Guest Post: Europe and Democratic Funding

27 Oct

Editors’ Note: The European banking crisis continues to unsettle markets, and to raise serious doubts about not just the economic but also political future of current European institutions. As our guest post today by Anush Kapadia points out, underlying the turmoil is the achingly familiar ‘democratic deficit’ problem, but this time present in a new form. The basic democratic challenge this time reaches beyond the question of the EU’s institutional structure to the question of how its member states, and supranational institutions, relate to (financial) markets. As Kapadia points out, this democratic challenge, though it has special characteristics in the European case, is a general one facing any state seeking funding yet also seeking to retain enough autonomy to remain under the control of its citizens.

Europe and Democratic Funding

Anush Kapadia

The European crisis is one of legitimacy, not of the European project per se but of the financial fundamentals of moderns states. The lopsided nature of the European project merely serves to highlight the potentially undemocratic side of the financial undergirding of state power. It also foreshadows a potential solution to the problem.

It is not hard to notice that while scorn is routinely reserved for the unelected Eurocrats who want to squash national sovereignty, very little seems to be said about the legitimacy of unelected markets dictating terms to sovereign states. Morality, it seems, is on the side of the creditor: sovereigns, like us ordinary folk, should pay their debts.

But sovereigns, like people, have a responsibility to maintain their own autonomy to the extent they can. When governments fund themselves in ways that put their sovereignty at risk, they are abrogating their democratic duty. This is the double-edged nature of government borrowing: democracy can be aided by the flexibility and liquidity of marketing government debt, but beyond a point debt turns to poison.

So how can democratic states take advantage of the bond markets without being consumed by them?

The answer from creditor-morality is simple: don’t borrow beyond your means. And there is truth in this homily. The problem of course is that the very extent of ones means is subject to the judgment of the self-same creditor. To a large degree, solvency is in the eye of the creditor.

For any economic unit, the pattern of cash inflows rarely maps perfectly on to the pattern of cash outflows. Individual cash (dis)hoarding can of course mitigate this mismatch; what we call “banking” is merely the socialization of this liquidity-matching function: units with excess inflow lend to units facing outflow constraints via the intermediation of a bank. If the matching process stops, a borrowing unit’s cash commitments can swamp its cash inflows: the unit is dead. If your creditors stop rolling over your debt, the music stops very quickly indeed.

Prudence dictates that the unit steer clear of such peril. Yet when faced with myriad constraints, units will load up on credit if that dimension is eased. The market price of the unit’s debt is meant to be an indicator of proximity to peril. Yet as we have seen, this indicator is notoriously fickle: one day the unit is extremely creditworthy, the next day it’s bust.

Now especially if the economic unit is a democratic state, it has a solemn duty to avoid such peril. This means that it has a solemn duty to avoid fickle funding. And this in turn means avoiding the bond market beyond the point of prudence.

This is exactly what Europe has been groping towards, willy nilly. It is precisely because Europe lacks a common fiscal authority that it is seeking this solution. In so doing, it foreshadows a more democratic method of state funding.

Most see Europe as an unfinished federal project and indeed weak on that score. What they miss is that Europe is a new experiment in interstate relations, not a slow-motion rerun of US history. The people of Europe do not want to be part of a federal state. This is axiomatic; it renders the nation-state analogy for Europe nugatory. Our imaginations are constrained by this nation-state frame.

This national impossibility is what ultimately ties the hands of the ECB as an effective lender of last resort; its paranoid ideology is merely icing on the cake. A prudent lender of last resort mitigates the fickle nature of market funding by stabilizing the credit system as a whole when the market mood inevitably turns. This function can only perform its stabilizing work if it has credibility; it has credibility because it is backed by a fiscal authority.

Thus if the ECB were to act as an adequate lender of last resort in this crisis, it would implicitly call into being the absent European fiscal authority. And this cannot happen because the European people don’t want it. The Bundestag is merely the institutional expression of this desire. Of course, if the ECB acts as a lender of last resort in this crisis without at least implicitly calling into being a common fiscal leviathan, the ECB itself will take the place of the impaired sovereigns as the target for the markets. A lender of last resort without fiscal backing is not credible; the markets will gnaw away at it until implicit backing is made explicit. The assets that the ECB purchases will lose value to the point where the ECB’s own balance sheet will start to look shaky; the Euro itself would start to melt away.

Hence all the machinations around the EFSF (recent summit statement here). One can see how this institution might be the kernel of a common fiscal authority, at least in its borrowing power if not (yet) its taxation power. And that’s what the fight is about now. The Germans want to keep it small and limited so that it won’t prefigure some kind of common fiscal mechanism, but if it’s too small it’s not credible enough to function as a lender of last resort.

So no ECB, no EFSF. And the markets are completely roiled. Where oh where can a distress sovereign go for funding? China.

Well, not literally, but certainly figuratively. With the ECB and EFSF hamstrung because of the latent common fiscality they imply, Eurocrats have to find another set of balance sheets with spare capacity. This is where the special-purpose-investment-vehicle (SPIV) solution enters the fray.

Without getting into the details, there are two current plans to bolster the capacity of the EFSF (ignoring the somewhat loopy French plan to turn it into a bank): make it an insurance company or make it a kind of collateralized debt obligation (remember those?). There might be some combination of these solutions, but the latter is the one to focus on.

Floating a SPIV by the EFSF means that the latter would create and underwrite an entity that would issue highly-rated bonds; the proceeds of this sale would be used to buy encumbered sovereign debt. (Note: The same structure was used to by mortgages; the resulting securities were thus called mortgage-backed securities. The same tranche structure is envisioned here so that private money take come in and take the more risky elements of the vehicle). And who are the potential sources of funding for this vehicle? Sovereign wealth funds and other “international public investors.” The patient, institutional capital, in other words, not the fickle market money.

Since these new investors have very deep pockets and have their eye on the very long-term (some of them are sovereigns themselves after all), they are not subject to the same incentives as normal players in the bond market. The latter tend to be highly-leverage and work on the narrowest of margins. Having drastically underpriced sovereign risk, the fickle money markets are now drastically overpricing it; yesterday’s promise of growth has turned in today’s demand for austerity. Long-term investors look at long-term value rather than short-term prices; think Buffet rather than Bear. These investors would typically hold the bonds to maturity and can ride out short-term fluctuations because of their deep pockets. And at the moment they are getting a deal.

The absence of a common fiscal authority in Europe has lead to a credibility crisis at its heart. Most see the solution to this as an aping of the history of the nation-state: “build a fisc already!”, this position screams. But that way is closed to Europe. They are charting a new history.

Because of these constraints, the Europeans are finding that another route to stability is in effect to de-marketize some portion of their sovereign debt and place it with buy-and-hold institutions. What we might consider is that Europe’s ex post crisis response might be a way of insulating democratic states from the fickle markets ex ante.

The analogy with bank funding is clear: part of the problem with banks leading up to the crisis was that they were funding in highly liquid markets at ever-shorter maturities and in ever-greater proportions. This made them vulnerable to a run; subprime burst the bubble and the inevitable run followed. What is the proposed solution? Mandatory funding durations imposed by the regulators: long-term assets ought to be funded by long-term liabilities to the extent possible.

The state is a long-term asset, our long-term asset. It needs a funding structure adequate to its long-term democratic duties. A state simply cannot legitimately allow itself to be bossed around by the markets. This means that the state (and the banks it underwrites) should not be allowed to fund in fickle markets beyond a certain point; no matter how cheap and liquid this funding appears, the cycle will turn and austerity will result.

The East Asians learned this after their crisis and responded with cash hoarding. But this is globally suboptimal: banking was invented so that we wouldn’t all have to keep our cash under our mattresses. Better lend it out to those who need it; if we are long-term savers, we can afford to lock it up for a while.

That’s what pension funds do; that’s what sovereign wealth funds do. We know that how we fund our governments matters for its legitimacy, but our democratic common sense ties only taxation to representation. Yet the structure of state borrowing is equally critical. It is to this patient structure of funding that Europe’s experiment now turns, at least at the critical margin. There might be a lesson in there for all of us.

2 Responses to “Guest Post: Europe and Democratic Funding”

  1. Siva Arumugam October 29, 2011 at 3:11 pm #

    Kapadia highlights exactly the moral and political tension between avowedly democratic states and financial markets that is being worked out in Europe at the moment. And the news from the summit over the last couple of days matches exactly with the descriptive framework Kapadia lays out here.

    It may be that private investors are supposed to come in and take the riskier tranches of the SPIV structure, but that is (a) very unlikely to happen and (b) it is supposed to necessitate involvement of hedge funds and the like — precisely the short term folks Kapadia says aren’t wanted.

    Remember Magnetar? The problem with selling CDOs once the housing market looked to be in trouble was the difficulty of finding investors for the risky “equity” tranches. So Magnetar helped construct ready-to-fail CDOs where it itself purchased the equity tranches so that it could short-sell the AAA rated tranches to long term investors. Their expectation was that profits from the latter would far exceed losses on the former.

    It seems clear rather that EFSF is supposed to purchase the risky SPIV tranches itself so that long term investors will find the more senior tranches palatable. To extricate itself from that business — continually buying the risky tranches in the face of a democratic opposition that is itself rather short-termist — will have to involve creating a market structure that brings back into the fold credit hedge funds. We will then be back to the starting point, except now with a eurobond market in all but name. The price will be further market pressure towards having a (core) Europe-wide fiscal authority.

    Moreover, the rhetoric around the proposed solution is all too familiar from other contexts. When’s the last time a CEO of a failing company didn’t blame the company’s difficulties on the short-termism of Wall St.? It is already the case that long duration and senior debt is largely bought by companies that have long term liabilities — pension funds and the like. Pinning one’s hopes of yet more of the same without a worked out proposal re market structure seems naive at best. I suspect that this experiment in political economy will have a familiar enough ending.

  2. Anush Kapadia October 31, 2011 at 3:35 pm #

    I don’t see why the involvement of private players for the more risky tranches is necessarily unlikely or unstable. The likelihood depends on the price, and we have already seen bargaining power in this regard shift to the states; how “voluntary” were these haircuts, after all? As for their instability, I ought to have made explicit that I am assuming a set of private balance sheets who would be closely vetted for the job: this is private placement for buy-and-hold rather than public auction for further secondary market activity. There is also a lot at stake here politically, so these private balance sheets will be those used to undertaking quasi-political functions. So I don’t think it’s clear that the EFSF will eat its own cooking: this would amount to a massive political failure.

    On the demand for long-duration debt, isn’t it the excess demand for the same that got us into this mess in the first place? And now that the cycle has turned, demand is even greater, and now in non-dollar-denominated form.

    The EFSF is indeed creating a kind of eurobond market, but it will only do the crisis-reducing job it is designed to do if it brings into being a market structure undergirded by value-based traders. Arumugam is entirely right in saying that this is where the stakes are. It remains to be seen whether or not Europe can pull it off. But whether it works or not in this particular case, this general space of solutions to the democratic funding problem seems to be productive. Indeed, we might learn more from Europe’s failure than its success.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 1,492 other followers

%d bloggers like this: