2010 December 24 Friday
Elena Carletti: Fast Euro Default Mechanism Needed

Elena Carletti, a professor of economics at the European University Institute in Florence, Italy, says sovereign defaults need to be set up so they can occur very quickly.

A sovereign default would need to be done very quickly, otherwise it would trigger enormous capital flows in the euro area from countries perceived to be weak to those seen as strong, such as Germany.

Of course, the biggest problem with this quite reasonable suggestion is that the Euro mandarins do not want to admit the high probability of eventual sovereign default. So they won't act fast enough now, before the acute severe crisis is upon us, to set up all the mechanisms needed for a lightning fast default.

The same holds with a country exiting from the Euro currency union. It has to be done fast. But that means governments, banks, and businesses need to be set up to handle the transition.

There is an alternative to sovereign default in the euro area: A country could simply leave the currency union, possibly temporarily. This would also need to be done quickly to avoid massive capital outflows.

Think of all the back office accounting systems that would need to know about a new currency distinct from the Euro. Think of all the businesses that do Euro transactions in from their home bases in Greece or Ireland or Italy both in their home country (where the currency would change) and abroad (where the currency would remain the Euro. They'd suddenly need to start doing their local payroll and utilities and local services in a new currency while doing some of their business transactions in Euros. The accounting costs and frictions would be high. An article in The Economist also argues for the need for a rapid transition when reinstating an old currency.

I do not expect the Euro zone countries to be saved from default by economic growth. If the price of oil continues its ascent then we'll head back into recession long before indebtedness begins to shrink and government deficits will hit levels that will guarantee default.

The United States faces a similar need for a default mechanism (without the need for a way to exit the US dollar) due to the financial troubles of states like Illinois and California. Massive unfunded government employee retirement liabilities and other costs make the eventual need for bankruptcy a real possibility. Reihan Salam points to a a recent piece by David Skeel on the need for a national law on state-level bankruptcy. Given the precedent of long established law for municipal bankruptcy it should not be hard to come up with an equivalent for states.

One can imagine something like a liquidation sale for cities and even states. Indeed, in the early 1990s, professors Michael McConnell and Randal Picker proposed that Congress amend the existing municipal bankruptcy chapter to allow just that. They argued that many of a city’s commercial, nongovernmental properties could be sold in a municipal bankruptcy, and the proceeds simply distributed to creditors. (They also suggested that municipal boundaries could be dissolved, with a bankrupt city being absorbed by the surrounding county.) Although California has taken small steps in this direction on its own—it recently contracted to sell the San Francisco Civic Center and other public buildings to a Texas investment company for $2.33 billion—it seems unlikely that Congress would give bankruptcy judges the power to compel sales in bankruptcy. Nor could it do so with respect to any property that serves a public purpose. Liquidation simply isn’t a realistic option for a city or state. (The same limitation applies to nation-states like Ireland and Greece, whose financial travails have reinvigorated debate about whether there should be a bankruptcy-like international framework for countries.)

Again, it is better to create a legal framework before a crisis reaches an acute stage. Skeel and Reihan think it cruciall to get this reform enacted before the US government decides to start bailing out states. But after Skeel points out the need for bankruptcies to enable rewriting of union contracts Reihan points out why passing this law will be so difficult:

Simply put, this is the reason why bankruptcy for states is so vitally important, and why it will prove an extremely tough political fight. State governments need to be given the option of preserving core public services even if it means forcing creditors to take a haircut and forcing public sector employees to accept the kind of retiree health benefits and pensions offered to comparable workers in the private sector.

Even with the Republicans in control of the House I give such a reform poor odds of passing. But I'm a little more optimistic that the US government won't bail out states. First off, California is so not a Republican state any more that Republicans in Congress will oppose a bail-out. Also, when the big federal fiscal crunch reaches a crisis stage in a few years (helped along by rising oil prices which will bring on another recession) the federal government will not have the money to bail out states. It'll be every government for itself. Then the states will do battle with their public employee unions.

Update Mish Shedlock says the state pension funds of New Jersey, California, and other states are in far worse shape than reported. He's right. These pension funds assume unrealistically high rates of return for their investments. They need high rates of economic growth that probably aren't in store. The fiscal crack-ups that are coming are epic in scope.

Share |      By Randall Parker at 2010 December 24 10:19 PM  Economics Sovereign Crises

A.Prole said at December 25, 2010 10:20 AM:

That's Randal PICKER mind you, not Randal Parker.

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