'Academic research reveals that market attacks take place also without a valid cause.'

Recent developments in the EU brought forward the alleged meeting between Germany's and France's administrators. In May 2010, European Financial Stability Facility was established. Member states can benefit from the fund in the case that they are unable to borrow from the market sufficient amount of funds at a reasonable cost, provided that they agree to implement an economic program commonly decided by the IMF and the European Commission.  Total amount invested in this fund by member states is €440 billion. With the contribution of the IMF, the fund sums €750 billion.

The alleged news said that Merkel and Sarkozy agreed to initiate a new system in 2013 after the termination of the European Stability Fund. The proposed system also made the private sector step in to reduce the amount of debt repaid by a relevant member state.

Implication of this plan reads as follows: for instance, I have €10 billion of Portuguese state's bonds in my balance sheet. If Portugal gets into trouble in repaying the debt, my bank and other creditor banks come to the table. I for instance accept to receive €6 billion instead of €10 billion because if there is no mechanism across EU that will undertake the debt of the indebted country, it is quite likely that I do not receive any amount at all. So I guarantee to get some part through a deal.

The news claimed that it is planned to put partial bankruptcy on autopilot. Of course reaction from the markets was fierce. As perceived risks elevated, interest on bonds of countries in trouble hiked. As a story in Financial Times on November 25 suggests, France took into account the warnings and cautioned Germany on the potential hazards of such system. Nonetheless, it is claimed that Germany still seeks a system where creditors shoulder responsibility.

There are two important criticisms against such an automatic bankruptcy system. First, such system would increase the borrowing costs, which actually took place: After the leaks, interest on the bonds of states in trouble hiked.

Second criticism is that if you design such a plan, you create a target to be attacked; coupled with the fact that there actually is a reason for this. Markets 'will attack' with no delay. Here 'attack' refers to selling the bonds of states in trouble immediately. And 'target' refers to states in trouble.

Academic research on monetary crisis suggests that such attacks can take place also in the absence of valid cause. For instance, a crisis occurs in Russia; investors believe that Brazilians also 'drink vodka' and dispose of Brazilian bonds in a hurry to switch to foreign exchange as soon as possible. If it is costly for the country in question to attempt to prevent possible hikes in the exchange rate (for example if higher interest rates are not desired or if the country is in FX shortage) no defense is established against the attack. Then, exchange rate jumps. No one cares even if Brazilians do not 'drink vodka'!

Research therefore claims that an automatic system give way to such attacks regardless of the presence of a valid cause. It argues that similarly, since the price of state bonds desired to be disposed of immediately will decrease (i.e. interest will increase), states that are not willing to shoulder higher interest rates would prefer to go bankrupt.

In short, it is argued that the system planned as an alternative to the bailout fund facility might further the problems. Note: I recommend you to read for more details on the criticisms a note by Paul De Grauwe, 9 November 2010, accessible at CEPS website (www.ceps.eu).

This commentary was published in Radikal daily on 29.11.2010