Friday, February 4, 2011


The euro area

The euro area’s bail-out strategy is not working
. It is time for insolvent
countries to restructure their debts

For a few weeks over the Christmas holidays, Europeans put their sovereign-debt
crisis on hold. Now they are facing grim reality once more. Bond yields are
spiking in an ever broader group of countries, just as the euro zone’s
governments need to raise vast sums from the markets. On January 12th
Portugal was forced to pay 6.7% for ten-year money—better than feared but a
price it cannot afford for long. Yields for Belgian debt have jumped, as investors
fret about its load of debt and lack of leadership. Spain is hanging on.

This mess leads to a depressing conclusion: Europe’s bail-out strategy, designed
to calm financial markets and place a firewall between the euro zone’s periphery
and its centre, is failing. Investors are becoming more, not less, nervous, and the
crisis is spreading. Plan A, based on postponing the restructuring of Europe’s
struggling countries, was worth trying: it has bought some time. But it is no
longer working. Restructuring now is more clearly affordable than it was last
year. It is also surely cheaper for everybody than it will be in a few years’ time.
Hence the need for Plan B.

The initial response, forged in the rescue of Greece in May 2010, has been
undone by its own contradiction. Europe’s politicians have created a system for
making loans to prevent illiquid governments from defaulting in the short term,
while simultaneously making clear (at Germany’s insistence) that in the medium
term insolvent countries should have their debts restructured. Unsure about who
will eventually be deemed insolvent, investors are nervous—and costs have risen.
The least-bad way to deal with this contradiction is to restructure the debt of
plainly insolvent countries now. Italy and Belgium have high debt levels but more
ample private savings, and their underlying budgets are closer to surplus. There
is, thus, a reasonable chance that, handled correctly, euro-zone sovereign
defaults could be limited to three small, peripheral economies.

The perils of procrastination

This newspaper does not advocate the first rich-country sovereign defaults in half
a century lightly. But the logic for taking action sooner rather than later is
powerful. First, the only plausible long-term alternative to debt restructuring—
permanent fiscal transfer from Europe’s richer core seems to be a political non-
starter. Some of Europe’s politicians favour closer fiscal union, including issuing
euro bonds, but they are unlikely to accept budget transfers big enough to
underwrite the peripheral economies’ entire debt stock.
Second, the dangers from debt restructuring have diminished even as the costs
of delay are rising. Eight months ago, when euro-zone governments and the IMF
joined forces to rescue Greece, their determination to avoid immediate
restructuring made sense. There were reasonable fears that default could plunge
Greece into chaos, precipitate bond crises in the euro zone and spark a European
banking catastrophe.

The European economy, as a whole, is now in better shape. Banks have had time
to build up more capital—and palm off some of their holdings of dodgy sovereign
bonds to the European Central Bank. Greece and other peripherals have shown
their mettle with austerity plans. Europe’s officials have created mechanisms to
stump up rescue money quickly. And lawyers have been thinking about managing
an “orderly” default. A sovereign restructuring could still spook financial
markets—fear that it would spread panic makes Europe’s politicians shy away
from it—but if handled correctly, it should not spawn Lehman-like chaos.

At the same time the costs of buying time with loans have become painfully clear.
The burden on the countries that have been rescued is enormous. Despite the
toughest fiscal adjustment by any rich country since 1945, Greece’s debt burden
will, on plausible assumptions, peak at 165% of GDP by 2014. The Irish will toil
for years to service rescue loans that, at Europe’s insistence, pay off the
bondholders of its defunct banks. At some point it will become politically
impossible to demand more austerity to pay off foreigners.

And the longer a restructuring is put off, the more painful it will eventually be,
both for any remaining bondholders and for taxpayers in the euro zone’s core.
The rescues of Greece and Ireland have increased their overall debts while their
private debts fall, so that a growing share will be owed to European governments.

That means that the write-downs in any future restructuring will be bigger. By
2015, for instance, Greece could not reduce its debt to a sustainable level even if
it wiped out the remaining private bondholders.

A cost-benefit analysis, in short, argues in favour of carrying out an orderly
restructuring now. The debt reduction should be big enough to put afflicted
economies on a sustainable path. Greece may have to halve its debt burden.
Ireland’s may need to be cut by up to a third, with some of this coming from
writing down bank rather than sovereign debt.

All creditors, including governments and the European Central Bank, will have to
chip in. New rescue money will also be needed: to fund defaulting countries’
budget deficits; to help recapitalise these countries’ local banks (which will suffer
losses on their holdings of government bonds); and, if necessary, to recapitalise
any hard-hit banks in Europe’s core economies. The ECB and others should stand
ready to defend Belgium, Italy and Spain if need be.
If Europe’s leaders stick to plan A, the debt crisis will continue to deepen. If they
get on with restructurings that are eventually inevitable, they have a fighting
chance of putting the crisis behind them. Plan B will require deft technical
management and political courage. Thanks to its emerging-market expertise, the
IMF has some of the former. It is up to Europe’s politicians to find the latter.

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