Europe has a problem with debt (European Commission 2013). CEPR and the International Center for Monetary and Banking Studies (ICMB) have just released a new report that fleshes out a plan for restructuring the debt (Pâris and Wyplosz 2014).
The so-called PADRE plan starts from the view that several Eurozone countries have accumulated unsustainable public debts. Unsustainability here does not imply that the governments are bankrupt; technically, given sufficient time, governments are rarely unable to raise adequate resources, one way or another. Some governments may run out of time when they lose market access or face high borrowing costs, which is a case of illiquidity, not insolvency. Unsustainability here means that once the sovereign debt crisis is over, several governments will face a debt burden that will stunt economic growth, prevent the use of fiscal policy – the only macroeconomic instrument left in a monetary union – to deal with cyclical swings, and generally make them excessively vulnerable to market sentiment. The implication is that public debts must be restructured.
Debt restructuring, however, is highly contentious, to say the least. One reaction is that ‘European states do not default’. This view runs counter to a long history of debt restructurings. More crucially, it ignores the costs of not restructuring and it assumes that any restructuring must lead to dire consequences, including bank crises and contagion. A rational approach must balance the pros and cons of all options. It must also allow for a careful preparation of each option, including a well-planned, non-disruptive debt restructuring.
Other objections to debt restructuring are political. It is pretty clear that the lower-debt countries of the Eurozone refuse to pay for the highly indebted countries. All governments are also determined not to provoke yet another banking crisis. These constraints are the starting point of the PADRE plan.
The plan involves an agency that acquires at face value a share of existing public debts and swaps them into zero-interest perpetuities. In practice, therefore, the corresponding debts are wiped out. To that effect, the agency borrows on the financial markets the amount needed to acquire the debts. As it pays interest on its obligations and receives no interest on the perpetuities, the agency makes losses. As it rolls over its obligations, its losses are forever. This is where the costs of the debt restructuring are borne. Existing bondholders are fully protected, eliminating any risk of banking crisis.
The agency best suited for the task is the ECB, for three main reasons. First, it is the only institution that can mobilise the required resources (in our main example, we assume that half of existing debts are bought and swapped, which amounts to some €4.5 billion). Second, because central banks do not have to worry about their capital, they have a unique credibility and can sustain large losses. Third, the ECB passes on its profits to Eurozone member countries. This applies to losses as well.
The way to eliminate politically unacceptable inter-country transfers requires that the ECB acquires and swaps public debts of all Eurozone member countries in proportion to each country’s share of its capital, which determines how profits and losses are passed on to governments. This feature means that over the indefinite future, each government will ‘pay back’ the ECB in the form of reduced distributed profits the total amount – in the present value sense – of the initial debt cancellation. The debt restructuring thus amounts to a transfer of the debt burden from current to future generations within each country, without any transfer from one country to another or from current debt holders. It is just a restructuring, without any giveaway. The main, and only merit is that a portion of public debts is not traded anymore. The remaining portion is moderate enough to dispel the threat of a run.
The PADRE plan is not inflationary because it is not a monetisation of public debts. It does not involve any money creation. The ECB borrows to acquire public debts. In practice, the ECB might use its money creation capacity to buy the public debts and then fully sterilise the money created in the first place, but the order of actions is immaterial.
Central bank profits will be reduced forever, in line with the nature of a perpetuity. However, over time, as GDP grows, the costs will become increasingly smaller. In the meantime, the costs are likely to exceed the regular seigniorage income of the ECB. Indeed, under our base case example, the Eurosystem will suffer losses for a long time, measured in decades, but it will return eventually to profitability. The question is whether seigniorage revenues are sufficient to make up for the losses in a present value sense. Our calculations show that this is indeed the case, provided that the interest rate at which the ECB borrows is not too high and economic growth is on a normal path, which occurs under most plausible scenarios.
Then comes the crucial issue of moral hazard. If debt restructuring can be painless, will that not become an incentive for governments to accumulate again and again unsustainable public debts? Moral hazard can be contained, indeed eliminated, if implementation is subject to some conditions. The first condition is a tight and precise covenant. The PADRE plan specifies that, should a country accumulate debt again, the ECB is obligated to swap the zero-interest national perpetuities back into interest-yielding bonds. Such an action, which is bound to trigger strong market reactions, should deter governments from sliding again into fiscal indiscipline. In order to prevent other governments from trumping the covenant in solidarity with a hard-pressed government, a second condition of the covenant also specifies that any such action would require a vote and it automatically imposes the resulting ECB losses on to the taxpayers of those countries that voted in favour of a relaxation of the conditions. Finally, the plan calls for the full implementation of the Treaty on Stability, Coordination and Governance (TSCG) – the adoption by each Eurozone country of a constitutional debt brake rule, if possible through a referendum. This stands in contrast with the current situation where a number of countries have not inscribed their rules in their constitution and where the rules depart in significant ways from the debt brake solution.
Finally, the plan puts the ECB into the highly exposed position of a fiscal agent. Other institutional arrangements are possible. If, however, it is recognised that the ECB is the best-suited agent, it is essential that the decision to undertake debt restructuring be made formally and publicly by the governments and that the ECB be free to accept this role. In particular, the ECB must have complete freedom to independently set its conditions.
In conclusion, the PADRE plan offers a painless and efficient way of solving the debt overhang that, if not treated, will haunt Europe for decades to come. The plan stands to effectively bring the sovereign debt crisis to a definitive end and save the euro for good. If the plan is adopted, the market reaction is bound to be enthusiastic, which would provide the boost to growth and the broad political support that the Eurozone so desperately needs.
European Commission (2013), 2013 Report on Public Finances in EMU.
Pâris, P and C Wyplosz (2014), PADRE: Politically Acceptable Debt Restructuring in the Eurozone, Geneva Special Report on the World Economy 3, ICMB and CEPR.