By Daniel Gros, Director of the Centre for European Policy Studies, Brussels. Cross posted from VoxEU.
Muddling through isn’t working. This column argues that troubled Eurozone nations should simultaneously open restructuring talks while continuing to service their debts normally. Germany, France, and other core Eurozone nations would have to stand ready to recapitalise the banks most exposed to the restructured debt. The ECB would then stabilise the banking system and the EFSF would stabilise sovereign debt. This big bang could be prepared in a weekend; the market already seems to be pricing it in.
I hope that everything I write in this column turns out to be irrelevant; I very much hope that it will not be necessary to resort to such drastic actions. Economic logic, however, suggests that it might soon represent the least bad solution to a crisis which keeps getting worse. That said…
The horses have left the stable. Europe’s leaders have announced officially that there might be sovereign defaults in the Eurozone. Now they have no good options left. Governments want markets to believe that defaults will happen only after 2013, but what investor is going to wait patiently to be fleeced in a couple of years? The buyer’s strike of peripheral Eurozone debt is thus likely to continue, thus raising the cost of the further rescue operations which are clearly on the horizon. The cost of muddling through is increasing by the day.
It would, of course, also be a mistake to let policy be dictated by short-term gyrations in the bond markets. But one recent development has increased the urgency of acting soon. This is the recent announcement of the Eurogroup of November 28th that the loans of the future “European Stability Mechanism” (ESM) would be senior to private creditors.
As I argue at length in a companion column (Gros 2010), this implies that large bailout programs might actually lead to higher risk premiums because large official bailout programmes would imply that little any eventual restructuring loses will be shifted to long-term creditors; short-term creditors will have already been paid off in full.
Moreover, the punitive interest rate (5.8%) imposed on Ireland now by the EFSF implies that a large official loan makes actually default more likely because an interest rate that is clearly above the growth rate one can now expect for the next years (1-2% only). When the numerator (debt service) rises faster than the denominator (GDP, i.e. ability to pay), a snowball effect occurs whereby it is ever more difficult for the country to service its debt (which in the case of Ireland would amount to 75% of GNP; see Eichengreen 2010).
The problem: Vicious circles
This creates the risk of a vicious circle under which a country that has only a manageable problem might be forced into an EFSF (ESM) programme, which would then make debt service more onerous because of the punitive interest rates. This is likely to induce investors to sell the longer-term debt of the country, which would in turn increase the pressure on the country to accept an EFSF programme. The larger the program, the less would be available in the end for bondholders should the programme not work. This is likely to lead to a further increase in the risk premium. The present strategy of “muddling through” on a case by case basis, but insisting that the future mechanism will be senior to private creditors (and that the latter must expect losses), thus carries a strong risk that more and more countries will be forced into a deadly spiral of increasing risk premiums and ever-increasing financing needs.
The only way out seems to be a big bang; to deal with all the problem cases in one go. The argument against a restructuring of, say, Greek public debt has always been that this would lead to contagion. But contagion is already a fact of life, and it focuses on countries with real problems. Portugal with its combination of high external debt and poor growth prospects looks like Greece. Spain has the “Irish disease”; a real estate bust that leads to huge losses in the banking system. Every country is different, and some countries (Spain, for example) would under normal circumstances not need a bail out. But these are not normal circumstance, and it is not possible to deal with each country in sequence because each bailout lead the markets to expect the next one. Only a big bang can resolve the impasse.
How should this “big bang” look like? A sudden collective default would of course constitute a “mega Lehman” and would have catastrophic consequences. However, it is entirely possible for the countries in question to make investors an exchange offer while continuing to service their payment obligations. There should thus be no technical default, but simply an offer to bondholders to engage in discussions about debt restructuring accompanied by a concrete exchange offer.
Everybody is different
All countries should thus move at the same time, but every country has different problems, and would make a different offer to creditors. Greece and Spain illustrate the two polar cases:
In the Greek case, the problem is clearly the sovereign. Holders of Greek public debt could be offered a par bond (100% of the nominal, but with a low interest rate and a long maturity). This would ensure that banks (and the ECB) would not have to book immediately huge losses on their accounts.
In addition to the par bond, creditors would be offered GDP warrants under which the government of Greece would offer to allocate a certain percentage of any increment in nominal GDP (after the through expected for 2010/11) to additional payments to foreign creditors, pro rata their present holdings. If Greece were to pay to foreign creditors about 4-5% of any increment in nominal GDP substantial payments could built up over time, with full (even if late) payment possible if Greece returns to a decent growth path. The annex provides some crude model calculations to this effect. For Portugal, a simple rescheduling might be sufficient.
In the Spanish case, the problem stems from the banks. Nobody can know with certainty how large their losses will be in the end. But this uncertainty drags down the entire country. The banks must thus be sacrificed if the sovereign wants to stay afloat. Holders of bonds of the banks most exposed to the real estate bust would thus be offered a debt for equity swap. The Spanish government would then be free of further large contingent liabilities, and should have no problems servicing its present debt of around 60% of GDP.
The accounting losses for the holders of Spanish bank bonds might again be limited if the bonds are transformed into subordinated debt with the same face value of the bonds. For holders of the bonds which do not mark to market the accounting losses could then be taken over a longer period. Spanish banks would not be forced into fire sales, and patient investors might limit their losses if the Spanish real-estate sector does recover.
The same should have been done in Ireland. But at this point it would require first the (new) Irish government to renege on the guarantee given by the old one. This will lead to legal problems and would formally be equivalent to a default, but it would restore the solvency of the Irish government, so that no haircut would be needed on Irish government debt. The debt-for-equity swap (as with GDP warrants) allows investors to participate in the upside that would materialise if the assets of the Irish banks and Spanish cajas are really worth as much as the banks and their regulators maintain.
Core governments would of course have to stand ready to recapitalise those of their banks with the highest exposure to the peripheral debt to be restructured.
All this could be prepared during a special weekend meeting of the European Council (followed by a Eurogroup and probably also an EcoFin meeting).
What about the day after? Although this package should restore the solvency of those governments currently under market pressure there might still be initially turmoil in the markets. However, at this point the ECB would be justified in providing abundant liquidity to the interbank market which should then be free of “zombies”. Governments and the ECB would thus agree on a division of a labour:
The ECB stabilises the banking system, and
The EFSF/ESM (the fiscal authorities) take care of the financing needs of governments.
The funding of the EFSF should then be sufficient to cover the (reduced) financing needs of all four GIPS (Greece, Ireland, Portugal and Spain) countries for quite some time.
The big-bang approach is not without risks. It could be prepared in a weekend, but it would require months of patient negotiations to get bondholders to agree.
This is actually very likely to happen because the offer would be close to current market prices and because a large part – maybe even a majority – of the bonds are in the hands of institutions that should respond to political pressures to accept the deal.
Could a “hold out” by a minority of bondholders who refuse to accept a deal created endless legal problems? There is a solution to this problem suggested by Buchheit and Gulati (2010). Greece and other countries could just pass a “mopping up” law which stipulates that any agreement by a super-majority of bondholders (say two-thirds) is binding on the remainder. This would create immediately a statuary “collective-action clause”. The absence of “collective-action clauses” thus does not constitute an insurmountable obstacle to reaching an agreement with creditors, as argued recently also in Nouriel Roubini in the Financial Times.
Muddling through is more attractive in the short run, but it does not lead anywhere when doubts about debt sustainability persist and the market has been destabilised by the announcement that the loans of the new permanent crisis mechanism would be senior to private creditors.
Restructuring will become virtually impossible once the Greek and Irish programs have run their course. At the end of these programmes the major part of the debt of these countries will be owed towards creditors which regard themselves a senior (IMF and ESM), but still impose interest rates far above growth rates.
At that point the haircut for the remaining private creditors would have to be enormous should the debt sustainability assessment announced by the Eurogroup come to a negative result. Even a low probability of such a result can destabilise markets today making procrastination expensive.
Please see VoxEU for references and a technical appendix on how to value GDP warrants
It could work (it would send an expansive financial wave to Wall Street but that may even be good considering how entrenched and useless the banks are now) but still a devaluation of the euro is necessary: Europe can’t compete internationally at such exchange rates, we need to consume less and sell more, not just inside EU but specially outside.
But where are the markets? I’d say that nowhere anymore. So there is a serious structural problem, problem that was temporarily patched by the Bubble but it was a remedy that aggravated the illness in the end. For demand to exist, workers must get decent salaries which they can then spend on goods and services. Instead the current dogma is just to increase poverty, what harms demand quite obviously. In turn producers face difficulties, have to cut jobs and/or salaries, what reduces even more the demand.
It is a global problem and soon it will be transferred to the emerging economies, which depend on Europe and North America to consume their products primarily. They are patching it with modest increases in domestic demand but still…
So the dogma of generalizing poverty in the name of market (in spite of poverty severely damaging markets) must change. States (and that includes the EU) must invest (and get indebted if need be) in order for the demand to be revived… if that is still possible.
If it’s not possible (or not done anyhow), you know where this ends: revolution.
It doesn’t have to be revolution. Another possible outcome is social disintegration, as is now happening in Mexico.
Mexican President Ernesto Zedillo took the bailout deal “offered” by the U.S. et al in 1995 which allowed Mexico to “emerge” from its financial crisis of 1994. Here’s how Carlos Fuentes describes the deal in A New Time for Mexico:
In effect, President Clinton withdrew the original $40 billion loan requiring congressional approval and gave Mexico $20 billion out of a discretionary fund. Strings were attached: Mexico’s oil revenue would serve as collateral and be paid directly into the Federal Reserve Bank in New York. President Zedillo didn’t even blink at this onerous condition and both Zedillo and Clinton knew that the U.S. lent Mexico money to repay U.S. banks, and investors, who had already harvested enormous earnings in their Mexican ventures. Production, employment, salaries, education, and social services—-the real saviors of the Mexican economy—-were once more postponed. Sovereignty was severely affected: the agreement gave the U.S. the right to monitor Mexico’s economic policies.
In 1997, Mexico repaid, ahead of schedule, all US Treasury loans. By 1997 the economy was growing again.
But under this neoliberalism-on-steroids arrangement, none of the growth “trickled down” to workers. The neoliberal regime did create the richest man in the world, Carlos Slim Helu. But the privations suffered by Mexican workers have been herculean. Between 1991 and 1998, the mean hourly income of Mexican workers fell 40% measured in 1993 pesos).
Don’t believe the lies and propaganda emanating from the U.S. Embassy that are being mindlessly aped by U.S. news outlets such as in this CNN report. I had a dinner party last night and asked my guests if they or anyone they knew supported President Calderon’s “war on drugs.” Not a single person did. Everyone here knows that Calderon’s “war on drugs” amounts to nothing but doing the bidding of his U.S. overlords, and that the “war on drugs” is in reality a war on the Mexican people.
I think this corrido, which honors the Mexican drug lord Chapo Guzman, offers an accurate reflection of what is now happening in Mexico. The Mexican government, which the Mexican people accurately perceive as being nothing but a puppet of the U.S., has absolutely zero credibility with the Mexican people. The result is that criminal drug cartels have more credibility with the Mexican people than does the Mexican government. The cartel leaders can thus become folk heroes in the eyes of the Mexican people.
The fiction being aped by the CNN reporter is from this Mexican Embassy cable, released as part of the latest Wikileaks dump:
►”Overall, Calderon’s approval ratings are still well above 50 percent, sustained largely by his campaign against organized crime.”◄
Oops! Should read “from this U.S. Embassy in Mexico cable…”
They can opt for a complex, convoluted series of temporary patches or they permanently can solve the fundamental problem shared by all euro states, which is: They have surrendered their Monetary Sovereignty .
There are but two long-term solutions:
1. Each nation drop out of the EU, and reclaim monetary sovereignty
2. The EU function as one central government, and create sufficient euros for economic growth.
All the other machinations merely are attempts to cover an elephant with a handkerchief.
Rodger Malcolm Mitchell
This looks like a very reasonable way to approach the whole thing. But
1) How to figure sovereign and bank CDS in this scenario? Should they be forbidden upfront or does the supermajority clause take care of them ?
2) Does this has any chance to happen with politics being what they are in the Eurozone? Has the author any indications that people in charge understand this as the best solution and will be going for it ?
3) Could not the ECB buying up all long-term debt at a discount with slowly decreasing bids until 2013 also be a de-facto-restructuring – if done intelligently ?
Vote for who you think have been the most influential people in financial regulation in 2010 here: http://www.gfsnews.com/vote.php
It continues to be absurd to me that nations rent their money supply from “investors” and banks. Since deficits seem inevitable and even necessary then it is ridiculous for governments to borrow what are essentially operating costs.
Still, there is a certain joy in seeing that a fundamentally dishonest money system is also unstable. It turns out the “smartest people in the room”, aren’t.
Mr. Beard, if they were monetarily sovereign, they wouldn’t even have to borrow. The U.S. borrows, but it doesn’t need to.
Some day, our leaders will answer the simple question: Why should a monetarily sovereign nation borrow the money it already has created and has the unlimited ability to create?
If you owned a money-printing press, would you borrow?
Rodger Malcolm Mitchell
If you owned a money-printing press, would you borrow? Rodger Malcolm Mitchell
Not only does a sovereign nation have no need to borrow but it should not borrow either, imo.
Is the ensuing treatise concerning Europe the approbation of unfair mercantilism practiced by ‘core countries’ ensuing in support of the power grab by europhiles seeking a pan-european trade region controlled by the ‘core countries’ and based on the Maastricht ‘treaty’ 3% deficit rule?
“However, at this point the ECB would be justified in providing abundant liquidity to the interbank market which should then be free of “zombies”.”
In essence, the EU tried to cure a minor problem (the inconvenience of multiple currencies), with vigorous bloodletting (elimination of monetary sovereignty.)
The tacit assumption was that when all nations used the same currency, they also would have the same economic problems, and require the same economic solutions. How foolish.
They called that assumption “monetary stability” when in fact, it is the height of instability. Nations with a positive balance of trade have dramatically different needs from nations with a negative balance of trade. The euro rules do not allow for these differences.
In a 2005 speech at the UMKC I said, “The economies of European nations are doomed by the Euro.” I see nothing to change that prediction.
Rodger Malcolm Mitchell
Looks like the dust has settled now.
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