Dec 10th 2010

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.
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