Saving Europe with sovereign equity
One way to think about the European financial crisis is that it is a matter of capital structure. Countries like the United States and Great Britain are equity-financed, while countries like Greece, France, and Germany are debt-financed.  There is no question that some European countries have very real problems. But there is also no question that no matter how badly a country may be arranged, nations cannot be “liquidated”. A “bankrupt” state must be reorganized. If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece’s creditors sometimes idiotically demand. Instead, a bankruptcy court would convert debt claims that are unpayable, or whose payment would impair the long-term value of the enterprise, into equity claims whose value would depend upon restoring the underlying enterprise to health.
Greece’s problems are extreme, but by no means unique. European states in general are crippled by overleveraged, fragile capital structures. What Europe requires, in financial terms, is a means of converting some part of member states’ sovereign debt into equity. One solution would be to redenominate the debt of European sovereigns into unredeemable fiat currencies. But that is a particularly extreme solution, and would represent a large setback to the European project. What follows is a more modest proposal to equitize part of European states’ capital structures. The proposal is not original. It is an elaboration of a suggestion by Warren Mosler. It seems politically impossible. But very recently, so did outright default and/or exit of a Eurozone sovereign, yet that political impossibility suddenly looks very likely. The boundaries of the possible are very much in flux. European governance, to its deep discredit, tends to disparage populism in favor of elite technocracy. This proposal intentionally includes a strong populist element.
Without further ado, the proposal:
- European governments would define a new class of security: European Sovereign Equity Shares. Governments would issue and sell these securities at par. Dividends would accrue at the Eurozone inflation rate (and negative accruals could occur in the event of outright deflation). However, these would be true equity securities. The timing of any redemptions, whether of principal or accrued dividends, in part or in full, would be at the discretion of the issuing sovereign.
- Under certain circumstances (like the current circumstances), member states and the ECB would agree that issuance of sovereign equity would serve the economic interest of the Union. The ECB would agree to purchase up to a certain quantity of each states’ equity shares, which it would carry on its books at par. With any purchase offer, the Bank would announce a maximum balance that the ECB would be willing to accept from each state. This limit would be equal for all states in per capita terms. For example, the ECB might set the maximum equity balance might at €20000 per capita. If that announcement were made today, it would mean that Greece could issue roughly €226 billion of shares, while Germany could issue roughly €1.6T. The maximum balance per country would be set at the time of an offer, and would not automatically change with population shifts. However, up to that balance, the policy would amount to a standing offer to purchase shares. Even if a sovereign has redeemed shares, should it have the need, it may issue new shares, and the ECB would purchase them, up to the ECB’s current limit for that country.
Purchase of equity by the ECB would be contingent upon member states agreeing to use the proceeds precisely as follows:
- First and foremost, any proceeds must be used to retire or repurchase the sovereign’s debt.
- Should the proceeds of any sale exceed the sovereign’s outstanding debt, the excess must be distributed directly to citizens in equal amounts.
- Distributions to citizens would be under analogous terms. Before receiving any cash benefit, citizens would be required to apply their allotments to retiring or defeasing outstanding debts. Only once all debts are retired would citizens receive a check, with which they could do as they please.
That’s basically it. This sounds opaque and technocratic. Why do I claim that it’s a good idea and also populist?
The reason it’s a good idea is because it does what obviously needs to be done in Europe, which is to eliminate the tyranny of zero. Suppose that Germany’s net financial position (however you want to compute that) is €30000 per capita while Greece’s is €5000 per capita, because Greeks have consistently consumed a greater fraction of their income than Germans. That’s fine and right: for whatever reason, the Greeks have saved less than the Germans, and therefore have a lesser claim on future consumption. But now suppose Germany’s net financial position is €10000 per capita while Greece’s is negative €15000. The difference in wealth, in absolute terms, is identical, but around and beneath zero all kinds of “distress costs” kick in. Loans go unpaid, interest rates spike, politics get ugly, etc. etc. (You don’t have to imagine. Just read the news.) The effect of this proposal, in practical terms, would be to shift the zero point. If Greece and Germany both issue €20000 per capita of sovereign equity, the non-equity financial position of both states shifts upwards, reproducing the first hypothetical. The operation keeps the absolute wealth difference intact but eliminates distress costs. Of course, a sovereign’s issued equity represents a liability to the ECB, so each sovereign’s overall financial position has not changed at all. But equity, redeemable at the discretion of the issuer, does not provoke distress costs, while a debt position very much does. For sovereigns as for corporates, capital structure matters in the real world. The long-term value of a distressed enterprise can increase dramatically if it is able to convert an unserviceable debt position to equity.
But why is this a populist proposal? What pisses off ordinary humans, quite legitimately, about bailouts is that they undermine the moral environment, the “karma” if you will, that we try to construct in our communities in order to preserve and sustain the social norms that is the “secret sauce” of every good society. It is corrosive if policy interventions render those who are industrious and prudent no better off than those who are reckless, indolent, or predatory. However, we needn’t (and ordinary humans don’t) demand that people who are reckless or disorganized be condemned to starvation or misery. What matters is that the industrious fare significantly better than the indolent. If an ordinary German citizen gets a €15000 check (or €15000 of burdensome personal debt forgiven) while an ordinary Greek gets nothing other than the vague knowledge that politicians have squirmed out of the debt they have accrued, that sustains the difference in reward. Ordinary people in rich countries are likely to be more open to a proposal that involves their receiving a nice check (while their counterparts in less disciplined countries get nothing at all) than they would be to a “transfers union” that implies their cutting a check to those who behaved poorly while seeming to get nothing in return.
But what about inflation? Does this just amount to a scheme to hide transfers from rich countries to poor behind a money veil? No, or not entirely. First off, many of the distress costs associated with insolvency are deadweight losses, not transfers. The benefit of preventing the burning of Athens does not impose any offsetting cost on Berliners. Shifting the zero point is just a good idea. Second, for the Eurozone as a whole, inflation need not rise at all. The ECB has the tools to combat a general inflation, if it wishes to. When inflationary pressures arise, the ECB can raise interest rates. In terms of Eurozone-wide consumption, the value of Germans’ new Euros can be sustained. The distribution of inflation rates across the Eurozone would likely be affected, in a way that disadvantages citizens of rich countries. Status quo inflation targeting across the Eurozone tends to distribute inflation towards current-account deficit countries, reducing their relative competitiveness and exacerbating the imbalance. Cash grants to citizens in rich countries reverse the maldistribution of inflation, raising income and prices in countries that are generating unsustainable current-accunt surpluses. If Germans but not Greeks receive €15000 grants, prices of German goods will rise relative to prices of Greek goods. At the margin, this will increase Germans’ propensity to spend their newfound wealth in Greece and help restore financial balance.
Further, the proposal creates a new policy tool by which countries can individually take some control over their own price level, helping remedy the “one size fits all” limitation of European monetary policy. Remember, the German government would have the right, but not the obligation, to issue sovereign equity in excess of its debt and distribute the proceeds to its citizens. To whatever degree the German polity values price stability over access to wealth on very easy terms, the German polity can choose not to issue. It loses nothing by doing this: it retains the right to issue equity and distribute the proceeds whenever it judges that its domestic economy would be helped more than harmed by a bit of “helicopter drop”. As a matter of political economy, when the ECB’s equity limits are raised due to a crisis in some corner of the Eurozone, solvent countries might wish to issue some equity and distribute the proceeds, to buy the support of citizens and sustain the sense of reward for collective prudence. But they could leave much of their capacity in reserve for a future domestic slump.
One genuine downside of this scheme is that it fails to distribute losses to foolish rich-country lenders, and therefore might encourage reckless lending to and borrowing from spendthrift countries going forward. Persistent current account imbalance is, I think, very dangerous and corrosive, and should absolutely be discouraged. Very few proposals credibly address this. Under current arrangements, trying to punish foolish lenders generates a crisis that threatens the existence of the Euro. The leading maybe-reform, a European stabilization fund financed by “Eurobonds”, would bail out creditors and impose deadweight austerity costs on debtors. It is naive to think that imposing harsh austerity on debtors will prevent intra-European debt crises going forward. In human affairs at every level, it is creditors, not debtors, who provide or fail to provide practical limits on bad lending. An individual person or government may be prudent and refuse to borrow funds they’ll be unable to invest and repay. But in any population of humans, and in most countries as governments change over time, there will always be people willing to take loans and consume the proceeds recklessly. The only way to prevent that behavior from causing systemic problems is to insist that creditors take responsibility for their loans. (Note that the roles of creditor and debtor are asymmetrical. Many humans have an innate impulse to spend recklessly that is not matched by an innate impulse to lend recklessly. Trying to punish foolish borrowing is fighting human nature in a way that insisting reckless creditors bear losses is not.)
The current proposal punishes creditors insufficiently. But it does punish them some, by reducing their relative advantage over debtors. Going forward, if it were up to me, I’d insist that bank loans to sovereigns other than a bank’s “home” sovereign carry the same risk weighting as corporate equity, and I’d tax cross-border fixed-income investment. But those are topics for another time.
This proposal would defuse the current crisis. And it would create a permanent mechanism for dealing with future crises. It does not pretend (absurdly) that interventions are “one-offs” that absolutely, positively, will never be repeated. The ECB can purchase sovereign equity whenever a systemic debt crisis threatens the Eurozone.
Enabling sovereign equity issuance would enlarge the space of macroeconomic policy options, both at the level of the Union and at the level of individual member states. Distributing the proceeds of equity sales (after debt retirement) directly to citizens means that crises get resolved in a manner that is comprehensible and fair to ordinary people. Nothing explodes. Citizens of countries that adequately discipline their governments and banks occasionally receive large checks. Citizens of less careful countries do not, and look across their borders with envy.
 If you don’t get this, think about it. The sine qua non distinction between debt and equity is involuntary redemption. The issuer of a debt security must redeem it for something else, either on a fixed schedule or on demand. Equity securities are redeemable only at the issuer’s discretion. Great Britain and the US finance themselves by issuing 1) fiat currency, which is plainly a form of equity; and 2) securities that convert to fiat currency on a fixed timetable, or “mandatory convertibles” to equity. In both cases, bearers have no right to demand redemption of the issuer’s paper for anything other than, well, the issuer’s paper. Just as firms that issue equity work to maintain the value of their equity despite the absence of any right to redeem, Great Britain and the US work to ensure that their paper is valuable in secondary markets by a wide variety of techniques, including taxation and the payment of interest. But all of those manipulations are at the discretion of the issuing sovereign. Great Britain and the United States have all-equity capital structures. Greece, France, and Germany finance themselves by issuing securities that are redeemable on a fixed time table for Euros, an asset which those states cannot issue at will. Greece’s sovereign debt is in fact debt, while the United States’ “sovereign debt” is a form of equity.