A new deal for debt over­hangs?

Financial Mirror (Cyprus) - - FRONT PAGE -

The In­ter­na­tional Mon­e­tary Fund’s ac­knowl­edge­ment that Greece’s debt is un­sus­tain­able could prove to be a wa­ter­shed mo­ment for the global fi­nan­cial sys­tem. Clearly, hetero­dox poli­cies to deal with high debt bur­dens need to be taken more se­ri­ously, even in some ad­vanced coun­tries.

Ever since the on­set of the Greek cri­sis, there have been ba­si­cally three schools of thought. First, there is the view of the so­called troika (the Euro­pean Com­mis­sion, the Euro­pean Cen­tral Bank, and the IMF), which holds that the eu­ro­zone’s debt-dis­tressed pe­riph­ery (Greece, Ire­land, Por­tu­gal, and Spain) re­quires strong pol­icy dis­ci­pline to pre­vent a short-term liq­uid­ity cri­sis from mor­ph­ing into a long-term in­sol­vency prob­lem.

The ortho­dox pol­icy pre­scrip­tion was to ex­tend con­ven­tional bridge loans to these coun­tries, thereby giv­ing them time to fix their bud­get prob­lems and un­der­take struc­tural re­forms aimed at en­hanc­ing their long-term growth po­ten­tial. This ap­proach has “worked” in Spain, Ire­land, and Por­tu­gal, but at the cost of epic re­ces­sions. More­over, there is a high risk of re­lapse in the event of a sig­nif­i­cant down­turn in the global econ­omy. The troika pol­icy has, how­ever, failed to sta­bi­lize, much less re­vive, Greece’s econ­omy.

A sec­ond school of thought also por­trays the cri­sis as a pure liq­uid­ity prob­lem, but views long-term in­sol­vency as an out­side risk at worst. The prob­lem is not that the debt of coun­tries on the eu­ro­zone’s pe­riph­ery is too high, but that it has not been al­lowed to rise nearly high enough.

This anti-aus­ter­ity camp be­lieves that even when pri­vate mar­kets to­tally lost con­fi­dence in Europe’s pe­riph­ery, north­ern Europe could easily have solved the prob­lem by co-sign­ing pe­riph­ery debt, per­haps un­der the um­brella of Eurobonds backed ul­ti­mately by all (es­pe­cially Ger­man) eu­ro­zone taxpayers. The pe­riph­ery coun­tries should then have been per­mit­ted not only to roll over their debt, but also to en­gage in full-on coun­ter­cycli­cal fis­cal pol­icy for as long as their na­tional gov­ern­ments deemed nec­es­sary.

In other words, for “anti-aus­te­ri­ans,” the eu­ro­zone suf­fered a cri­sis of com­pe­tence, not a cri­sis of con­fi­dence. Never mind that the eu­ro­zone has no cen­tralised fis­cal au­thor­ity and only an in­com­plete bank­ing union. Never mind moral-haz­ard prob­lems or in­sol­vency. And never mind growthen­hanc­ing struc­tural re­forms. All of the debtors will be good for the money in the fu­ture, even if they have not al­ways been re­li­able in the past. In any case, faster GDP growth will pay for ev­ery­thing, thanks to high fis­cal mul­ti­pli­ers. Europe passed up a free lunch.

This is a fully co­her­ent view­point, but naive in its un­qual­i­fied con­fi­dence (for ex­am­ple, in the polem­i­cal writ­ings of the No­bel lau­re­ate economist Paul Krug­man). As a re­sult, the anti-austerian view masks strong as­sump­tions and risks. In fact, piling loans atop al­ready-high debt bur­dens in the eu­ro­zone’s pe­riph­ery en­tailed a sig­nif­i­cant gam­ble, par­tic­u­larly as the cri­sis erupted.

Po­lit­i­cal cor­rup­tion, ex­em­pli­fied by the re­volv­ing door be­tween Spain’s gov­ern­ment and fi­nan­cial sec­tor, was en­demic. Dual la­bor mar­kets and prod­uct-mar­ket mo­nop­o­lies still hob­ble growth, and oli­garchs have dis­pro­por­tion­ate power to pro­tect their in­ter­ests. In re­al­ity, Ger­many could not have un­der­writ­ten all of the Euro­pean pe­riph­ery’s debt with­out risk­ing its own sol­vency and cred­it­wor­thi­ness, par­tic­u­larly in the ab­sence of a func­tion­ing sys­tem of eu­ro­zone-wide checks and bal­ances. Ex­pan­sive and ope­nended guar­an­tees might have worked, but if they didn’t, the eco­nomic rot from the pe­riph­ery could have spread to the cen­tre.

A third point of view is that, given the mas­sive fi­nan­cial cri­sis, Europe’s debt prob­lem should have been di­ag­nosed as an in­sol­vency prob­lem from the start, and treated with debt restruc­tur­ing and for­give­ness, aided by mod­er­ately el­e­vated in­fla­tion and struc­tural re­form. This has been my view­point since the cri­sis be­gan.

In Ire­land and Spain, pri­vate bond­hold­ers, not Ir­ish and Span­ish taxpayers, should have taken the hit from bank fail­ures. In Greece, there should have been faster and larger debt write-downs.

Of course, na­tional gov­ern­ments would have had to use tax­payer funds to re­cap­i­talise north­ern Euro­pean banks – es­pe­cially in France and Ger­many – that lent too much to the pe­riph­ery. And trans­fers would have been needed to re­cap­i­talise the pe­riph­ery banks. But at least then the public would have un­der­stood the re­al­ity of the sit­u­a­tion, while re­struc­tured and re­cap­i­talised banks would have been in a po­si­tion to start lend­ing again.

Un­for­tu­nately, too many pol­i­cy­mak­ers in ad­vanced economies al­lowed them­selves to be­lieve that such hetero­dox poli­cies are only for emerg­ing mar­kets. In fact, ad­vanced coun­tries have re­sorted to hetero­dox poli­cies to re­duce debt over­hangs on many oc­ca­sions. Debt restruc­tur­ing would have given Europe the re­set it needed. Yes, there would have been risks, as IMF chief economist Olivier Blan­chard has pointed out, but run­ning those risks would have been well worth it.

So what is the way for­ward? Deeper Euro­pean in­te­gra­tion, stricter eq­uity re­quire­ments for banks, and deeper but home­grown struc­tural re­forms are cer­tainly key el­e­ments of any so­lu­tion. Fur­ther aid to the Euro­pean pe­riph­ery is still badly needed.

But, be­yond that, Europe’s ex­pe­ri­ence ought to spur a full re­think of the global sys­tem for ad­min­is­ter­ing sov­er­eign bank­rupt­cies. That could mean bring­ing back older IMF pro­pos­als for a sov­er­eign bank­ruptcy mech­a­nism, or find­ing ways to in­sti­tu­tion­alise the Fund’s re­cent stance on Greek debt. There is no free lunch in Europe, and there never was; but there are much bet­ter ways to deal with un­sus­tain­able debt.

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