Librarians by the numbers

July 6, 2012

For the past couple of weeks we have examined the critical issues facing some members of the EU. The need to properly address the unfolding crisis cannot be overstated, with a failure to calm developing market fears potentially impacting every other major economy around the world, including the United States.

While final decisions regarding the mechanisms to be used to forestall the impending default of Greece (were no additional aid to be provided), the potential insolvency of EU banks, and the “tapped out” nature of the EFSF remain extremely murky, the few details that have emerged could suggest a number of problems as time progresses. At least a few underlying (and potentially unresolved) issues seem reasonably clear at this point.

First, should the EU decide to increase the financial firepower of the European Financial Stability Facility (EFSF) through a leveraging effort, the 10-to-25 percent loss guarantee becomes extremely problematic in both design and implementation. Regarding the design, is this loss guarantee for all purchases of the debt instruments in both primary and secondary (resale) markets? If it applies to only original (primary) purchasers, would this limit secondary market activity as time progresses, and thereby reduce demand and price (and thereby causing the loss guarantee to “perform” if the purchaser wishes to sell the sovereign debt instrument)?

In terms of the implementation of the loss guarantee, would there be some time limit placed upon the buyer’s ability to utilize the loss provision. Does it only apply to those who hold the sovereign debt instruments to maturity? If so, wouldn’t this produce an investor mindset to avoid long-term debt instruments in favor of short term instruments? In the case of the long-term instruments, would a provision to provide loss coverage only at maturity cause a drop in demand for long-term instruments, with resulting higher long-term interest rates? And can countries such as Greece, Spain, Italy, Portugal, and Ireland afford the higher interest rates that would come with such a policy implementation? And if it applies to all maturities at all times, might this not cause speculation in the market for such securities, produce wild price (and interest rate) gyrations, which might then allow the loss guarantee provision to bleed the EFSF of its funds?

And what happens if the losses far exceed the ability of the EFSF to repay its obligations to provide a 10-to-25 percent loss guarantee? Such a scenario is not all that improbable, particular given the 50 percent “voluntary” reduction financial institutions are now being asked to absorb to keep Greece from defaulting on its obligations. What happens if future investors in primary or secondary markets ignore the call for more “voluntary” reductions?

Other issues in the bailout effort of Greece (or any other country receiving some sort of aid via the EFSF efforts) involve “asymmetric information” issues. One possibility is the emergence of a “moral hazard” on the part of governments receiving assistance, that is, once aid is provided (in whatever form), governments change their behavior and become less diligent in solving their underlying financial imbalances, under the belief that should problems develop in the future, another bailout will result.

A second problem might ensue in the form of an “adverse selection” of parties interested in purchasing the sovereign debt instruments of nations with financial difficulties. Since a loss guarantee would be provided by the EFSF, those purchasing the sovereign debt instruments (or even those helping to recapitalize EU banks) may include investors with little experience in evaluating the risks involved in such market transactions. Should this occur, the initial interest rates associated with the sovereign debt instruments of Greece, Italy, and the like might be held down, and cause (over time) a greater opportunity for losses as interest rates rise to more appropriate levels. This might then deplete funds from the EFSF and endanger the entire stabilization/bailout effort.

Of course, I could be exaggerating these (and other) potential problems with the EU bailout. Should this happen to be true — with final decisions regarding the implementation of the EFSF proving effective — a great deal of time will likely be required for planning and implementation of EFSF actions. In the meantime, financial markets will undoubtedly remain highly agitated as markets attempt to anticipate outcomes. This uncertainty could produce wild swings in U.S. (and worldwide) stock markets and keep many investors on the sidelines via U.S. Treasury (and German sovereign debt) securities.

Dr. James Newton serves as Chief Economic Advisor to Commerce National Bank and is an auxiliary faculty member in economics and statistics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not necessarily reflect those of Commerce National Bank or OSU-Marion/Newark.