The Debt Problems of the European Periphery
Last week's renewed anxiety over bond market collapse in Europe's periphery should come as no surprise. Greece's EU/IMF program heaps more public debt onto a nation that is already insolvent, and Ireland is now on the same track. Despite massive fiscal cuts and several years of deep recession Greece and Ireland will accumulate 150 percent of GNP in debt by 2014. A new road is necessary: The burden of financial failure should be shared with the culprits and not only borne by the victims.
The fundamental flaw in these programs is the morally dubious decision to bail out the bank creditors while foisting the burden of adjustment on taxpayers. Especially the Irish government has, for no good reason, nationalized the debts of its failing private banks, passing on the burden to its increasingly poor citizens. On the donor side, German and French taxpayers are angry at the thought of having to pay for the bonanza of Irish banks and their irresponsible creditors.
Such lopsided burden-sharing is rightly angering both donors and recipients. Rising public resentment is testing German and French willingness to promise more taxpayer funds. German Chancellor Angela Merkel's hasty and ill–thought out plan to demand private sector burden-sharing, but only "after mid-2013," marks a first response to these popular demands. We should expect more.
Financial crises are actually not rare, and the rules for their resolution are clear. The fundamental insight is that huge amounts of financial losses, of seemingly real value, need to be distributed across creditors, debtors, equity holders, and taxpayers. The first step is to bring the current budget deficit under control to achieve a primary balance, which both Greece and Ireland are now attempting. The second is to attract sufficient emergency funding, which the IMF and the European Union essentially have done. But in neither Greece nor Ireland is that sufficient. They still have unaffordable debt burdens. Therefore, one more measure is needed, namely a reduction of the public debt.
The public debt can be contained in two ways. The first and preferable option is that the state never nationalizes private bank debt as Ireland has done. For Ireland, this opportunity has probably passed, but other countries should be warned not to make the same mistake. Kazakhstan's refusal last year to bail out its major banks, despite strong demands from the senior creditors of these banks, has proved a far more successful path. Banks can and should go under if they have failed. The state should only defend small- and medium-sized depositors.
If the state has taken on too large of a debt, sovereign default is the natural outcome. In their excellent book This Time Is Different, Carmen Reinhart and Kenneth Rogoff argue that 90 percent of GDP is the highest sustainable level of public debt for a developed country. This limit is not absolute, but there is little reason to believe that Greece and Ireland would belong to the exceptions. As Germany and France so sensibly, though perhaps not very cautiously, have argued in public, the European Union needs a facility for sovereign debt default.
Sovereign defaults are always contentious, but they don't need to end in catastrophic financial collapse. This is especially so in Europe, as Lee Buchheit and Mitu Gulati have argued in a well-read paper on "How to Restructure Greek Debt," because over 90 percent of these debts are issued under domestic law. Troubled nations, as part of their rescue plans, can and should introduce legislation that permits a qualified majority of creditors to change terms on outstanding sovereign and bank debt, while protecting bank deposits. Such rules could, for example, require two-thirds of nonprotected creditors to agree to a restructuring plan. This reduces the risk that holdouts can prevent a deal from being reached, but still gives creditors clear powers to negotiate terms.
Well-planned debt restructuring will not cause a systemic financial collapse. It is misleading to draw parallels from the chaotic liquidation of Lehman Brothers for the outcome of debt relief in Europe. The direct impact of debt relief for Greece, Ireland, and others is easily measured and managed. The debtors and creditors are well known.
If Greece's reform program included a write-down of 50 percent (in net present value) on its debts, and they received an additional 20 percent of GDP in bridge financing over the next three years, its debt burden in 2013 would be a comfortable 80 percent of GDP. As Greek debt already trades below face value, the total additional losses to creditors could amount to 35 percent of debt, or approximately €100 billion. Ireland is smaller so total costs should be less. This debt relief could be conditional on successful implementation of IMF-monitored programs, similar to traditional Paris Club debt restructurings. Fears that debt relief could spark panic-selling and contagion in other debt markets can be arrested through temporary interventions by the European Central Bank, and the European Union needs to publicly declare strict criteria when debt restructuring may occur.
Opponents to debt relief for Greece and Ireland are wrong to think that Europe's current strategy makes Europe safe from systemic collapse. The implied risk of default on Spanish, Italian, and Portuguese debt rose sharply during the last month as concerns over Ireland and Greece spread, and this in turn caused yields on related bank debts to soar. The potential economic time bombs left in Europe's periphery are growing. They can and must be resolved. Otherwise the economic and political risks might become overwhelming.
Also posted on Simon Johnson's blog, Baseline Scenario.