Why Europe’s periphery should restructure their bonds
The drumbeat for debt restructurings on Europe’s periphery is becoming too loud to ignore. The Economist has now come out strongly in favor; its leader gives the strongest case for biting the bullet now. And Mohamed El-Erian has now officially signed on:
You do not solve a debt problem by adding new debt on top of old debt. Yet it seems that European officials are fixated on this approach…
More people are recognising that the time has come for another approach – what this week’s Economist magazine calls “Plan B”. This involves the orderly restructuring of some European sovereign debt on terms that allow a meaningful chance of re-accessing markets in future at sustainable rates. This would be accompanied by measures to enhance growth prospects in highly indebted European countries; ring fence the other, fundamentally sound economies; and push banks and other institutional holders of restructurable debt to raise prudential capital.
The FT article El-Erian links to quotes all manner of other private-sector actors, including Citigroup chief economist Willem Buiter, saying that there will inevitably be several euro area sovereign debt restructurings over the next few years. And if there’s one thing that everybody can agree on, it’s that if you’re going to restructure your debt, it’s always better to do it sooner rather than later. And, as the inimitable Lee Buchheit says, the European Stability Mechanism, if enacted, will make any future restructuring much worse for private-sector creditors:
In a euro area restructuring, ESM loans, junior only to those from the IMF, would enjoy preferred status as well, leaving bondholders to shoulder more of the losses from mid-2013 onwards.
That has scared some investors. “It’s like telling a fellow that you won’t shoot him until after lunch. He was never going to enjoy the shooting, but now you have also spoiled his lunch,” says Lee Buchheit, a sovereign debt restructuring specialist at law firm Cleary Gottlieb Steen & Hamilton.
All of which makes Paul Krugman’s big NYT piece on Europe very well timed. He clearly lays out how we got to where we are, and what the four different paths are that the Eurozone could follow from here: along with the debt-restructuring approach, there’s also “toughing it out”, which basically entails painful deflation, recession, and fiscal austerity in much of the eurozone periphery; and the two extreme corner solutions in Europe — either the peripheral countries leave the euro entirely, and probably devalue too, or else the currency union becomes a fiscal union, and the debts of any one country get covered by all member states.
Liz Alderman has a good report in the NYT about the serious problems with the “toughing it out” approach, which Europe is attempting to follow at the moment. And so some economists, like Dean Baker, are pushing Krugman’s “Revived Europeanism” approach — fiscal union, essentially — saying that it “would essentially be costless right now”.
Politically, however, it’s a much harder sell, especially in Germany. And it would also require a level of confidence about Europe’s economic future which I don’t think anybody has right now. And as the Economist leader notes, even the debt-restructuring path will involve a serious fiscal hit for Europe’s wealthiest countries:
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.
To use a US analogy, the choice facing Europe right now is whether to deal with its peripheral nations like Frannie, like AIG, or like General Motors.
The Frannie approach means a fiscal union: their debts are our debts. The AIG approach is the current “tough it out” one, where the hoped-for outcome is that a solvency crisis can be solved with liberal applications of government liquidity. But that only happens when you have strong growth — share-price growth in the case of AIG, with lots of expected future profitability, or economic growth in the case of countries like Greece, Portugal, and Ireland. And right now it’s impossible to see how a country like Greece can possibly grow its way out of its debt trap.
Finally, there’s the GM approach: restructure the debt, and get back onto a long-term sustainable footing. It’s harder for countries than it is for companies. But it might well be the least-bad option, by some large margin.