July 21, 2011
WASHINGTON—Europe’s efforts to stabilize its finances are failing and the region needs to prepare for widespread restructuring of sovereign and bank debt according to a new Policy Brief from the Peterson Institute for International Economics. In "Europe on the Brink," authors Peter Boone and Simon Johnson argue that Europe’s financial system has relied on a policy of protecting creditors from default and has thus spread pervasive moral hazard—a presumption by creditors that they will not take losses on their loans to Greece and other ailing countries. The authors argue that this situation is no longer tenable and examine three possible scenarios for what might happen in coming months as the sovereign debt crisis evolves.
Under the first scenario, the euro area would try to reassert its commitment to avoid defaults and inflation. This continuation of the moral hazard regime would require severe austerity for Greece and other countries on the periphery of the euro area. This approach has failed so far because countries subjected to tough budget measures, either spending cuts or tax increases, face declining economies and popular revolts. A blame game has characterized the politics of Europe, in which creditors deride the troubled nations and those countries refuse to accept adequate responsibility for their weaknesses. If austerity programs continue to fall short, investors will question the credibility of all parties involved.
The second scenario involves elimination of the moral hazard regime. The euro area would admit that some sovereigns have too much debt. A series of debt restructurings would follow. This could be achieved by swapping bonds for longer maturities and reducing principal or interest as needed. Extending maturities would raise confidence that troubled nations could repay their debts. Domestic banks, insurance companies and pension funds should also be recapitalized through a public sector program in the absence of private financing. But the troubled nations would still need to end their budget deficits through public sector wage and benefit cuts broadly similar to those discussed in the previous scenario. Even with debt relief, these countries will need to move their budgets to a "primary surplus" quickly.
The final scenario would be for policymakers to continue to contradict themselves by promising selective defaults or restructurings of some countries’ debts while maintaining that they can ensure the stability of the rest of the euro area. But the authors argue that it is an illusion to believe that selective restructuring would not introduce contagion. Such an approach would result in panic, massive capital flight and disorderly defaults. The ensuing chaos would in turn lead to a negatively charged political atmosphere that would make consensus nearly impossible. The European Central Bank (ECB) would likely have to provide credit to support creditor bailouts with the result that the value of the euro would plummet, the yield curve would steepen, and inflation would likely rise sharply. Italy and Spain would probably have to restructure their debts under this scenario; most likely the ECB would do all that it can to protect France. Under such circumstances, it is conceivable that Northern European countries would leave the euro area and start a new currency. Alternatively, they could join forces and evict certain members of the euro area. In either case, the euro would no longer be the strong currency it once was.
About the Peterson Institute
The Peter G. Peterson Institute for International Economics is a private, nonprofit, nonpartisan research institution devoted to the study of international economic policy. Since 1981 the Institute has provided timely and objective analysis of, and concrete solutions to, a wide range of international economic problems. It is one of the very few economics think tanks that are widely regarded as "nonpartisan" by the press and "neutral" by the US Congress, its research staff is cited by the quality media more than that of any other such institution. Support is provided by a wide range of charitable foundations, private corporations and individual donors, and from earnings on the Institute’s publications and capital fund. It moved into its award-winning new building in 2001, and celebrated its 25th anniversary in 2006 and adopted its new name at that time, having previously been the Institute for International Economics.