomte).
There’s a lot of truth in the popular image, but it doesn’t tell the whole story. Fouquet tackled problems that would be familiar to any European finance minister today, using means that are still part of the policy response to the current crisis such as cutting public spending, rescheduling debt and raising taxes and improving their collection. (He also used a few that aren’t so common or so blatant anymore such as selling public offices to his cronies.)
Fouquet understood something that is key to the present crisis: the need to restore confidence and get the economy moving. He did this thanks to a number of instruments including reassigning to solvable funds sovereign debt that had in today’s terms become junk bonds and even providing collateral himself for sovereign borrowing.
So, restore trust, fix the financial system, stimulate growth. Three and a half centuries later, you can read a similar argument in a paper by Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. In Solving the Financial and Sovereign Debt Crisis in Europe, Blundell-Wignall looks at why the crisis is worse in Europe than elsewhere and what can be done.
Monetary union means that euro members can’t devalue their currencies to help exports, and pressures on international competitiveness are transmitted directly to the labour market, leading to increased unemployment. Some governments responded by allowing their deficits to grow, and debt with it. Moreover, monetary union has resulted in high levels of debt in the household and corporate sectors in many of the countries that are in the worst competitive positions, leaving little hope that savings can be spent to stimulate growth.
The crisis and recession have increased indebtedness, contributing to underlying financial instability. One of the main reasons the situation is worse in Europe is the nature of its banking system. European banks mix traditional business such as loans to firms and households with activities in capital markets. Countries with large capital markets banks are heavily exposed to the sovereign debt of larger EU countries like Spain and Italy. Traditionally, holding this dull but dependable debt was a safe form of collateral for other activities, but the sharp price fluctuations that are now typical of sovereign debt trading affects the true value of this collateral and the price that shares in this debt could be sold for at any given time.
Deregulation and innovation in financial markets are to blame too. Apart from capital market banking, “re-hypothecation” has grown massively – the practice of reusing the same collateral repeatedly. This increases risk, given that the value of this collateral can drop suddenly, plus the fact that the banks are doing deals for themselves using collateral originally pledged by clients. As the number of deals using the same collateral multiplies, so does counterparty risk, the risk that one of the parties involved can’t meet their obligations.
Blundell-Wignall argues that underpricing of risk is the core cause of the financial crisis and that excessive risk in banking can always be traced to two basic causes: too much leverage, and for a given leverage, increased dealing in high risk products. Far from acting to contain the risk of the proliferation of these products, such as derivatives, regulators cleared the way for them, for example by removing barriers to mixing different types of banking business such as those in the Glass-Steagall Act in the US.
At one time, derivatives were used for practical day-to-day business operations, such as an airline hedging against a big rise in fuel prices, but they rose from 2.5 times world GDP in 1998 (already a staggering figure) to 12 times world GDP before the crisis.
Derivatives trading needs collateral and the price shifts we mentioned above can result in calls for collateral the banks can’t meet. This provokes a liquidity crisis, and the banks don’t have time to recapitalise through earnings, so they stop lending to businesses, especially small and medium-sized enterprises, adding a further twist to the downwards economic spiral.
It’s easy to feel helpless in the face of such arcane and seemingly uncontrollable forces, but solutions exist. Fracturing the eurozone would be one, but while this may lead to a short-term improvement for certain countries, it would weaken the status of the euro as a global currency, increase pressure on countries that stayed in the euro, and create legal uncertainty about financial contracts in euros.
A more coherent approach would include solving the Greek crisis via a 50% or bigger “haircut” on its sovereign debt (reduction in its stated value) and granting the European Financial Stability Facility a bank license. The European Central Bank should continue to support economic growth and investor confidence via funding for banks and putting a lid on sovereign bond rates in key countries. Private banking should be reformed too, with investment banking separated from traditional retail and commercial banking.
That said, sending musketeers to arrest the financiers would appeal to many people.