The eurozone's borrowing costs may stay lethally high

Lord Turner in 2009

A newish narrative for why the eurozone faces a stark choice between break-up and transforming itself into a federal super-state has been given by the chairman of the Financial Services Authority, Lord Turner.

The analysis in the speech he gave last night in Frankfurt, "Debt and deleveraging, long-term and short-term challenges", also implies that - on the basis of the eurozone's current rules and structure - it is rational for investors to charge more for lending to any eurozone government (even Germany's) than to governments such as those of the US or UK which have their own respective currencies and central banks.

To put it another way: Italy, Spain and France can manage their respective fiscal affairs as prudently as they like, but there are - in Turner's view - bigger risks in lending to each of them than to governments of comparable economies outside the eurozone.

The reason is that as and when the UK government, for example, is perceived to have borrowed too much, the Bank of England can buy some of its debt and turn it into money. This is, in fact, the Bank of England is doing, to the tune of £275bn, through quantitative easing (though it hasn't gone the whole hog - which it could do if the UK were ever in a seriously deflationary recession - of cancelling the debt).

Of course, this so-called monetisation can debase the currency and spark inflation.

Central bank

But here's the thing. Although devaluation of the currency and inflation would generate losses for creditors, those losses are typically a fraction of losses that would arise from a default by government or - as Greece is trying to do - from a request to creditors to voluntarily forgo an element of what they're owed.

Also, inflation and devaluation are worst for overseas creditors. If you are resident in the UK, and you have substantial liabilities and outgoings in sterling, a bit of inflation will help you service what you owe at the same time as eroding the real value of your assets (or in this case, the real value of your loans to Her Majesty's Government).

But surely, you may say, the eurozone has a central bank: the European Central Bank. What is to stop it buying up Italian government debt or Spanish government debt in substantially bigger amounts than it is currently doing?

To be clear, right now the ECB is purchasing modest amounts of Italian and Spanish government debt, for example, in an attempt to keep the respective interest rates they're charged at a bit less than the penal and prohibitive 7%.

But the ECB is prevented both by its own constitution and by the passionately held views of the Bundesbank - the German central bank and the ECB's most influential shareholder - from purchasing substantially more than that.

Although many economists believe the Germans are wrong-headed in refusing to countenance substantial purchases of government debt by the ECB, there is some logic to the prohibition.

If profligate members of a currency union know that their reckless spending and borrowing will always be bailed out by a central bank, they will have an incentive to borrow as much as they dare relative to the balance sheets of the more prudent members of the currency union, rather than to their own balance sheets.

Asymmetric risk

To put it in more practical terms, if Greece or Italy had known that the ECB would purchase their debts and let them off the hook, they would have had an even bigger incentive to borrow, to the point (but no further) where the losses on their debts would have either wiped out the central bank and taken Germany to the brink of financial collapse, or would have sparked rampant inflation (if all the debt had been turned into money).

In the good years, Greece and Italy would have reaped all the benefits of their spendthrift behaviour, knowing that most of the bill for the party would be picked up by other eurozone members. It's an asymmetric distribution of risk and rewards that more-or-less guarantees long-term financial disaster (you'll note a similarity with what happened in the banking sector, where bonuses in the boom years of lending were enjoyed by bankers, and losses when it all went pop fell on taxpayers).

By the way, there is nothing particularly unusual about a central bank refusing to purchase the debt of public-sector entities. In the US, it is taken for granted that states and municipalities can and do go bust.

But if there is a good reason for central banks in monetary unions not to bail out subsidiary entities - whether they are local, regional or even national - then by definition there is an elevated risk of those subsidiary entities defaulting on what they owe.

Which is why the economist Charles Goodhart has devised the useful concept of "subsidiary sovereign bonds", to describe the debt issued by any individual sovereign member of a currency union, such as Spain, Italy or Germany, and why he argues that subsidiary sovereign bonds are inferior to fully sovereign debt.

All sorts of other things flow from that distinction.

Unhealthy incentive

It was (and is), for example, a chronic failure of international bank regulation that the debt of Italy, Spain, Germany and so on was classified by financial regulators as completely safe and without risk after monetary union - which gave an unhealthy incentive to banks to lend to these governments (in the jargon, the government bonds of these countries were given a zero risk-weighting).

International bank regulators gave a second dangerous incentive to banks to lend to these countries, by classifying the debt as a close proxy for money for liquidity-management purposes (or to give protection against the risk of a bank run).

Finally, even the ECB helped to inflate the market for this debt and therefore encouraged the likes of Greece and Italy to borrow substantially more than was sensible. It did this by classifying such subsidiary sovereign debt as the highest quality collateral - which means that banks wanted an ample stock of it, just in case they needed assets to swap for central bank loans.

So by failing to recognise the elevated risks of subsidiary sovereign debt, regulators made it cheaper for the likes of Italy, Greece and Spain to borrow for a good number of years before the penny dropped.

And regulators made sure that when the penny dropped, a sovereign debt crisis would become a banking crisis, because the Italian, Greek, Portuguese and Spanish banks were all stuffed to the gunnels with Italian, Greek, Portuguese and Spanish government debt.

Anyway, if you're still with me (which I rather doubt you are), then you may have worked out where this argument is heading.

Which is that the putative economic benefits of monetary union may well be completely wiped out by the higher borrowing costs for member states that stem from their ability only to issue subsidiary sovereign bonds, or their inability to issue fully sovereign bonds.

Bye-bye eurozone?

Probably the only way to regain those economic benefits would be for member states to pool their sovereignty when it comes to spending and borrowing decisions, for there to be centralised decision-making for the budgets of all member states, for them to become (to use the ghastly emotive cliche) a federal superstate.

Only in those circumstances would it be possible for the eurozone to raise money on a consolidated basis, through the sale of what have come to be known as euro bonds.

Now, once the eurozone were borrowing in this way as a de facto single sovereign entity, then of course these euro bonds would be fully sovereign bonds, available for purchase (in theory) by the central bank (though gawd alone knows whether Germany would allow it).

So the borrowing costs for the eurozone should then fall to the levels enjoyed by the likes of the US and UK - or indeed lower, given that on an aggregated basis both the indebtedness and external deficit of the eurozone is lower than those for the US and UK.

Which is why you might say that it's either bye-bye eurozone, because the costs for borrowing of an unreformed eurozone remain prohibitively high, or it's bye-bye eurozone, because it turns into something that looks more like a giant single country.