I have an op-ed in the Guardian today (with my good friend Eduardo Sousa) following up on the one we published there last month, this time defending a soft restructuring of Greek, Irish, and Portuguese debt, replacing burrent bonds by new ones with GDP-pegged interest rates and maturities. Read it below and follow the comment thread here.
While a growing number of analysts recognise the likelihood of sovereign-debt defaults across Europe’s periphery in the next few years, the continent’s political and financial elites continue to see restructuring as the third rail of financial options. Despite all signs that the euro may be set on an implosion course, the EU and the European Central Bank (ECB) are in a state of denial.
As we have recently argued – and, in response to our readers, here – the most likely scenario is that Greece and Ireland default on their debts over the next few years, with Portugal soon following, dragging Spain into the circle of the damned. But instead of facing this likely state of affairs, Europe’s top leaders remain obdurate in placing the burden of the crisis entirely on the shoulders of the highly indebted countries’ taxpayers. Every time a eurozone default is mentioned, European political leaders – and the bankers whose money is at risk – come out in force against a serious discussion of the topic, in a short-sighted attempt to keep the sinking bailout ship afloat.
This wall of silence creates a false polarisation between a solution that burdens solely debtors and another that punishes only creditors. It pretends there is no middle ground and, by doing so, prevents a serious discussion on how to design and implement a restructuring plan. But by refusing to explore this middle ground and develop softer options in case bailout packages fail, Europe’s statesmen are increasing the likelihood of a hard, unstructured and unmanaged default by Europe’s peripheral countries, with severe effects for European and global markets, including the possible breakup of the euro.
In fact, there is a lot of middle ground between the complete fulfilment of Greece, Ireland and Portugal’s debt obligations and a hard default in which they suspend all payments to their creditors and, inevitably, pull out of the euro. The key issue at stake is how to distribute losses between debtors and creditors in an equitable fashion. Peripheral European countries have always posed greater credit risk, captured by the higher spread charged to them. Once those higher risks result in a debt bubble, there is no good reason to shield creditors entirely from its costs. In fact, the overall costs for creditors of a reasoned debt restructuring pale in comparison with the risks inherent in the gamble that European leaders are currently taking.
As Greece and Ireland have recently demonstrated, and Portugal likely will soon, current bailout packages risk sending indebted countries into a recessive spiral. They impose inflexible repayment schedules that are feasible only if weakened governments are able to make a panoply of necessary but deeply unpopular reforms work like a charm. This is a recipe for political trouble, at home and across Europe.
In contrast, a reasoned debt restructuring plan would redistribute the risks inherent in the failure of the current bailout packages between debtors and creditors by indexing interest rates and repayment schedules to GNP growth. Rescheduling and repricing of current loans should be co-ordinated at the EU level and indexed to the debtor countries’ GNP and fiscal performance. This would keep all stakeholders focused to maturity.
It would also shift the political interests of core countries, such as Germany, towards reviewing ECB targets, making room for moderate inflation at the core in order to facilitate economic growth in the periphery. EFSF-tagged loans with IMF backing might support immediate post-restructuring financing needs. An autonomous financial mechanism should be created to support strained lenders.
A restructuring plan with repayment schedules and interest rates indexed to the economic performance of debtor countries would bring three advantages. First, by making creditors assume the higher risks inherent to the peripheral Europe sovereign-debt assets they own, it would broaden the realm of stakeholders interested in the plans’ success and tame moral hazard, strengthening European cohesion. Second, by giving the troubled economies some breathing room to recover, it would boost their chances of economic success, and therefore of long-term solvency. Finally, through its inherent repayment flexibility, such a plan would ensure the ultimate reimbursement of creditors’ capital, making it more palatable to distressed creditors and thus safer in terms of market stability.
With a plan along these lines in hand, European leaders should extract debt holders’ agreement to the new terms. To do so, they need to show that the costs of a managed restructuring are smaller than the overall risks of its more likely alternative – a hard default with unfathomable shockwaves across the world financial system.
It is time Europe’s political leaders bite the bullet and recognise debt default is not an unlikely outcome. Foolishly pretending otherwise will only make matters worse.