Europe’s Inevitable Haircut

by Barry Eichengreen

Barry Eichengreen is Professor of Economics at the University of California, Berkeley.

BERKELEY- What once could be dismissed as simply a Greek crisis, or simply a Greek and Irish crisis, is now clearly a eurozone crisis. Resolving that crisis is both easier and more difficult than is commonly supposed.

The economics is really quite simple. Greece has a budget problem. Ireland has a banking problem. Portugal has a private-debt problem. Spain has a combination of all three. But, while the specifics differ, the implications are the same: all must now endure excruciatingly painful spending cuts.

The standard way to buffer the effects of austerity is to marry domestic cuts to devaluation of the currency. Devaluation renders exports more competitive, thus substituting external demand for the domestic demand that is being compressed.

But, since none of these countries has a national currency to devalue, they must substitute internal devaluation for external devaluation. They have to cut wages, pensions, and other costs in order to achieve the same gain in competitiveness needed to substitute external demand for internal demand.

The crisis countries have, in fact, shown remarkable resolve in implementing painful cuts. But one economic variable has not adjusted with the others: public and private debt. The value of inherited government debts remains intact, and, aside from a handful of obligations to so-called junior creditors, bank debts also remain untouched.

This simple fact creates a fundamental contradiction for the internal devaluation strategy: 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.

Policymakers are understandably reluctant to go down this road. Contracts are sacrosanct. Governments fear that they will lose credibility with financial markets. Where their obligations are held by foreigners, and by foreign banks in particular, writing them down may only destabilize other countries.

These are reasonable objections, but they should not be allowed to lead to unreasonable conclusions. The alternatives on offer are internal and external devaluation. European leaders must choose which one it will be. They are united in ruling out external devaluation. But internal devaluation requires debt restructuring. To deny this is both unreasonable and illogical.

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. But there are three prerequisites for success.

First, bondholders will need to be reassured that their new bonds are secure. Someone has to guarantee that they are adequately collateralized. When Latin American debt was restructured in the 1980's under the Brady Plan, these "sweeteners" were provided by the United States Treasury. This time around, the International Monetary Fund and the German government should fill that role.

Second, countries must move together. Otherwise, one country's restructuring will heighten expectations that others will follow, giving rise to contagion.

Finally, banks that take losses as a result of these restructurings will need to have their balance sheets reinforced. The banks need real stress tests, not the official confidence game carried out earlier this year. Where realistic debt-restructuring scenarios indicate capital shortfalls, across-the-board conversion of bank debt into equity will be necessary. And where this does not suffice, banks will need immediate capital injections by their governments.

Again, making this work requires European countries to move together. And, with banks' balance sheets having been strengthened, it will be possible to restructure mortgage debts, bank debts, and other private-sector debts without destabilizing financial systems.

Now we get to the hard part. All of this requires leadership. German leaders must acknowledge that their country's banks are dangerously exposed to the debts of the eurozone periphery. They must convince their constituents that using public money to provide sweeteners for debt restructuring and to recapitalize the banks is essential to the internal devaluation strategy that they insist their neighbors follow.

In short, Europe's leaders - and German leaders above all - must make the case that the alternative is too dire to contemplate. Because it is.


Copyright: Project Syndicate, 2010.
www.project-syndicate.org
For a podcast of this commentary in English, please use this link:
http://media.blubrry.com/ps/media.libsyn.com/media/ps/eichengreen25.mp3

 


This article is brought to you by Project Syndicate that is a not for profit organization.

Project Syndicate brings original, engaging, and thought-provoking commentaries by esteemed leaders and thinkers from around the world to readers everywhere. By offering incisive perspectives on our changing world from those who are shaping its economics, politics, science, and culture, Project Syndicate has created an unrivalled venue for informed public debate. Please see: www.project-syndicate.org.

Should you want to support Project Syndicate you can do it by using the PayPal icon below. Your donation is paid to Project Syndicate in full after PayPal has deducted its transaction fee. Facts & Arts neither receives information about your donation nor a commission.

 

 

Browse articles by author

More Current Affairs

Added 22.06.2018
It is now clear that the twenty-first century is ushering in a new world order. As uncertainty and instability associated with that process spread around the globe, the West has responded with either timidity or nostalgia for older forms of nationalism that failed in the past and certainly will not work now. Even to the most inveterate optimist, the G7 summit in Quebec earlier this month was proof that the geopolitical West is breaking up and losing its global significance, and that the great destroyer of that American-created and American-led order is none other than the US president. To be sure, Donald Trump is more a symptom than a cause of the West’s disintegration. But he is accelerating the process dramatically.
Added 20.06.2018
Sessions quoted a line written by the apostle Paul to a small community of Christians living in Rome around 55AD to defend the Department of Justice’s approach. He said: "I would cite you to the Apostle Paul and his clear and wise command in Romans 13, to obey the laws of the government because God has ordained them for the purpose of order." Sessions used the Bible because one of the most vocal opponents of the crackdown on asylum cases has been the Catholic Church. It’s no surprise that Sessions appealed to Romans chapter 13 verse 1 in response: not only did he hope to undermine Catholic authority by using the Bible against them, he cited a statement so broad that one might use it to defend anything a government does, good or bad. Picture below St Paul writing his epistles, by Valentin de Boulogne, via Wikimedia Commons.
Added 19.06.2018
 

I find it exceptionally irritating when I hear liberals worry about whether Israel will be able to remain a "Jewish and Democratic State" if it retains control of occupied Palestinian lands.

Added 18.06.2018
Daniel Wagner: "My prediction Korean War will be formally ended, the peninsula will be denuclearised, and a lasting peace will be the result."
Added 14.06.2018
Extract: PiS [ the ruling Law and Justice party] has established the most significant addition to the Polish social safety net since 1989: the Family 500+ program. Launched in 2016, Family 500+ embodies the nationalism, traditional family values, and social consciousness that the PiS seeks to promote. The program pays families 500 złoty ($144) per month to provide care for a second or subsequent child...........The program has been enormously popular. Some 2.4 million families took advantage of it in the first two years. The benefit, equivalent to 40% of the minimum wage, has almost wiped out extreme poverty for children in Poland, reducing it by an estimated 70-80%........... Liberal pro-European politicians and policymakers are not convinced. They complain that such a generous family benefit will weaken work incentives and blow up the government budget. But initial evidence suggests that Family 500+ has actually increased economic activity. It has also reversed the post-communist decline in fertility, increased wages (particularly for women), and enabled families to buy school materials, take vacations, buy more clothes for their kids, and rely less on high-priced credit for basic household needs. And, thanks to rapid economic growth, the government deficit has steadily fallen, not grown.
Added 12.06.2018
The depths of hypocrisy of the Republican Party in supporting Trump’s meeting with the North Korean dictator in Singapore are hard to plumb. This is a party whose leading members adopted the Ostrich Foreign Policy Principle for decades. If you don’t like a country’s government or political and economic system, pretend it does not exist.
Added 12.06.2018
US Defense Secretary Jim Mattis has spoken out against China’s strategy of “intimidation and coercion” in the South China Sea, including the deployment of anti-ship missiles, surface-to-air missiles, and electronic jammers, and, more recently, the landing of nuclear-capable bomber aircraft at Woody Island. There are, Mattis warned, “consequences to China ignoring the international community.” But what consequences?
Added 12.06.2018
With a general election approaching in September, Swedish voters are being warned that now it’s their turn to be targeted by Russian interference in the democratic process. According to Sweden’s Civil Contingencies Agency (MSB), which is leading the country’s efforts to counter foreign-influence operations, such interference is very likely, and citizens should be on the lookout for disinformation and fake news.
Added 11.06.2018
Extract: "While the presidency has grown stronger over the years, during the Trump administration Congress has been timid and subordinate. That is because the leaders of the Republican Party – which controls both the House of Representatives and the Senate – are frightened of Trump’s base. They cannot afford to alienate the roughly 30-35% of Americans who passionately back him, ignore his personal transgressions, tolerate his degradation of the country’s civil discourse, favor his brutal treatment of immigrant families, and don’t mind that he is leaving the US almost friendless in the world."
Added 08.06.2018
Has North Korea’s ruler, Kim Jong-un, made a strategic decision to trade away his nuclear program, or is he just engaged in another round of deceptive diplomacy, pretending that he will denuclearize in exchange for material benefits for his impoverished country? This is, perhaps, the key question in the run-up to the summit between Kim and US President Donald Trump in Singapore on June 12. Until then, no one will know the answer, perhaps not even Kim himself.
Added 07.06.2018
Some analysts even project that, before long, Facebook will hold more data on its users than any government. Meanwhile, it makes a lot of money from this data. Its advertising revenues came up to around US$40 billion in 2017 (up 50% from 2016). With Google, it holds an 84% market share in online advertising.
Added 05.06.2018
Roseanne Barr is an American comedian whose fictional TV character of the same name is a working-class Trump supporter. For those who remember the show “All in the Family,” she might be usefully compared to Archie Bunker, the crude proletarian patriarch from Queens, New York. Barr’s show was swiftly canceled late last month by the television network ABC, not for anything her “character” said in her show, but for a tweet in which she described Valerie Jarrett, an African-American former adviser to Barack Obama, as the offspring of the Muslim Brotherhood and “Planet of the Apes.”
Added 04.06.2018
 

When Donald Trump was elected, I, like many others feared what his presidency might do to the country. A year and a half into his term in office, our concerns have been justified. 

Added 01.06.2018
Extract from the article: "While the West’s relative decline is almost inevitable, its economic dysfunction is not. Yet pessimism can be self-fulfilling. Why undertake difficult reforms if a dark future seems preordained? As a result, accepting and anxious pessimists tend to elect governments that duck difficult decisions (witness Germany’s grand coalition), while angry pessimists make matters worse (by voting for Donald Trump’s “America First” agenda or for Brexit, for example). It doesn’t have to be this way. As French President Emmanuel Macron has demonstrated, bold leaders can succeed with a message of hope, openness, and inclusion, and by promoting a vision of progress based on credible reforms."
Added 30.05.2018
It has been nearly two years since the United Kingdom narrowly voted in favor of leaving the European Union. As the march toward Brexit – formally set for the end of next March – proceeds, fundamental questions about the nature of the future UK-EU relationship remain unanswered. Instead, every time a tough decision must be made in the negotiations in Brussels, British ministers kick the can down the road, or even into the long grass. This is somewhat surprising. Apparently, none of the politicians and newspaper editors who plotted for years to get the UK out of the EU thought much about what would happen if their machinations succeeded.
Added 30.05.2018
Discussions are now underway to establish a system of joint deposit insurance for eurozone banks. Proponents of the scheme, with the European Commission and the European Central Bank (ECB) taking the lead, point out that deposit insurance would avert the danger of a run on banks in times of crisis. While this argument is true, critics emphasize the disparity in risks, owing to the high share of bad loans on the balance sheets of banks in some countries. To address this risk disparity and move ahead with the plan, balance sheets will need to be cleaned up before considering the next step. While the share of bad loans for banks in the stable eurozone countries is just 2%, the most recently published International Monetary Fund statistics, from last April, show a share of 11% for Ireland, 16% for Italy, 40% for Cyprus, and 46% for Greece.
Added 29.05.2018
Trump’s decision cannot be justified by any breach of the agreement on Iran’s part. It is, rather, a return to the old, largely unsuccessful US policy of confrontation with Iran. The only difference this time is that the Trump administration seems determined to go to the brink of war – or even beyond – to get its way. If the administration has any plans for keeping Iran’s nuclear program in check in the absence of the nuclear deal, then it is keeping them a secret. Judging by some of the administration’s rhetoric, it would appear that airstrikes against Iran’s nuclear facilities are on the table. But bombing would only delay Iran’s nuclear program, not stop it. Would Trump then consider a massive ground war to occupy the country and topple the regime? We know all too well how that strategy worked the last time it was tried.
Added 28.05.2018
US President Donald Trump’s abrupt decision to cancel his planned June 12 summit with Kim Jong-un represents a diplomatic coup for the North Korean leader, and an even bigger victory for China. In the space of just a few months, Kim’s image has gone from that of international pariah to that of thwarted peacemaker.
Added 23.05.2018
The good news is that the United States and China appear to have backed away from the precipice of a trade war. While vague in detail, a May 19 agreement defuses tension and commits to further negotiation. The bad news is that the framework of negotiations is flawed: A deal with any one country will do little to resolve America’s fundamental economic imbalances that have arisen in an interconnected world.
Added 21.05.2018
The cryptocurrency revolution, which started with bitcoin in 2009, claims to be inventing new kinds of money. There are now nearly 2,000 cryptocurrencies, and millions of people worldwide are excited by them. What accounts for this enthusiasm, which so far remains undampened by warnings that the revolution is a sham? One must bear in mind that attempts to reinvent money have a long history. As the sociologist Viviana Zelizer points out in her book The Social Meaning of Money: “Despite the commonsense idea that ‘a dollar is a dollar is a dollar,’ everywhere we look people are constantly creating different kinds of money.” Many of these innovations generate real excitement, at least for a while. As the medium of exchange throughout the world, money, in its various embodiments, is rich in mystique. We tend to measure people’s value by it. It sums things up like nothing else. And yet it may consist of nothing more than pieces of paper that just go round and round in circles of spending. So its value depends on belief and trust in those pieces of paper. One might call it faith.