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Many people, observing the severe problems caused by Greece and other financially weak members of the European Union, wonder why the United States is not similarly afflicted. After all, the structures seem quite similar; the EU is united through a treaty into a single political grouping, while the U.S. is a union of states in a constitutional system.
In addition, the U.S. federal government has no control over the budgets, taxing or spending of the various states, just as the European Union’s government in Brussels has no control over the similar fiscal decisions of the various sovereign nations that are part of the EU. Why is it, then, that the Euro group may be coming apart, while the U.S. does not face a similar problem? The answer says a lot about the adverse effects of moral hazard.
The crucial difference may be found in the relationship between the subordinate political units and the central bank in each grouping. The U.S. central bank- the Federal Reserve – carries out its monetary policies by buying and selling U.S. government securities. If the Fed wants more dollars in the economy, it buys U.S. government securities from banks and thus increases the number of dollars outstanding. The Fed does the opposite if it wants to reduce the amount of dollars outstanding, by selling U.S. government securities and thus pulling back cash.
“If moral hazard cannot be avoided, there is little likelihood that the EU’s debt problems can be solved unless the member nations are willing to surrender a substantial portion of their standing as sovereign nations to a central government.” – Peter J. WallisonOn the other hand, the European Central Bank, known as the ECB, carries out its monetary responsibilities by purchasing and selling the bonds of Euro group member countries. If the ECB wants more Euros outstanding in the Euro group economy it buys the debt of EU member countries, primarily from banks, under an agreement in which the ECB’s counterparties must repurchase the debt within a specified time period. By putting more Euros in circulation, that has the same effect as the Fed’s purchase of U.S. government debt from U.S. banks. The repo can be renewed if the ECB wants to continue the money supply increase. The ECB does the opposite if it wants to reduce the number of Euros outstanding – selling the bonds of member countries, subject to a renewable agreement to reacquire the bonds at a subsequent time.
Thus, ECB deals in the debt of the various EU countries, but the Fed buys and sells only U.S. government debt; it does not accept the debt issued by U.S. states.
This difference turns out to have important consequences. For example, the bonds of U.S. states have much less value to U.S. banks than the bonds of the Euro member countries have for EU banks. They can exchange the debt of EU member countries they are holding to acquire Euros from the ECB, while U.S. banks, by and large, can only get cash from the Fed by selling U.S. government bonds. In addition, the ECB has not in the past been able to discriminate against the bonds of one country as opposed to another – these are, after all, sovereigns – even if the countries themselves have very different credit standings.
Finally, the Basel framework for bank capital allows the bonds of EU members to carry a zero risk weight when banks calculate their capital positions, again providing a preference for sovereign bonds that does not exist for U.S. states. Both these factors give the bonds of Euro member countries added value that enabled them to borrow more than their credit positions alone might otherwise suggest.
In contrast, U.S. states are subject to far greater market discipline than the members of the EU. Banks and other U.S. bond buyers have no reason to give the bonds of U.S. states special value beyond their inherent credit value. If there is doubt that a state is able to meet its obligations, it won’t be able to raise funds for its daily operations, or those funds will become substantially more costly. As a result, U.S. states have to be careful to manage their expenses so that their ability to meet their financial obligations is credible.
It is questionable whether the Euro member countries can agree on changes in their current relationship with the ECB. As the central bank of a union of sovereign nations, it seems doubtful that the ECB will be permitted to discriminate among the bonds of the members based on its perception of each country’s creditworthiness. Nor is it likely that the Basel framework – which is again a kind of treaty among the financial regulators of the participating nations – will agree to impose differing risk weights on the bonds of EU members.
Under these circumstances, it is difficult to see how – as a political matter – the moral hazard associated with sovereign debt can be overcome. And if moral hazard cannot be avoided, there is little likelihood that the EU’s debt problems can be solved unless the member nations are willing to surrender a substantial portion of their standing as sovereign nations to a central government.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI. He was general counsel of the Treasury and White House counsel in the Reagan administration and a member of the Financial Crisis Inquiry Commission.
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