The crisis in the Eurozone is primarily a debt crisis. Debt overhang, whether public or private (as it originally was in Ireland and Spain), impedes investment and growth (Reinhart and Rogoff 2010). And it diminishes incentives for fiscal rigor if the benefits accrue mainly to creditors, and aggravates the macroeconomic effects of austerity if much of the additional saving that deleveraging requires is transferred to creditors abroad. Low growth and capital flight reinforce the debt problem and create a downward spiral, from which belated budgetary austerity provides no exit.
Any strategy of dealing with the Eurozone crisis therefore must be evaluated in light of its effectiveness in dealing with the debt overhang problem. Two solutions are possible.
- Inflation reduces the real value of nominal debt, lowering the debt burden both on the sovereign and all other debtors.
An unanticipated inflation increase of three percentage points amounts to a 34% (compounded) debt relief on a ten-year bond; little of the government debt in question is inflation-indexed (less than 8% in Italy and none in Spain). But such relief hits all investors alike, independent of the solvency of their respective debtors.
- Or sovereign default writedowns of the face value and interest payments or reprofiling of such payments. These can take various forms.
For example, exchanges of short-run debt for long-run debt and adjustments of the interest payments can help restore sustainability to debt dynamics.
The Eurozone has so far studiously avoided the default option, with the exception of the half-hearted Greek restructuring, where denial of the problem was no longer possible. Instead it has embarked on two transfer strategies that will worsen the Eurozone crisis.
- The first consists in public bailout schemes, such as the EFSF or the ESM, which replace private credit with public credit of the still-solvent states.
The debt overhang problem of some countries thereby becomes the debt overhang problem of all the others, without any net relief for the Eurozone as a whole. Needless to say: private investors do not have any confidence that this strategy will work for the Eurozone. But they support it enthusiastically, for it allows them to transfer their credit risk to Eurozone taxpayers. Substantial policy pressure from the US, UK, and China supports such a risk transfer in pursuit of investor interests.
- The second futile policy consists of central bank purchases of distressed sovereigns’ bonds.
The declared goal of this programme is to reduce yields on outstanding debt with such purchases and thus reduce the cost of issuing new debt. But this argument contradicts the cold reality of bond valuation. As long as distressed sovereigns continue to issue new debt, they will still have to pay a large default premium. This premium is augmented by the ECB’s seniority. Investors anticipate that if the issuer defaults, the central bank would always be first in the recovery queue. ECB bond buying will therefore have no lasting positive effect on sovereigns’ financing costs.
Why are bond purchases so strongly advocated by southern countries in the Eurozone? It is essentially a 21st century version of beggar-thy-(Eurozone)-neighbour: Through massive bond buying, the ECB will accumulate considerable sovereign default risk which is then shared by all Eurozone members. Ironically, rather than reducing the risk of sovereign default, the ECB’s bond buying will eventually produce the opposite effect. The larger the scale of sovereign debt transfers from domestic investors to the ECB, the less will there be domestic resistance against default. ECB policy might delay sovereign default, but does not make it less likely.
Early debt restructuring as a policy alternative
While many central bankers and policymakers are still in denial, time is running out to address the real problem of Europe's debt overhang. The Greek example has shown how sovereign debt can be restructured without the market upheaval and contagion predicted by many (Landon 2012). The legal instruments can be put in place for Spain, Portugal, Italy, or other countries to undertake exchange offers of existing debt with new debt which include reductions of the principal and postpone interest payments. With primary deficits near zero, such debt restructuring is a real policy alternative. It has proven workable in previous cases, such Uruguay in 2003 (Buchheit and Pam 2004). The historical evidence from the large number of previous sovereign default episodes tends to show that the economic costs are short-lived (Borensztein and Panizza 2009).
Ultimately, the Eurozone will have to choose between sovereign default through debt restructuring and default on the real value of government bonds through inflation. Debt restructuring has many advantages if it is undertaken at an early stage.
- Through orderly default, investors take responsibility for their investment decisions. This is not the case if they are bailed out via debt socialisation. Debt restructuring in the Eurozone would typically come with onerous conditions for borrowers, whereas excess inflation provides an easy windfall to all debtors. Thus, moral hazard for creditors and for debtors is attenuated.
- Debt restructuring puts a much larger fraction of the financial burden on financial investors outside the Eurozone, whereas debt mutualisation bails out financial investors worldwide at the cost of Eurozone taxpayers.
- Given the extremely high concentration of financial wealth, losses in any sovereign default will fall mostly on wealthy investors (as bank shareholders or bond investors typically are). By contrast, when debt is mutualised, middle-class taxpayers, the main source of tax revenues in the Eurozone countries, will have to bear a much larger fraction of the burden (Hau 2011).
- Bailout schemes, as in the case of Greece, Portugal, Ireland, and soon Spain, come with politically sensitive external monitoring over an extended period of time. Orderly sovereign default in the Eurozone is likely to be linked to external conditions as well, but by reducing the transfers from over-indebted countries to their creditors, it removes one of the most poisonous elements of this process.
A sovereign debt writedown would hit undercapitalised banks. Many Spanish and Greek banks already operate with negative equity if their balance sheet is valued at current market prices. Spanish banks held €160 billion or 31.7% of all outstanding Spanish government bonds as of June 2012, a dramatic increase from 13.1% a year earlier. A speedy bank recapitalisation is needed, after forcing losses on shareholders and bank bondholders; it is here that the ESM can put its resources to best use.
In most Eurozone countries, national bank regulators have failed to impose sufficiently high capital requirements. Regulatory capture in bank supervision is primarily a political economy problem. Dysfunctional national bank regulators thus hinder Europe's financial stability. One can only hope that centralisation of bank supervision in the forthcoming euro-wide banking union will improve matters. The financial tools for stabilising banks undoubtedly exist; like suspending all dividend payments, forcing equity issuance, and converting debt into equity.
There is much fear mongering about contagion in the banking sector and financial markets following a European sovereign default. The Greek example has shown the opposite. As far as banks are concerned, these fears appear exaggerated given the currently low levels of interbank exposure. The main risk for foreign banks is the write-offs from their sovereign bond holdings; but few foreign banks would be threatened by insolvency according to the last bank-level data available from EBA for 2011, and many banks have reduced their foreign bond holdings further since December 2011. Similarly, the volume of credit default swaps on southern European sovereigns is practically negligible – for the five GIIPS countries the volume of outstanding CDS contracts (net notional) has seen a steady fall from a combined €66 billion in January 2010 to €42 billion in August 2012, less than 1.5% of their combined government debt; it has fallen in each of the five countries. In all default episodes of five years of financial crisis, financial markets have proven their resilience, with the exception of September 2008 when there was no advanced warning and market participants had no time to adjust their exposures.
Political outlook: The ECB should stop digging its own grave
Is orderly default likely to happen? To be useful, it must come 'early': that is, before default risk is largely transferred to the ESM or the ECB. We fear that the chances of this happening are slim. The key actor is the ECB. It has unprecedented power to pull the plug on any financial institution or put pressure on a sovereign by refusing to accept its debt as collateral (Whelan 2012). Unfortunately, the previous ECB executive board, headed by Trichet, has tried its best to slow Greek sovereign default. The effect was only that financial investors reduced their losses to the detriment of Eurozone taxpayers. The current ECB board and national governments have shown little sign that they are more open to sovereign default. Not having learned their lesson from Greece, policymakers will insist that the next case of sovereign distress is different.
The latest push for selective purchases of bonds issued by Spain and Italy poses the greatest threat to the Eurozone so far. In the long run, the euro cannot survive without political support and legitimacy among voters. Finding voter support for fiscal and political union will be even harder. The political backlash from voters in northern Eurozone countries could be devastating when the costs of sovereign default eventually fall on a toxic ECB balance sheet. By forestalling timely sovereign default, the ECB is digging the euro's grave.
Borensztein, E and U Panizza (2009), “The Costs of Sovereign Default”, IMF Staff Papers, 56:683-741.
Borensztein, E and U Panizza, “What will happen if Greece defaults”, VoxEU.org, 6 May.
Buchheit, L and J Pam (2004), “Uruguay's Innovation”, Journal of International Banking Law and Regulation, 19(1).
Hau, H (2011), “Europe's €200 billion reverse wealth tax explained”, VoxEU.org, 27 July.
Landon, T (2012), “An Architect of a Deal Sees Greece as a Model”, The New York Times, Global Business, 6 March.
Reinhart and Rogoff (2010), “Growth in a Time of Debt”, American Economic Review, 100(2):573-578.
Whelan, Karl (2012), “The Secret Tool Draghi Uses to Run Europe”, Forbes.com, 22 July.