Larry Summers’s inadequate plan for Europe
Larry Summers reckons that “with last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase”; he’s right about that. But his prescriptions for what must be done, laid out in the second half of his column, are a mess. For one thing, they’re impossible to implement from a political perspective. For another, they contradict Summers’s own diagnosis of what the problem is, as laid out in the first half of his column. And in any case they’re a textbook case of too little, too late: even if implemented they wouldn’t actually fix the problem.
Summers is quite right, in the first half of the column, to write this:
The approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative.
It’s hard to see how he can square that with his prescription in the second half of the column:
First, for program countries. Interest rates on official sector debt will be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated so there is no reason to charge a risk premium, since charging a risk premium needlessly puts the success of the whole enterprise at risk.
Somehow, Summers has magically gone from “the debts incurred will in large part never be repaid” to “default to the official sector will not be tolerated so there is no reason to charge a risk premium,” without ever explaining how he got there from here.
It seems, here, that Summers has gone effortlessly from “you can’t just extend and pretend that there won’t be any default to the official sector” to “let’s extend and simply declare that there won’t be any default to the official sector.”
It’s precisely this kind of thinking that the tumult in Italian markets makes untenable. As the chart in Summers’s column makes clear, Italy has $471 billion of government debt maturing in less than one year. If the private-market window for Italian debt closes as it has done for Greece and Portugal, then the official sector would be on the hook to lend Italy that entire sum itself. And there’s simply no way that Europe can find that kind of money, especially not if it’s lending it out at close to risk-free rates.
And then it gets worse:
Third, there must be a clear and unambiguous commitment that whatever else happens, the failure of major financial institutions in any country will not be permitted. The most serious financial breakdowns—in Indonesia in 1997, Russia in 1998, and the USA in 2008–come when authorities allow there to be doubt about the basic functioning of the financial system. This responsibility should rest with the European Central Bank with the requisite political support and cover provided.
The implication here — although Summers doesn’t quite spell it out — is that the debt of a country’s banks can and should be safer than the debt of the sovereign. That’s something which has never worked in the past, and it’s very hard to see how it could possibly work in the future. After all, if you look at the assets of any given country’s banks, sovereign debt in one form or another constitutes a huge proportion of that number. And look what Summers wants to do to that debt:
Creditors gain nothing from breakdown. They have signalled that they will support an approach based on a menu of options. Some will want to sell out of their exposures at prices marginally above their current market value. Others who still regard sovereign European debts as worth par should be provided with appropriate reduced interest rate, longer maturity options. Debt repurchases are a possibility if the private sector accepts sufficiently large present value debt reductions. The key standard by which any approach should be judged is the genuine sustainability of program country debt repayments on realistic assumptions.
If the present value of the banks’ debt plunges, then the banks become insolvent and fail. If that will not be permitted, then the present value can’t go down very much. In which case you’re unlikely to get to the “genuine sustainability” that Summers wants.
In general, if you have a private-sector debt restructuring where reprofiling is an option — where principal value is untouched and maturities just get termed out with lower coupons — then that’s not going to make enough of a difference to the stock of sovereign debt to make the difference between unsustainable and sustainable. On the other hand, if you take a serious hatchet to the stock of sovereign debt, then there’s no way that any country’s domestic banks could avoid failure.
Summers says of his plan that “much of this will seem unrealistic given the terms of Europe’s debate.” But frankly most of it seems unrealistic just on its own terms — it doesn’t bring countries back onto a sound fiscal footing, and it punts the questions of how much they can be lent by the official sector, and how much the ECB would have to spend to bail out their banks. Summers is quite right that the European debt situation is dangerous. But he doesn’t have much of a plan to deal with it.