Time for euro zone to revisit debt default option

Wed, Nov 14, 2012, 00:00

OPINION:When a country’s public debt exceeds 100 per cent of its gross domestic product it enters a zone of heightened vulnerability, says the International Monetary Fund’s October 2012 World Economic Outlook.

The economic outlook projects that the debt ratios of the five heavily indebted euro zone economies – Greece, Ireland, Italy, Portugal and Spain – will remain over 100 per cent into the foreseeable future, ie at least until 2017. After a decade of fiscal austerity, these nations will still be in the high-vulnerability zone.

Thus, perpetual austerity seems destined to fail. Alternatives include spreading the debt burden across the euro zone members, or asking private lenders to share the pain.

But the possibility of transparent burden-sharing within the euro zone has generated an acrimonious divide, reflected in the language of core/periphery, north/south, and creditor/debtor. And, the option of extending the pain to private lenders has apparently been closed, except as a “too-little-too-late” gesture made necessary for Greece. So, is the answer doubling the bets on austerity, as the European Commission suggests? No, says the IMF’s outlook. For the UK in the inter-war period, it reports, “The policy of fiscal austerity, pursued to pay down the debt, further limited growth. Debt continued to rise . . .” There is no instance of sustained debt reduction without the support of modest inflation or export growth.

History is rewriting its way through the euro zone. In just 18 months (from the April 2011 IMF economic outlook to now), the projected debt ratios of the heavily indebted economies, other than Ireland, have risen. These ratios will rise further as the full extent of the austerity-induced growth damage is revealed.

European debt is spreading its woes through the global economy. The heavily-indebted nations have scaled back imports from other European countries and Asia, with cascading effects on world trade. Europe cannot export its way out of this tangle because Europe is helping drag down world trade. And the elixir of structural reforms to boost domestic growth is a policy myth. Nor are there helpful bursts of inflation on the horizon.

Thus, creditor nations face the looming prospect of sharing the pain.

Day of reckoning

With Greece, the day of reckoning is here. The delay in Greece’s private debt restructuring implied that most private creditors were paid with official credit. Lee Buchheit, the attorney who oversaw the eventual Greek debt restructuring, has lamented that the strategy of delay imposed “appalling costs” on Greece and the remaining private creditors. The official sponsors of that delay must now accept they will likely not be repaid in full.

The tussle involving Ireland is more pre-emptive. The collective judgment of Europe was that the debts owed by Irish banks should become the obligation of the Irish taxpayer. This decision was particularly egregious because a substantial fraction of those debts were incurred by an evidently rogue bank, Anglo Irish. The new government that assumed charge in March 2011 – when private creditors were still exposed to the losses incurred – chose to acquiesce with the prevailing dogma.

Now, cognisant of the high public debt burden assumed as a consequence, the Irish authorities are engaged in a debt-restructuring negotiation with the European Central Bank, offering to repay an obligation to the ECB over 40 years.

The flurry over the direct lending to banks by the European Stability Mechanism is also an argument about sharing the debt burden. The European Summit of June 29th opened up this tantalising possibility. The Irish authorities, supported by the IMF, saw an opportunity to place some of their burden on the collective shoulders of Europe. But was it a mirage?

The creditor nations now say the June 29th statement was unclear and, perhaps, “legacy” debt would not be assumed by the ESM.

The United States has federally funded deposit insurance for banks, a fiscal union, and a “no bailout” provision; bank rescues are centrally co-ordinated, and states have historically been allowed to default.

The ECB’s Outright Monetary Transactions – the bond-buying programme designed to lower interest rates for crisis-hit euro zone countries – may finesse the need for hard choices.

But if holding the taxpayers of the debtor nations liable remains the centrepiece of the debt-reduction strategy, growth will remain throttled and debt ratios will remain high. The ECB will be sucked further into burden-sharing.

Default option

It is time to revisit the default option. Stunningly little use has been made of bank resolution powers. There are well-known and orderly ways to bring banks’ creditors to the table and engineer debt-equity swaps. Similarly, there exist well-established techniques for sovereign debt reprofilings. The notion that markets would be “spooked” has no good basis. True, Lehman is still fresh in the memory. But the Greek debt-restructuring was well received. And resolution of the festering Latin-American debt crisis in the 1980s required a co-ordinated restructuring.

Procrastination is costly. The high debt ratios will perpetuate vulnerability, and episodic surprises will ignite new crises. In pursuing the elusive debt problem, European institutions will be undermined and uncertainty and slower growth will be imposed on the rest of the world.

The default option is economically efficient, it is fair, and it is politically sensible. It may be the only way to hold together an unsustainable structure that threatens to drive deeper divisions and set back the magnificent integration project on which Europe has embarked.

Ashoka Mody is Charles and Marie Robertson visiting professor of international economic policy at the Woodrow Wilson school, Princeton University. He was a deputy director in the IMF’s research department

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