Greece CAN Go it Alone
Yesterday at 5:00pm
By Marshall Auerback and Warren Mosler

Greece can successfully issue and place new debt at low interest rates. The trick is to insert a provision stating that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes. This makes it immediately obvious to investors that those new securities are ‘money good’ and will ultimately redeem for face value for as long as the Greek government levies and enforces taxes. This would not only allow Greece to fund itself at low interest rates, but it would also serve as an example for the rest of the euro zone, and thereby ease the funding pressures on the entire region.

We recognize, of course, that this proposal would also introduce a ‘moral hazard’ issue. This newly found funding freedom, if abused, could be highly inflationary and further weaken the euro. In fact, the reason the ECB is prohibited from buying national government debt is to allow ‘market discipline’ to limit member nation fiscal expansion by the threat of default. When that threat is removed, bad behavior is rewarded, as the country that deficit spends the most wins, in an accelerating and inflationary race to the bottom.
It is comparable to a situation where a nation like the US, for example, did not have national insurance regulation. In this kind of circumstance, the individual states got into a race to the bottom, where the state with the laxest standards stood to attract the most insurance companies, forcing each State to either lower standards or see its tax base flee. And it tends to end badly with AIG style collapses.

Additionally, the ECB or the Economic Council of Finance Ministers (ECOFIN) effectively loses the means to enforce their austerity demands and keep them from being reversed once it’s known they’ve taken the position that it’s too risky to let any one nation fail.

What Europe’s policy makers would like to do is find a way to isolate Greece and mitigate the contagion effect, while maintaining the market discipline that comes from the member nations being the credit sensitive entities they are today; hence, the mooted “shock and awe” proposals now being leaked, which did engender an 8% jump in the Greek stock market on Thursday.

But these proposals don’t really get to the nub of the problem. Any major package weakens the others who have to fund it in the market place, because the other member nations are also revenue dependent, credit sensitive entities. Much like the US States, they do not control central bank operations, and must have good funds in their accounts or their checks will bounce.

The euro zone nations are all still in a bind, and their mandated austerity measures mean they don’t keep up with a world recovery. And Greek financial restructuring that reduces outstanding debt reduces outstanding euro financial assets, strengthening the euro, and further weakening output and employment, while at the same time the legitimization of restructuring risk weakens the credit worthiness of all the member nations.

It does not appear that the markets have fully discounted the ramifications of a Greek default. If you use a Chapter 11 bankruptcy analogy, large parts of the country would be shut down and the “company” (i.e. Greece Inc) could spend only its tax revenues. But the implied spending cuts represent a further substantial cut in aggregate demand and decreased revenues, in a most un-virtuous spiral that ends only with an increase in exports or privation driven revolt.

The ability of Greece to use the funds from the rescue package as a means to extinguish Greek state liabilities would improve their financial ratios and stave off financial collapse, at least on a short term basis, with the side effect of a downward spiral in output and employment, while the sovereign risk concerns are concurrently transmitted to Spain, Portugal, Ireland, Italy, and beyond. Those sovereign difficulties also morph into a full-scale private banking crisis which can quickly extend to bank runs at the branch level.

Our suggestion will rescue Greece and the entire euro zone from the dangers of national government insolvencies, and turn the euro zone policy maker’s attention 180 degrees, back to their traditional role of containing the potential moral hazard issue of excessive deficit spending by the national governments through the Stability and Growth Pact. If the member states ultimately decide that the Stability and Growth Pact ratios need to be changed, that’s their decision. But the SGP represents the euro zone’s “national budget”, precisely designed to prevent the hyperinflationary outcome that the “race to the bottom” could potentially create. At the very least, our proposal will mitigate the deflationary impact of markets disciplining credit sensitive national governments and halting the potential spread of global financial contagion, without being inflationary.

20 Responses

  1. ECB Statement here this AM:

    “The Governing Council of the European Central Bank (ECB) has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Greek government. This suspension will be maintained until further notice.

    Now that they have this (blown off the Ratings Agencies, & btw now no more excuses are acceptable from their Dealer Banks imo), if they could couple it with Marshall & Warren’s proposal for extinguishing Greek tax liabiities, it would put Greece in the most enviable position in the EMU system.

    Resp,

    1. As I said earlier, governments have control over the box they put themselves in, and they can change its contours at will. This make is dangerous to go short in circumstances that can change very quickly, erasing one’s expectations. For example, lots of folks were short the big banks until the FASB was “prevailed upon” to get rid of mark to market, allowing them to continue to mask their true condition. The market took off as a result, and the rest is history.

      I suspect that the EMU will decide incrementally to change the rules it imposes on itself in order to preserve itself while imposing as much austerity as possible without leading to consequences that the chief decision-makers can’t live with.

  2. This “tax offset” provision simply won’t work, as I explained in a previous comment. The Greek government simply doesn’t have enough of a tax base to support a value anywhere near 100 cents on the dollar on its debt. If it did, we wouldn’t even be discussing the issue. If this provision is inserted, and Greece defaults, the debt would end up trading to the same recovery value (S&P estimates about 30 cents on the dollar). It would be a nice windfall for rich Greeks with big tax bills to pay, certainly, but there aren’t enough of those to raise the price above recovery value (a tautology I know).

    There is a huge loss of upwards of 200B Euros that has to be absorbed by non-Greeks in some fashion. Either the actual owners of Greek bonds have to take a hit, or the other Eurozone governments have to. The Greeks have managed to live well beyond their means for over 11 years thanks to the rest of the Eurozone, but that has to end. One way or ther other, Greeks will have to return to a lower standard of living, and the rest of the Eurozone will have to take a hit and get over it.

  3. Also, there is no such thing as Chapter 11 bankruptcy (or any other kind of bankruptcy) for a sovereign country. A sovereign default can actually be executed rather painlessly if done carefully. Sovereign immunity laws make it extremely difficult (and well-nigh impossible in Europe) to seize sovereign assets. Argentina has spent the last 8 years proving that.

    There is no reason for the country to shut down. Greece is not a company. There will be dislocations, particularly in the import sector, but after reinstituting the drachma as the currency in which taxes are paid, there is no reason for there to be high unemployment or anything worse than a very short recession.

  4. “The trick is to insert a provision stating that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes.”

    Not sure I understand how this works. I will assume all Greek treasurys have a principal of 1k.

    Let’s say I’m domiciled in Greece, and I hold a Greek-defaulted-Tsy. With the new provision I can subtract 1k Euros from my tax debt by tendering it to government.

    The government, in turn, does not have to cough out the 1k Euros as repayment of the Tsy’s principal, but it does not collect 1k Euros in taxes either… How is the government better off?

    This is useless to the bearer unless it is domiciled in Greece. Isn’t most of Greece’s debt held outside? The Greek private sector might want to buy them for say 0.9k to make a profit of 0.1k… What are the implications here? Again, the bottom line for each party is not clear to me.

  5. Let’s say I’m domiciled in Greece, and I hold a Greek-defaulted-Tsy. With the new provision I can subtract 1k Euros from my tax debt by tendering it to government.

    RIGHT, USE IT AS PAYMENT OF 1K PLUS ACCRUED INTEREST FOR TAXES

    The government, in turn, does not have to cough out the 1k Euros as repayment of the Tsy’s principal, but it does not collect 1k Euros in taxes either… How is the government better off?

    IT GETS THE BONDS SOLD INITIALLY. THAT’S ALL.

    This is useless to the bearer unless it is domiciled in Greece.

    THEY ARE TRANSFERABLE BUT ULTIMATELY THE VALUE COMES FROM THE ABILITY
    TO USE THEM FOR PAYMENT OF TAXES.

    THE EURO ITSELF GETS VALUE THE SAME WAY- ABILITY TO USE TO PAY TAXES THROUGHOUT THE REGION

    Isn’t most of Greece’s debt held outside? The Greek private sector might want to buy them for say 0.9k to make a profit of 0.1k… What are the implications here? Again, the bottom line for each party is not clear to me.

    YES, THEY MAY TRADE AT SOME DISCOUNT, BUT THEY DO PAY INTEREST.

    THE POINT IS FOR GREECE TO BE ABLE TO FUND ITSELF

  6. By the way, can California ( or any state) from a legal perspective issue bonds or IOU’s and them accept the bonds as payment for taxes? I think California can’t issue the bonds or IOU’s to pay for goods and services but what about the former?.

    1. Missouri tried it in 1830. The Supreme Court ruled it unconstitutional:

      http://www.blackwellreference.com/public/tocnode?id=g9781577180999_chunk_g97815771809995_ss1-316

      http://press-pubs.uchicago.edu/founders/documents/a1_10_1s21.html

      But the Supreme Court reversed itself in 1837 (After Chief Justice Marshall died)

      http://www.answers.com/topic/briscoe-v-bank-of-the-commonwealth-of-kentucky

      The key difference was Kentucky created a state bank, and then used its notes instead of directly issuing them. So for California to do this, it would first need to create a State Bank of California.

      1. wonder if they were only acceptable for payment of taxes in the case of default?

        In 1830 the Supreme Court (4–3) refused to exempt states from a strict interpretation of the Constitution’s prohibition against their issuing bills of credit or other types of fiat money. The Court disallowed a Mo. law that authorized the emission of loan certificates that were not legal tender, but which the state pledged to accept at face value for payment of taxes or any other obligations due to it. The Court later gave states more flexibility, in Briscoe V. Bank of Kentucky, to legislate on regulations concerning notes issued by local banks.

      2. The second link is the text of the Supreme Court decision against Missouri, I only skimmed it but it quotes some parts of the Missouri law.

        The thirteenth section declares: “that the certificates of the said loan office shall be receivable at the treasury of the state, and by all tax gatherers and other public officers, in payment of taxes or other moneys now due to the state or to any county or town therein, and the said certificates shall also be received by all officers civil and military in the state, in the discharge of salaries and fees of office.”

        Just from that section it seems like they could always be used for taxes. They were also issued in denominations ranging from $10 to 50 cents. So it seems Missouri knew it was issuing it’s own functional currency.

  7. don’t see why not. seems there’s a bill to do just that going through the legislature now

    1. Doing this is somewhat problematic. Although it would probably lower California’s borrowing costs and improve its liquidity in the short-term, it might increase costs and hurt liquidity in the longer-term.

      Basically, California would be issuing bonds with a par put. If the bonds ever trade below par due to interest rates rising, credit spreads widening, or implied tax rates falling, somebody who owed California taxes could buy a bond at a discount to par and get credit for par on his taxes.

      Although the bonds could be issued at a lower interest rate due to the implicit put option, I doubt that the put would be fully valued by the market, so California would not be getting a good deal. And although it improves liquidity somewhat to lower borrowing costs in the short-term and not have to worry about paying principal and interest on put-back bonds, every dollar of taxes offset by bond principal and accrued interest is a dollar of cash missing from tax collections.

      Altogether, I think that issuing such bonds would make managing California’s borrowing costs and liquidity needs much more difficult.

      The United States government used to issue bonds with a similar idea called “flower” bonds. These were low-coupon bonds trading at a deep discount to par which could be used to offset estate taxes at par value. The interesting thing is that the bonds could only be cashed in as an estate tax offset by the decedent’s estate at the time of death (assuming the decedent owned the bonds before he died). This meant that buying such low-coupon deep discount bonds was equivalent to buying a life insurance policy where the premiums were equal to the market yield discount, and the death benefit was equal to the market price discount to par.

      1. California could lower the value of the par put by issuing the bonds at a premium (due to an above market coupon, say 10%) but the increased debt service would be a problem for their cash strapped economy.

        Or they could shorten up the maturity, so even a large change in rates wouldn’t take a non redeemable bond far from par.

        Of course they could also get realistic about state employee compensation …

  8. all bonds mature at par any way. these are just ‘default protected’ by being able to be used to pay taxes in the case of default only

  9. Let’s do the math.

    Greece decrees that government debt can be used to satisfy a tax obligation. As a result, the government can continue to deficit spend a bit longer — how much longer — until there are more bonds maturing than tax obligations.

    That should take what — a year? Wait — we are already there!

    During the peak boom year of 2007, Greece could collect less than 5% of GDP as income taxes. That figure is now much lower. But Debt to GDP is over 110% — and that figure is most likely fraudulent.

    So even if 100% of income taxes were paid with bonds, then such a scheme would only allow Greece to redeem about 4% of its current debt stock each year. It would not even allow for any additional borrowing.

    That is, even if Greece has Germany’s cost of funds, the inability of the government to collect tax revenue would not allow it to borrow any more than it currently owes — it would not supply Greece with any fiscal space to fight this crisis, and it would not address any of the underlying valuation problems.

    What would happen is that as more euros left greece and went into Germany, Greece would start using government euro bonds as currency, but that is effectively a gold-standard model — the IOU’s are for something that Greece can’t produce — the Greek “bond currency” would fall in price relative to the euro. That is just another fancy way of saying that yields on Greek Debt would increase, which is what is happening now. What Greece would need to do is make those bonds non-convertible into euros, suspend convertibility, or take similar steps. But that is just another way of saying that Greece should default.

    I don’t think this proposal would have any substantive effect. The same exact thing would happen to bond yields and Greece would still face real default risk. You would just call it by different names: “falling exchange rate of Greek Debt money to euros” and “suspension of convertibility”

    1. Yes, very nice explanation. That was my point precisely. All financial debt is a form of money of course. So Greece is already circulating its own currency — Greek govt debt (which derives its value from convertibility into the Euro) — and it is depreciating in value. Making that currency slightly more flexible in its use as legal tender (by allowing it to be used to settle debts directly with the Greek govt) is not going to affect its value materially.

  10. YOU GUYS ARE MAKING ME WORK!
    🙂
    COMMENTS IN CAPS:

    Greece decrees that government debt can be used to satisfy a tax obligation.

    ONLY IN THE CASE OF DEFAULT.

    As a result, the government can continue to deficit spend a bit longer — how much longer — until there are more bonds maturing than tax obligations.

    NO, UNTIL SAVINGS DESIRES ARE SATISFIED. WITH THE BONDS ‘SECURE’ SAVINGS DESIRES ARE HIGHER FOR THOSE ASSETS THAN WHEN THERE IS DEFAULT RISK.

    AND AS THEY APPROACH GETTING SATISFIED, THE EVIDENCE WILL BE THE NEW BONDS SELLING AT HIGHER RATES.

    That should take what — a year? Wait — we are already there!

    BECAUSE THE GOVT NEEDS TO PAY BACK IN EURO WHICH IT DOESN’T HAVE.

    During the peak boom year of 2007, Greece could collect less than 5% of GDP as income taxes. That figure is now much lower. But Debt to GDP is over 110% — and that figure is most likely fraudulent.

    OK.

    EXCEPT WITH THE UNDERGROUND ECONOMY GDP MAY BE A LOT HIGHER THAN REPORTED.

    So even if 100% of income taxes were paid with bonds, then such a scheme would only allow Greece to redeem about 4% of its current debt stock each year. It would not even allow for any additional borrowing.

    NO INCOME TAXES GET PAID WITH BONDS UNLESS GREECE DEFAULTS ON THE PAYMENTS.

    That is, even if Greece has Germany’s cost of funds, the inability of the government to collect tax revenue would not allow it to borrow any more than it currently owes — it would not supply Greece with any fiscal space to fight this crisis, and it would not address any of the underlying valuation problems.

    I RESPECTFULLY DO NOT AGREE.

    What would happen is that as more euros left

    AS ABOVE. TAXES CONTINUE TO GET PAID IN EURO UNLESS GREECE DEFAULTS ON ITS BONDS.

    AND SINCE THEY ARE, WORST CASE, TAX CREDITS, THEY SHOULD FIND IT MUCH EASIER TO ROLL OVER DEBT.

    AND THEY CAN ALWAYS INCREASE TAXES OR CUT SPENDING WHICH THEY ARE DOING ANYWAY.

    THE DIFFERENCE IS CURRENTLY THE CUTS DON’T HELP AS THEIR CREDIT ISN’T UNDERPINNED BY THE ABILITY TO USE DEFAULTED BONDS FOR TAX PAYMENTS.

    greece and went into Germany, Greece would start using government euro bonds as currency, but that is effectively a gold-standard model — the IOU’s are for something that Greece can’t produce —

    GREECE CAN ‘PRODUCE’ TAX LIABILITIES AT WILL. THEY CAN’T PRODUCE EURO.

    the Greek “bond currency” would fall in price relative to the euro.

    YES, AT SOME POINT INTEREST RATES WOULD RISE FOR GREEK DEBT. BUT THAT’S NOT A BINARY EVENT, BUT A GRADUAL RISE IN RATES, AS IT ISN’T ABOUT CREDIT WORTHINESS

    That is just another fancy way of saying that yields on Greek Debt would increase, which is what is happening now.

    RIGHT, BUT NOT BECAUSE OF CREDIT WORTHINESS WHICH CAUSES THE RATE CURVE TO GO VERTICAL, AS OUTLINED ON THIS WEBSITE WHEN GREEK YIELDS FIRST WENT PARABOLIC IN SHAPE AND I SAID IT LOOKED LIKE IT WAS OVER UNLESS THE ECB STEPPED IN.

    What Greece would need to do is make those bonds non-convertible into euros, suspend convertibility, or take similar steps. But that is just another way of saying that Greece should default.

    THAT’S STARTING ITS OWN CURRENCY WHICH WOULD CAUSE A DEFAULT ON ITS EURO DEBT

    I don’t think this proposal would have any substantive effect. The same exact thing would happen to bond yields and Greece would still face real default risk. You would just call it by different names: “falling exchange rate of Greek Debt money to euros” and “suspension of convertibility”

    HOPE THIS HELPS!

    1. “As a result, the government can continue to deficit spend a bit longer — how much longer — until there are more bonds maturing than tax obligations.”

      NO, UNTIL SAVINGS DESIRES ARE SATISFIED. WITH THE BONDS ‘SECURE’ SAVINGS DESIRES ARE HIGHER FOR THOSE ASSETS THAN WHEN THERE IS DEFAULT RISK.

      AND AS THEY APPROACH GETTING SATISFIED, THE EVIDENCE WILL BE THE NEW BONDS SELLING AT HIGHER RATES.

      The logical flaw here is that savings desires can be satisfied with the very Euros that Greece is trying to get people to trade for Greek bonds.

      Look, ultimately the discount that Greek bonds trade at in the market will be equal to the perceived probability of default x (1 – the perceived recovery value). If what you are proposing is to work, it either has to reduce the perceived probability of default, which it won’t, or it has to increase the perceived recovery value.

      Would allowing defaulted Greek bonds to be used as a Greek tax offset increase the recovery value? I don’t see why it would. Ultimately, the outstanding Greek debt will be restructured into a smaller aggregate obligation that the Greek government can credibly stand behind. Essentially, there are two ways to do this: 1) haircut the principal and leave the obligations denominated in Euros; or 2) leave the nominal terms of the obligations roughly the same, but redominate them in units of a new Greek fiat currency called drachma. My claim is that your proposal is financially equivalent to the second restructuring method.

      I also claim that measured in units of Euros, both methods will yield roughly the same recovery value (S&P believes it will be about 30% of face value). This is because the value that the Greek government can impart to its IOUs is determined by its ability to tax, which is obviously limited for a country of 11MM, of which only 5MM work (and not so hard).

      We discuss all the time here that the US is not limited in the amount of money it can spend and the amount of debt it can issue. But if the US govt wants to maintain the value of its IOUs, i.e. the dollar, then of course it really is limited. I’m pretty sure it couldn’t just hand every US resident a $1MM Treasury bond for free without the dollar dropping substantially in value, for example.

      I suppose the wildcard here is that Greece owns a lot of valuable real estate (far more per capita than most developed nations apparently), which could be used to increase the recovery value on defaulted Greek debt. I doubt that such an idea would be given serious consideration by either the Greek government or by creditors — 150 years ago, maybe, but not today.

  11. IN CAPS AGAIN:

    Would allowing defaulted Greek bonds to be used as a Greek tax offset increase the recovery value?

    YES. REMEMBER, THE OLD BONDS ARE WORTH NOTHING IN DEFAULT. AND THE NEW BONDS CAN BE USED FOR TAX PAYMENT. SO AS LONG AS THEIR ARE ONGOING TAX LIABILITIES THEY WILL HAVE VALUE, AND THEY ACCRUE INTEREST AS WELL WHICH MEANS THERE IS MINIMAL IF ANY HOLDING COST.

    I don’t see why it would. Ultimately, the outstanding Greek debt will be restructured into a smaller aggregate obligation that the Greek government can credibly stand behind.

    EXCEPT THE NEW ONES THAT CAN BE USED TO PAY TAXES, UNLESS YOU THINK GREECE WILL DEFAULT ON THAT AS WELL? NOT IMPOSSIBLE, OF COURSE. BUT NOT NECESSARY IF THEY RESTRUCTURE THE OLD DEBT FOR ANY REASON.

    Essentially, there are two ways to do this: 1) haircut the principal and leave the obligations denominated in Euros; or 2) leave the nominal terms of the obligations roughly the same, but redominate them in units of a new Greek fiat currency called drachma. My claim is that your proposal is financially equivalent to the second restructuring method.

    ACCEPTING DEFAULTED BONDS FOR TAX PAYMENT REDUCES EURO AVAILABLE TO SPEND, BUT THIS HAPPENS ONLY IN THE CASE OF DEFAULT.

    MEANWHILE, GREECE’S ‘ABILITY TO PAY’ THE BONDS THAT CAN BE USED FOR TAXES IS NOT IN QUESTION (THOUGH WILLINGNESS MIGHT BE) WHILE WITH CURRENT DEBT ‘ABILITY TO PAY’ IS VERY MUCH IN QUESTION.

    THE IMPORTANT THING NOW IS TO ELIMINATE THE FEAR OF ‘ABILITY TO PAY.’

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