Felix Salmon

Greece is going to restructure its debts — and it’s going to do so before mid-2013. That’s the clear message sent by the latest Reuters poll of 55 economists from across Europe: 46 of them saw a restructuring in the next two years, with four saying it would happen in the next three months.

This is a major development. The markets haven’t believed Greece for a while — but now they don’t believe the European Union, either. Remember that back in November, the EU put out a statement laying out a mechanism for restructuring a member’s debt “in the unexpected event that a country would appear to be insolvent”. It clearly says that “any private sector involvement based on these terms and conditions would not be effective before mid-2013″.

But almost nobody believes that Greece can last that long any more. Landon Thomas has the story:

All of which reflects an emerging view, although it has not yet been officially stated, that it makes little economic sense for the monetary fund and the European Union to keep lending money to Greece so that the government can pay back private investors at double-digit interest rates — especially as Greek citizens suffer the effects of a severe austerity program.

“Behind the curtains, they are looking for a smooth restructuring,” said Theodore Pelagidis, an economist in Athens and the author of recent book on the Greek economy’s collapse. “The basic reality is that we cannot service our debt.”

A smooth restructuring, however, is going to be all but impossible to achieve. For one thing, the EU’s preferred mechanism for such things — the use of standardized collective action clauses — isn’t going to be in place before 2013. And more generally, as Lee Buchheit and Mitu Gulati show, there’s no easy way of restructuring Greece’s debts.

Buchheit and Gulati reckon there are two ways that Greece could restructure before 2013; they call the two scenarios “A Light Dusting” and “The Full Monty”. The former option would be something along the lines of a reprofiling: Greece would extend its maturities, but keep its principal obligations untouched. The problem with this kind of deal is that it’s not worth the trouble: the EU would have to go back on its promise, and Greece would publicly default on its bonds, all in the service of a restructuring which would be clearly inadequate, and which wouldn’t actually decrease its debt-to-GDP ratios at all. There’s no possible way that a light dusting could bring Greece to a position of sustainability, so it’s hard to see why they would bother.

On the other hand, the “Full Monty” approach doesn’t look very likely either. Here’s Buchheit and Gulati:

Having spent billions of Euros of taxpayer money to stave off any restructuring of Eurozone sovereign debt, will the political class in Europe really be prepared now to careen to the other extreme of countenancing a savage debt restructuring?

A major tremor of this kind affecting the Greek debt would indeed be felt in Lisbon, Madrid and elsewhere in peripheral Europe.

So maybe Simon Nixon is right, and Europe’s economists are wrong, and Greece won’t restructure before 2013, since doing so “would be a recipe for chaos”. The question, I guess, is whether Europe’s politicians are capable of acting in concert to avert such chaos. The consensus right now seems to be that they’re not.

Four years ago, I started pushing back against the idea that whenever the government fails to make good on some obligation or other, that’s exactly the same thing as a bond default. Of course it isn’t: bond payments are a very special form of government obligation, involving specific sums of money to be paid in a specific manner on specific days. If you fail to make such payments, you’re in default. If a government takes money from, say, the military-salaries pot and uses it to make its bond payments, then that’s a drastic way of avoiding default. It’s a broken promise, to the servicemembers in question. But it’s not a default.

No one understands this better than Treasury. Just ask Tim Geithner himself, who was undersecretary for international affairs from 1998 to 2001, during the Asia and Russia crises. When he was dealing with sovereign defaults, there was a clear understanding that what mattered for such purposes was whether or not countries made their principal and coupon payments in full and on time. Domestic obligations, while important, were a separate issue — and in many cases the international community, led by Treasury and the IMF, would encourage countries to radically overhaul those obligations. No one at Treasury back then made the argument that such overhaul might itself be tantamount to default.

How things have changed now that the problem is domestic, rather than foreign. Neal Wolin has penned an astonishing blog entry at Treasury.gov:

Adopting a policy that payments to investors should take precedence over other U.S. legal obligations would merely be default by another name, since the world would recognize it as a failure by the U.S. to stand behind its commitments. It would therefore bring about the same catastrophic economic consequences Secretary Geithner has warned against.

Wolin really seems to be saying here that Illinois has already defaulted, since it’s late on many payments it’s legally obliged to make. And that a late Social Security check is just as bad in terms of America’s creditworthiness as a missed bond payment — even if Treasury is making all of its payments to the Social Security trust fund in a timely manner.

This is a dangerous and ill-advised rhetorical tack to take. For one thing, it’s false: the transfers made from a government to its citizens are qualitatively different from its bond payments to creditors, and if they’re missed the consequences are not nearly as catastrophic. On top of that, Wolin seems to be saying that Treasury has no particular desire to differentiate its bond obligations from any other obligations. Which, at the margin, increases the likelihood of a bond default. If bonds aren’t special — if they’re just one of many US government commitments — then bondholders should rightly worry that spending cuts might hurt them, too.

There may be some political or tactical reasons why it makes sense for Treasury to talk like this. But strategically, I fear, it could turn out to be very a big mistake indeed.

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.

After I blogged Greg Ip’s post on the dangers of a US debt default if the debt ceiling isn’t raised, it became clear that we were very much lacking an expert take on the matter. So I asked James Macdonald, author of my favorite book about sovereign debt, if he might weigh in. Here’s what he replied:

Constitutional issues:

In the event of a refusal by Congress to raise the debt ceiling, would public debts have precedence over other government obligations? Some commentators have referred to the Fourteenth Amendment, passed in the aftermath of the Civil War, which states that “the validity of the public debt… shall not be questioned.” Is the public debt of the United States constitutionally sacrosanct in ways that its other obligations are not?

The Fourteenth Amendment was needed because, as the ex-Confederate states rejoined the Union after the Civil War, they were likely to hold a great deal of power in Congress, just as they had before 1860. In fact southern whites had been over-represented thanks to the extraordinary provision of the original Constitution that States could count 60% of their slave populations towards their seat allocations in Congress even though slaves had no rights. The main purpose of the amendment was to ensure that emancipated slaves could not be deprived of the right to vote, and as an additional weapon the amendment stated that States would only be entitled to seats in Congress in proportion to their voting populations.

The clause on public debt was the amendment’s final provision, and reads:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.”

There are a number of issues raised here. As the southern states regained power in Congress they might have refused to honour war pensions to Union veterans unless an equivalent provision was made for Confederate soldiers. Or they might have demanded equivalent treatment for the war debt of both sides. The amendment put exiting debts, agreed while the Confederate states were not in the Union, out of bounds of discussion. The most striking aspect of the clause may be the second sentence. It rode roughshod over States’ rights by prohibiting them from paying any Confederate war debts, even if they wanted to. It also set aside the protection of property rights enshrined in the Fifth Amendment (“nor shall private property be taken for public use without just compensation”) by making it illegal to compensate slave owners for the loss of their property, even those in States that had not joined the Confederacy. It is perfectly possible that without the Fourteenth Amendment, slave owners could have taken to government to the Supreme Court on the basis of the Fifth Amendment.

What implications are there for the present situation? Prior to the Fourteenth Amendment, the main constitutional protection for public creditors was the Fifth Amendment. It is not clear just how much the Fourteenth Amendment added to that protection in the case of debt securities, which, as a form of property, are protected by the Fifth Amendment anyway. Where the Fourteenth Amendment might have some implications is in the case of state pensions, and by extension Social Security benefits, which could be deemed to be protected in the same way as post-Civil War veterans’ pensions. The Amendment also has a bearing on any attempt by the government to default on some debts while honoring others. (What happens to Chinese holdings of US Treasuries if China invades Taiwan triggering economic war between the two superpowers?)

Neither the Fifth nor the Fourteenth Amendments protected creditors in 1934, when the US declared that, as part of removing gold from circulation, it would no longer honor the “gold clause” that required the government to pay its bonds in gold coin of a fixed standard. The matter went to the Supreme Court, which found for the government on the basis that section 8 of the Constitution allowed Congress to determine what constituted money; so if it wanted to demonetize gold, it could. This, of course, did not mean the the government had not defaulted, merely that the Constitution allowed it to default under certain circumstances.

Since the Constitution gives the government the power to redefine money at will, it could be argued that the government might find a way around the debt ceiling by some monetary sleight of hand. However, the Constitution would not help in this instance, since the power is vested in Congress, not the administration.

Historical precedents:

The power of the debt ceiling can be very effective. The closest historical analogy to the present situation – other than the shutdown of government under Clinton in 1995 – is the run-up to the French Revolution. The French government was running a chronic deficit, although nothing like so large as the present US deficit in relation to GDP. There was no elected assembly in France, but registration of government loans by the Parlement of Paris, an unelected body of lawyers, was required to give them the force of law. In 1788 the Parlement refused to register the loan needed to cover the annual deficit unless the Estates General was reconvened. The government responded by disbanding the Parlement and imprisoning its leaders, but its access to the credit markets was frozen. In the end it was forced to summon the Estates General in 1789, and the rest, as they say, is history.

Thoughts on the present situation:

Clearly the US does not have to default just because the debt ceiling is reached – for the reasons outlined in this blog and elsewhere. It can temporarily cut back, or delay, its expenses. There is very unlikely to be a problem covering interest on this basis, since the interest on the market debt is only running at $16bn per month and only represents 5% of spending.

The problems could occur for other reasons:

- Given a budget deficit of $1,500 billion per year, new debt has to be issued at a average rate of $130 billion per month. The government would therefore have to reduce/delay spending by $145 billion per month to cover interest and avoid increasing its debt. This is a far more serious problem than finding a mere $16 billion per month, and represents 44% of total spending.

- The market could take fright and refuse to refinance existing debt as it matures, leading to default. Since, quite apart from bond maturities, there are around $2 trillion of T-bills outstanding, the government is on a very short leash when it comes to its credit standing. However, I do not take this risk seriously, since the Fed will simply lend the government the money to roll over the debt if the market refuses to do so.

Given that the the prices of government bonds have not collapsed, the market clearly assumes that that Congress will blink first and there will be no crisis. Personally, I am pretty confident that the market is right. However, there is a risk that, precisely because the only thing that the government can do legally to avoid default is to reduce spending, which is what the Republican right wants, there is an incentive for the Republicans to continue with the game of chicken until it is arguably too late.

At that point, even if the government does avoid default, the battle may be such a “damn close run thing” that the markets may decide that American politics is in so parlous a state that the risk premium on government bonds needs to rise sharply.

PS. Diverting the Social Security surplus (as per your blog) is not an option. Because of the recession, the program is currently running at a deficit, although it is supposed to return to surplus as employment increases.

Greg Ip makes a very important point today, which I haven’t seen made anywhere else*: even if the US debt ceiling isn’t lifted, that doesn’t mean the government will default.

In any given month, the government’s income dwarfs its debt-service obligations, which means that the government could simply pay all interest on Treasury bonds out of its cashflow. Greg hasn’t run the numbers on principal maturities, but I’m pretty sure that they too could be covered out of cash receipts—and when that happened, of course, the total debt outstanding would go down, and we wouldn’t be bumping up against the ceiling any more.

The point here is that the government has enormous expenditures every month, and debt service constitutes an important yet small part of them. If the debt ceiling weren’t raised, it stands to reason that just about any other form of government spending would get cut before Tim Geithner dreamed of defaulting on risk-free bonds.

Some of those spending cuts could be implemented almost invisibly. For instance, Social Security runs a surplus for the time being; it invests that money in special non-marketable Treasury securities, which count as Treasury debt. If the Social Security trust fund accepted instead just some kind of promise of a top-up at a later date, that could save billions of dollars right there.

Beyond that, large defense contractors aren’t going to stop working for the government just because they’re late in being paid; neither are doctors, hospitals or most of the rest of the healthcare industry.

But maybe the smartest thing for Geithner to do would simply be to stop paying the salaries of members of Congress and their staffs. It probably wouldn’t take long, in that event, for Congress to vote Obama the debt-ceiling raise he needs.

The bigger picture here is that the US government, like any other company or individual, has enormous freedom when it comes to which creditors it chooses to pay when. Just like GM had every right to privilege some creditors over others, even when those creditors were legally pari passu, the US government can do exactly the same thing. And there’s no way that this administration, or any other that I can think of, would choose to cut debt service given that they have every choice in the matter.

*Update: Which doesn’t mean the point wasn’t made earlier elsewhere, of course. Stan Collender made it in his Roll Call column, which he posted on his blog here. Apologies, Stan, for missing it.

John Carney takes a stab at answering my question about why we have a debt ceiling, saying that it “helps raise public awareness about the costs of government”:

Lawmakers must go on record as approving an increase in the debt limit in order to enable the government to borrow to fund the spending the lawmakers have approved. They must confront, in a very public manner, the costs of the programs they have enacted.

I’m not at all sure this is the actual reason why we have a debt ceiling; at best it’s a behavioral reason not to abolish it. But it’s not a good reason.

Let’s take a personal-finance analogy here. A credit card company comes along and offers you a card with a $200,000 credit limit—much more than you should ever borrow. But you know that if the money is there for the spending, you’ll be more likely to spend it. So you phone up the credit card company and do a deal with them. You set the limit very low—$1,000, say—and then, any time you want to go over that limit, you have to phone up the credit card company and get them to raise it.

You know in advance that the credit card company will say yes: after all, they’ve already told you that as far as they’re concerned they’re happy to lend you $200,000. But being forced to phone them up and ask for a credit-line increase helps to drive home the consequences of your spending decisions, in a way that simply whipping your card out at the Apple Store doesn’t.

So far so good. But what if you were using your card not only to buy iPads, but also to make rent? And what if there were possible glitches with the system whereby you phoned up and asked for a credit-limit increase, so that you couldn’t be sure it would always work? And what if a single late rent payment could be catastrophic, ending up with you thrown out of your home? At that point, your clever system would stop seeming so clever, and start seeming downright risky.

And that’s the problem with the debt ceiling. It might have interesting and possibly even beneficial behavioral second-order effects, although there’s precious little evidence for that. But getting those beneficial effects means playing with fiscal high explosives, which run the risk of blowing up in the economy’s face and causing major damage. It simply isn’t worth it.

Can someone please explain to me why we have a debt ceiling at all? Its existence seems to violate every tenet of risk management and good governance.

James Hamilton put it well back in 2006:

One of the peculiar embarrassments of the American political process is the fact that Congress votes separately on the deficit and debt, as if they were two different decisions…

If the government is (a) required by the deficit legislation to spend, and (b) precluded by the debt legislation from borrowing, the Treasury would be forced into default. The greater the likelihood markets attach to such an event, the higher will be the interest rate the government has to pay on Treasury debt. A politician who votes for the spending and tax measures that produced the deficit but against a debt ceiling consistent with these is deliberately wasting taxpayer dollars for no purpose other than to grandstand before voters as a “fiscal conservative”. Anyone playing such a game has complete contempt for the intelligence of their constituents.

Looked at another way, this has very little to do with hypocrisy or the voting records of individual legislators. Instead, it’s a built-in systemic stupidity: the existence of the debt ceiling can cause lots of harm, while it does no good whatsoever. As a result, at the margin it will always needlessly raise US borrowing costs, at least by some small amount.

But it’s worse than that—not only is the debt ceiling an utter idiocy, it’s also extremely popular, in a way which only serves to ratify any contempt which US politicians have for the intelligence of their constituents:

71 percent of those surveyed oppose increasing the borrowing authority…

Expensive benefit programs that account for nearly half of all federal spending enjoy widespread support, the poll found. Only 20 percent supported paring Social Security retirement benefits while a mere 23 supported cutbacks to the Medicare health-insurance program.

Some 73 percent support scaling back foreign aid and 65 percent support cutting back on tax collection.

There’s no particular reason why the US public needs to have a reasonably sophisticated understanding of credit spreads, default risk, and the federal budget. I daresay that lots of people genuinely believe that if you cut back foreign aid and tax collection, that would obviate the need to raise the debt ceiling. But the consequence of this is that it gives a real incentive to politicians to vote against raising the debt ceiling, and to attack their opponents, in elections, for repeatedly voting for such a raise.

In other countries, hard limits on debt issuance or total debt or debt servicing costs constitute a serious fiscal commitment and credit risk. In the US, they’re a political distraction at best, and a massive potential tail risk at worst. I’d love to know how this bonkers system came to be, and whether there’s any way of getting rid of it.

Update: Wikipedia tells me that the debt ceiling was introduced to replace a system where Congress approved every debt issuance individually. Which makes sense as a halfway-house on the road to getting rid of this silly constraint completely.

My headline in April 2010, less than eight months ago, said “Ivory Coast’s bond exchange gets it exactly right”. Clearly, I spoke too soon: it seems that they should have simply held off until after the elections.

Ivory Coast’s Eurobonds sank to a record-low 40 cents on the dollar after the world’s biggest cocoa producer missed a $29 million interest payment amid a fight for political control of the West African nation.

Neither of the claimants to the presidency is talking about this issue, although the winner of the election, Alassane Ouattara, says that there isn’t any money left, and his predecessor, Laurent Gbagbo, has been cut off from state accounts.

The chairman of the London Club, Thierry Desjardins, is putting on a brave face, saying that “there is a willingness from the Ivorians to pay” — but it’s unclear who if anybody he’s talking to, or how he can have any good reason to believe that.

If the chaos in Ivory Coast continues past February 1 without the $30 million coupon being paid, the country will have defaulted within a year of restructuring, which would surely be some kind of record. But let’s get real here about this kind of thing:

Ivory Coast’s debt has already been restructured twice because of past defaults, and any repetition would leave it frozen out of international debt markets.

Ivory Coast is already frozen out of international debt markets; there’s no way that it will be able to issue debt in the foreseeable future, whether it makes this particular coupon payment or not. Even if Ouattara takes power and there’s no civil war and the best-case scenario works out, he still won’t be able to issue an international bond for the duration of his term in office. Which, admittedly, hardly gives him an enormous incentive to get that $30 million coupon paid this month.

There are basically two ways that the European crisis might end up resolving itself. Either the peripheral countries start defaulting, or else the eurozone becomes a fiscal union as well as monetary union. Both are politically unacceptable, of course. And George Soros, in a lucid column today, reckons that both might be in the cards:

The lack of a common treasury is now in the process of being remedied, first by a rescue package for Greece, then by creating a temporary emergency facility, and – the financial authorities being a little bit pregnant – eventually by establishing some permanent institution…

Structural changes may not be sufficient to provide the eurozone countries in need of rescue an escape route from their predicament. Additional measures, such as “haircuts” for holders of sovereign debt, may be needed.

Soros’s solution to the crisis involves recapitalizing the banks, and bringing them under a single European regulator. I like that idea—Europe’s banks have been far too leveraged for far too long, and Europe’s member states will always look forgivingly on their domestic institutions, setting off a regulatory race to the bottom. If a tough regulator can turn the banking systems in countries like Ireland and Spain into something strong and credible, that will help enormously in terms of reducing tail risk in the eurozone. And once that has happened, as Soros says, the banks should even be able to absorb a modest default from Greece or Portugal, and maybe even finance those countries’ recoveries.

When politics meets economics, politics always wins. Eurozone countries will only default when it’s in their political interest to do so; until then, some European institution or other will always be there, in extremis, to bail them out and provide the extra few billions needed to plug whatever budget gaps might be temporarily ineradicable. If you’re going to implement a fiscal union out of necessity that way, you might at least make a virtue of it by imposing a common set of banking standards at the same time.

Are we going to see debt defaults in Europe? Yes—and Barry Eichengreen has a positively crystalline explanation why. It’s a first-rate example of economic concepts being explained in plain, easy-to-understand English:

The more that countries reduce wages and costs, the heavier their inherited debt loads become. And, as debt burdens become heavier, public spending must be cut further and taxes increased to service the government’s debt and that of its wards, like the banks. This, in turn, creates the need for more internal devaluation, further heightening the debt burden, and so on, in a vicious spiral downward into depression.

So, if internal devaluation is to work, the value of debts, where they already represent a heavy burden, must be reduced. Government debt must be restructured. Bank debts have to be converted into equity and, where banks are insolvent, written off. Mortgage debts, too, must be written down.

Where I part ways with Eichengreen is here:

The mechanics of debt restructuring are straightforward. Governments can offer a menu of new bonds worth some fraction of the value of their existing obligations. Bondholders can be given a choice between par bonds with a face value equal to their existing bonds but a longer maturity and lower interest rate, and discount bonds with a shorter maturity and higher interest rate but a face value that is a fraction of existing bonds’ face value.

This is not rocket science. It has been done before.

Yes, this has been done before, but I’m not at all convinced it can be done in Europe, even with financial backing from Germany and the IMF.

To oversimplify a bit, there are two different ways you can do a restructuring like this: “market-friendly” and “coercive.” There’s a bit of a grey area between the two, but one way of looking at the difference is that in a market-friendly restructuring, old bonds get swapped directly into new bonds, with the implied threat that if bondholders don’t accept the deal, then the old bonds will simply default and stop making payments. In a coercive restructuring, the old bonds stop paying first, and then that defaulted debt gets swapped into new bonds which actually have a cashflow associated with them.

As a rule, the haircut on a coercive restructuring (think Argentina or Ecuador) is much greater than the haircut on a market-friendly restructuring (think Uruguay or Pakistan).

But in Europe, the necessary haircuts are big, just because the debt ratios are so big. The richer the country, the higher its debt can go before it has to default—and European countries, if and when they default, will be the richest countries ever to do so. What kind of debt-to-GDP ratio would Eichengreen like to see in Greece, say, post-restructuring? Is it even possible to get there with par bonds? (I’m not sure it is.) In any event, it’s hard to see how a “market-friendly” restructuring could do the trick. In order to concentrate bondholders’ minds, you’d need to actually default, rather than just threaten to default.

Because here’s the real crux: no one knows who would win the game of chicken if the European periphery attempted a “market-friendly” restructuring. If bondholders said no, would European governments make good on their threat and go ahead and default, with all the chaos that would imply? The temptation to refuse anything but a very generous offer will be very great, since the moral-hazard trade has worked out so well so many times in the past: in extremis, bondholders always seem to get bailed out.

But given the periphery’s debt levels, a very generous offer isn’t good enough—not even close. Remember that the point of a restructuring is to get countries like Greece to a place where they have regained access to the markets, at sustainable interest rates which don’t result in spiraling debt ratios. I find it very hard to believe that bondholders will ever voluntarily accept a deal which cuts their holdings that much—and I wonder, too, how many of them, upon receiving such a large haircut, would then turn around and start lending to Greece again, on the grounds that hey, its debt ratios look so much better now.

Engineering a successful sovereign debt restructuring in the eurozone, then, is rocket science. It hasn’t been done before, and it might not even be possible. But as Eichengreen shows so clearly, that doesn’t make it any less necessary.

Is the market in European sovereign debt rife with speculation? The NYT would have you think so. And indeed the EU was so worried about the possibility of manipulation in the sovereign CDS market that it commissioned a comprehensive report on the subject.

Wonderfully, Martin Visser of Dutch newspaper Het Financieele Dagblad managed to obtain a copy of the report, using the European equivalent of a FOIA request. His article is here; a Google-translated version is here; and the actual report — a 6MB PDF file, I’m afraid — is here. (For all of these links I’m highly indebted to @ldaalder.)

You can see why the EU might have wanted to keep the report secret: it concludes that the sovereign CDS market is a force for good, and that curtailing it in any way is likely to be a bad idea. Here’s part of the executive summary:

First, the results show that there is no evidence of any obvious mis-pricing in the sovereign bond and CDS markets. Second, the CDS spreads for the more troubled countries seem to be low relative to the corresponding bond yield spreads, which implies that CDS spreads can hardly be considered to cause the high bond yields for these countries. Finally, the correlation analysis shows that changes in spreads in the two markets are mainly contemporaneous. The vast majority of countries show now lead or lag behaviour, and when series are not changing contemporaneously, CDS and bond markets are basically equally likely to lead or lag the other. Furthermore, these relationships have been broadly stable over time.

The report goes on to look specifically at the idea of banning “naked shorting” in the CDS market:

Prohibiting naked positions in credit default swaps could dramatically impact the market. If the CDS market is reduced to hedgers only, market liquidity is likely to drop substantially…

Under a permanent naked CDS ban, CDS would possibly become more classical insurance devices, i.e. customised to closely-related exposure. This would reduce the market’s ability to trade credit risk and, make proxy-hedging impossible. As a result, the cost of bond market financing for the broader economy could increase…

Overall, it is not clear how the bond market would be affected by a ban on naked CDS. Moreover, there are substitute strategies to bet on a downturn in sovereign risk: sell a future on the bond, buy a put option, sell a call option, short sell the bond are usual investment techniques…

Using temporary bans could prove to be an efficient way of dealing with short-term emergency situations. On the other hand, if temporary bans become a “normal” practice of supervisors, this could create additional uncertainty in the market. If in more volatile situations a ban can be imposed, market participants might price in this uncertainty and bond yields might therefore increase…

Another drawback of a ban is that it can send a very strong message to the financial markets about the gravity of the situation of the country(ies) for which the ban will be set in place.

It’s only natural for issuers of bonds and stocks to complain about speculators and short-sellers whenever those bonds and stocks decline in value; sovereign countries are no exception to this rule. But precisely because such complaints are so natural, they should, as a rule, be ignored. Even the EU, when it investigated the situation, came to the conclusion that market manipulation is not the problem here: the market is simply doing its job of pricing credit risk. If anything, the market failure took place in the past, when investors (especially European banks) were not properly pricing credit risk.

I don’t blame the NYT for missing a report in a Dutch newspaper, but I’m still stumped as to the source of its assertion that Dominique Strauss-Kahn has been warning about speculation in European sovereign debt. Because the fact is that if you’re looking at the views of big international organizations, the consensus would seem to be that speculation is actually nothing much to worry about at all.

Did you know there’s a fight to the death going on in Europe? The NYT covers it today, under the headline “Central Bank and Financiers Fight Over Fate of the Euro.” Let’s see if we can spot a theme here:

On one side is the European Central Bank, which is spending billions to prop up Europe’s weak-kneed bond markets…

On the other side are hedge funds and big financial institutions that are betting against those same bonds…

The war keeps escalating as traders position themselves for what some believe is inevitable: a default by Greece, Ireland or perhaps even Portugal…

The head of the International Monetary Fund, meantime, urged Europe to take broader action to fend off speculators…

The speculators keep coming back…

No single hedge fund, after all, can hope to outgun the central bank…

By emphasizing that the central bank is “permanently alert,” Jean-Claude Trichet, its president, has raised the risk for speculators who might try to profit by selling short Greek, Portuguese or Irish bonds…

Speculators have been maintaining large positions in credit-default swaps on Spanish bonds and on the debt of Spanish banks.

OK, that seems pretty clear. On the one side there’s the ECB, nobly trying to defend a young and embattled currency; on the other side there’s hedge funds and traders and big financial institutions—collectively, “speculators”—looking to destroy the euro and collect a big payday, in a manner reminiscent of when George Soros broke the pound.

But who are these speculators? The NYT never specifies. It talks about Pimco selling euro-periphery bonds last year; about JP Morgan clients also being eager to sell their sovereign holdings; and about one hedge fund which made money in the CDS market over the summer and which has now closed its position. The first two can’t really be considered speculators, because speculators are people making a directional bet, rather than simply selling bonds they own and which they fear might fall in value. The hedge fund does count as a speculator, but it’s anonymous, and the size of the trade is not divulged, and it’s far from clear that such funds have any ability at all to move the market.

The NYT also fails to link to any story about the head of the IMF warning about speculators, which is sad, because I’d like to see exactly what he said. Was it this? I can’t see anything about speculators there.

It seems to me that blaming speculators for anything going on in Europe is lazy and unproven. There’s obviously credit risk in various European sovereign bond markets, and those markets are naturally going to trade at levels commensurate with that risk whether they’re full of speculators or not. So long as the ECB remains essentially the only buyer in the market, there will be tension about where the price should be. Real-money investors will tend to consider bonds overvalued and want to sell them at the ECB’s levels: that’s not speculation, that’s just the way that markets work. Yes, such sales put downward pressure on bond prices—as do purchases of protection by investors worried about what might happen in an event of default.

But the fact is that a European sovereign default would almost certainly cause a huge amount of financial harm across the continent—much more than any marginal benefit accruing to short-sellers and speculators. The markets don’t want a default; they’re just trying to determine the probability of a default, and to price assets accordingly.

And by Occam’s Razor, if everything going on in European bond markets can be explained without recourse to evil speculators, then there’s no reason to talk about them at such great length or to demonize them—unless you’re some kind of politician. Journalists should beware “speculator” terminology unless and until they have concrete evidence that what’s going on really is speculation rather than perfectly normal price discovery. So far, I don’t think that evidence exists.

Jim O’Neill of Goldman Sachs is now going around saying that the eurozone needs “solidarity,” and that Germany in particular needs to get with the all-for-one-and-one-for-all program, after getting itself into this mess by encouraging far too many countries to join the euro in the first place. At the same time, the survival of the euro, he says, “requires Germany to be not so noisy and aggressive about how other countries should run their economies.”

You can see the problem here: if enacted, it would mean that the European periphery can run up massive debts, safe in the knowledge that Germany will pay them off. Willem Buiter calls this by its proper name—permanent fiscal transfer—and says that it’s “most unlikely” even in Ireland, let alone in (say) Greece.

Even Buiter—who now works for Citigroup, remember, which has a long and painful institutional memory when it comes to sovereign lending—is talking about the fact that some kind of default (he calls it “restructuring”) will be necessary, certainly in Greece and Ireland, before markets have any confidence that the problems in those countries are resolved.

Certainly the current pain in Greece—retail sales down 10% year-on-year—feels very similar to the deflationary nightmare that Argentina lived through pre-default. The post-default chaos was worse, but the fact is that default was needed, in Argentina, to get the country back onto a growth path. And Argentina’s debt levels were much lower than those in the European periphery.

Europe is going through a debt crisis, and a debt crisis can only be permanently resolved by reducing—rather than simply rolling over—the debt in question. Sovereign debt crises are special cases, and in some rare cases—Brazil in 2002, say—they can be resolved through fiscal policy and economic growth rather than through default. But Greece 2010 is not Brazil 2002. It has vastly more debt, for starters, it doesn’t have a free-floating currency, it doesn’t have oil and other natural resources like soybeans and iron ore which bring in enormous income during a commodity bubble, and more generally it doesn’t have the ability to grow quickly for a sustained period of time.

The EU in general and the European Financial Stability Facility in particular have bought Europe’s periphery some breathing room. They need to take the next couple of years to work out an equitable and workable debt restructuring in these countries. Without one, they will be mired in deflationary recession, exacerbated by massive fiscal cutbacks, for years to come.

Many thanks to my colleague Eric Burroughs for sending over this chart, showing how Portugal’s CDS curve has evolved over the course of this year:

The black curve is how Portugal looked in April: a pretty standard upward-sloping curve, with default more likely the longer you go out.

By June, however, with the onset of the Greece crisis, things looked very different. (This is the green curve.) Obviously default probabilities were higher across the board. But they were highest at the short end of the curve: 6 months to a year out. If Portugal could make it that far, markets were saying, then it would become steadily less likely to default thereafter.

Today, with the red curve, it’s very different yet again. The contrast from just a few months ago is striking: while the 1-year CDS showed the highest default probability back then, today it’s the lowest. The EU bailout of Ireland confirms that Portugal will probably not be allowed to default any time soon.

But then look at where Portugal’s CDS curve goes after that: straight up, to the point at which the country is now considered more likely to default at 3 years out, and on from there.

The implication is clear: any bailout now only serves to make a future default more likely.

Which is not, I’m pretty sure, the message that the EU is really intending to send.

Color me underwhelmed by the Irish bailout. By all accounts it’s going to be less than €100 billion — probably in the €80 billion to €90 billion range — and that sum has to cover the country’s entire borrowing needs for the next three years. The NYT has a breakdown:

While a precise breakdown was not given, analysts and people involved in the talks said that about 15 billion euros was likely to go to backstop the banks. As much as 60 billion euros would go to Ireland’s annual budget deficit of 19 billion euros for the next three years.

That leaves a few billion euros left over for one-off expenses and emergencies — but I worry that Ireland’s banks are going to need a lot more than €15 billion. The banking system is on its knees and it has roughly half a trillion euros in assets. The black hole in commercial real-estate alone — over and above the €50 billion or so that the Irish government has already shelled out — is estimated at somewhere in the €20 billion to €25 billion range and that’s before you even start thinking about residential mortgages:

Where the first round of the banking crisis centred on a few dozen large developers, the next round will involve hundreds of thousands of families with mortgages. Between negotiated repayment reductions and defaults, at least 100,000 mortgages (one in eight) are already under water, and things have barely started.

Banks have been relying on two dams to block the torrent of defaults – house prices and social stigma – but both have started to crumble alarmingly.

When a residential property bubble as big as Ireland’s bursts, there will be always enormous bank losses. But because those losses haven’t materialized yet, everybody in Ireland and the EU is sticking their heads in the sand, pretending that they’re never going to arrive at all.

The best-case scenario, then, is that the EU bailout will kick the Irish can three years down the road. But in implementing the plan, Ireland’s banks will effectively be nationalized and any future mortgage losses will have to come straight out of these bailout funds. Which aren’t remotely sufficient for such a task. If the spike on mortgage defaults comes sooner rather than later, this particular bailout package could prove to be very short-lived indeed.