Richard Koo’s Euro Crisis Non-Solution

I’d like to endorse Felix Salmon’s comments on Richard Koo’s idea that banning Euro area governments from selling sovereign bonds to anyone other than their own citizens represents a solution to the Euro crisis. A colleague asked me about this in January and I sent them the following reply:

Hi X,

Richard Koo is an interesting guy but this is an odd suggestion. First, yes this is inconsistent with treaty provisions related to free movement of capital.  And it would be almost impossible to enforce – bonds can be sold to anyone on the secondary market and I can’t imagine US or Swiss banks or hedge funds refusing to allow a German investor buy Spanish bonds as part of his investment fund.

Also, it’s a funny suggestion from a simple supply and demand angle. Normally, when we want the price of something to go up, we suggest increasing the demand for it.  He’s suggesting the yield on Spanish bonds will go down, and thus the price up, if we ban a load of people that used to be able to purchase these bonds from doing so.

He would still allow Spanish banks to purchase non-Spanish private bonds or shares, so it is possible that they would transfer their purchases of non-Spanish government bonds to other non-Spanish assets.

In fact, there are arguments for the exact opposite position, i.e. for limiting the exposure of individual financial institutions to the bonds issued by their own government. I’ve argued this e.g. page 14 here

on the grounds that these purchases are a very bad “hedge” for these banks and they mean that a sovereign debt crisis automatically transfers to become a banking crisis.

At a more general level, there is no doubt that more severe forms of “financial repression” have been successful in the past in allowing governments to cope with high debt levels but I don’t think this small change to EU freedom of capital laws would do it.  What would be required would be a more draconian regime imposing capital controls.  But that would most likely mean the end of the euro.