The real question is the extent of collateral damage that a Euroarea-member’s default – in the form of debt restructuring – would cause, in view of the interdependence between banks and “sovereigns” both within countries at risk and across the entire area.
Yet on 24 February 2011 no fewer than 189 German economists [1]signed a letter, published in Frankfurter Allgemeine Zeitung, in which they expressed an exceptional degree of consensus. They “called on the German government to refuse any extension of the EFSF [European Financial Stability Facility], and to force highly indebted countries into an insolvency procedure. They include some of the best known German economists – Hans Werner Sinn, Jürgen von Hagen, Manfred Neumann, Michael Burda and Volker Wieland.” (Eurointelligence.com, 25 February). What is the collective noun for economists? A pride, or a flock, or a swarm? A basket, a case, a basket-case? Let’s call them an assumption of economists, to cover such an uncommon coincidence of views.
The unusually firm (single-handed) recommendation by the 189 German economists is based on the following six points:
“1. A permanent credit guarantee for insolvent countries would provide massive incentives to repeat the mistakes of the past. The reforms of the stability pact, and the newly discussed Pact for Competitiveness, are too weak to counteract this;
2. A long-term strategy against debt crises requires the possibility of a sovereign insolvency;
3. Credits to countries should be possible, but only after debt restructuring;
4. The fact of state insolvency should be determined not by the country itself, but by an international institution, such as the IMF;
5. The ECB must not provide unlimited support of insolvent countries through bond purchases;
6. Of the three solutions to a national debt crisis – debt reduction through growth, insolvency, and bailout – the latter would imply higher taxes, and/or higher inflation.”
“Holger Stelzner [2], the openly anti-European editorialist of Frankfurter Allgemeine Zeitung, writes that the eurozone is drowning in its debt, which has turned the ECB into a bad bank. The approach of policy makers everywhere is to solve a debt crisis through more debt. The increase in the ECB’s balance sheet from €900bn to €1800bn of mostly low quality debt was immensely risky. The ECB is no longer an independent institution, but an interested party.” (Eurointelligence.com, Ibidem).
Since its publication the letter has been criticized in the financial press, mostly for some inaccuracies – such as the failure to recognize that the lending capacity of the EFSF is much lower than its nominal €440 mn due to the need to over-collateralize its bonds in order to obtain an AAA credit rating in spite of the less-than-AAA-rating of several of its guarantors (Wolfgang Munchau in FT Deutschland, Eurointelligence.com, 2-3-2011, who also criticizes their failure to take into account the externalities associated with various alternative options, such as debt restructuring).
Nevertheless, it is exceedingly difficult to take issue with the substance of the arguments put forward by the 189, other than by conjuring up the unlikely and implausible prospects of Euro-area dis-integration, of a split into a Nordic strong-euro-area and a Southern weak-euro-area, or worse, the prospect of Greece going back to the drachma and Germany restoring the DM. The real question is the extent of collateral damage that a Euroarea-member’s default – in the form of debt restructuring – would cause, in view of the interdependence between banks and “sovereigns” both within countries at risk and across the entire area.
As it happens, a reasoned answer to this question has been provided recently by a Policy Brief (2011/02) [3]of the Bruegel Think-tank, “A comprehensive approach to the euro-area debt crisis” by Zsolt Darvas, Jean Pisany-Ferry and André Sapir. They note the ineffectiveness of measures taken to date to tackle the euro crisis, seeing that sovereign debt spreads are higher today than they were in April 2010 in spite of EFSF, and the EU European Financial Stability Mechanism, the ECB debt purchase programme, on top of national austerity and structural reform programmes.
European policies have been insufficient, Darvas et al. say, because 1) they have failed to recognize the possibility of insolvency, treating crises as pure liquidity crises; 2) they have failed to address systemically the interdependence between sovereign and banking crises, and cross-country interdependence; 3) they have been re-active rather than proactive, squandering their credibility in partial, inadequate and belated responses. Their recommendations include a plan to restore banking-sector soundness; promoting budgetary consolidation and competitiveness through domestic reforms in peripheral countries; revising EU assistance facilities and – hear, hear – the restructuring of public debt where needed.
The Bruegel paper provides a detailed analysis of alternative scenarios in the “high-spread” countries (usually euphemistically labelled “peripheral”, or aggressively PIGS – where I stands for Ireland; Italy for once flies, or rather crawls, low enough not to appear on the radar screens). The starting point in Greece is a debt/GDP ratio scheduled to reach 150 % in 2011, mostly due to the mismanagement of public finances, and poised to continue rising in subsequent years. By contrast, in Spain and Ireland, “a major reason for solvency concerns arises from the public finance consequences of private-sector debt accumulation, not least because of the cost of rescuing insolvent banks. Furthermore, public debt levels in these two countries and in Portugal are more manageable (with levels in 2011 remaining below 70, 90 and 110 % of GDP”).
Alternatives hypothesis are considered involving growth and interest rates, in order to evaluate fiscal sustainability in the four countries. In 2010 primary balances were -3.7% in Greece, -9.6% in Ireland (excluding bank support), -4.4% in Portugal and -7.3% in Spain. Their evolution to 2014 is taken from EU and IMF programmes and reports; on these assumptions the persistent primary balance needed from 2015 onwards is calculated, in order to (a) stabilise the debt/GDP ratio at its 2015 level, (b) reduce the debt/GDP ratio from its simulated 2014 level to 60 percent of GDP (the Maastricht criterion) by 2034. Consensus Economics forecasts of nominal GDP growth and an optimistic evolution of market interest rates (in the case of Greece, a reduction of spreads vis‐a‐vis Germany from 970 basis points today to 350 in 2014) provide the optimistic baseline, set against a more cautious alternative.(See Figure below; detailed calculations are provided in Zsolt Darvas, Christophe Gouardo, Jean Pisani-Ferry and André Sapir, “A Comprehensive Approach to the Euro-Area, Bruegel, forthcoming 2011).
[4]
The stabilised levels of debts in the case of the adjustment indicated by the blue part of the bars are: 160% in Greece, 123% in Ireland, 98% in Portugal and 84% in Spain. “The adjustment needs are of frightening magnitude, not only in Greece but also in Ireland. This is even truer under more cautious assumptions for growth and interest rates”.
“Even under the optimistic scenario, the primary surplus required to reduce the debt ratio to 60 per cent of GDP in twenty years would be 8.4 per cent of GDP. It would reach 14.5 per cent of GDP under the cautious scenario. This would imply devoting between one/fifth and one/third of tax revenues to interest payments on the public debt. Over the last 50 years, no country in the OECD (except Norway, thanks to oil surpluses) has ever sustained a primary surplus above 6 per cent of GDP. Even less ambitious targets would require politically unrealistic surpluses”.
The paper thus argues that Greece is insolvent, inevitably heading for default. “The various “soft options” (lowering of interest rate on EFSF, extension of maturity of EU/IMF loans, debt buybacks) might prove useful for other periphery countries, but are not enough for Greece.” They provide a simplified map of interdependence between banks and sovereigns in the periphery countries, and between periphery banks and those in the rest of the euro area. On that basis they can evaluate the spillover effects of debt restructuring, which in the case of Greece would be limited and manageable (the real threat coming from Irish and Spanish banks). Their conclusion is that a 30% haircut on Greek debt, in top of the “soft options” might prove a viable exit.
Markets have been expecting a “grand bargain” to be agreed and unveiled at the Eurozone March summit, resolving the sovereign debt crisis once and for all. The toughening of the German position now makes it unlikely. The hard facts of likely insolvency, if faced in earnest instead of denied against all evidence, might provide a springboard for a new approach. As Barry Eichengreen declared to Der Spiegel on 2 March, it is necessary “That at their summit in March, the member states face up to some unpleasant truths. Plan A has failed. Now they have to switch to Plan B. They must stop attempting to combat the crisis in Greece and Ireland by forcing these countries to pile more debt onto their existing debts by saddling them with overpriced loans.”… ”The present bailout attempts have never made sense. Essentially, all Germany and France want to achieve with these measures is to protect their own banks from collapsing. Now people are beginning to realize that there is no way around rescheduling Greece's debt - and that will also involve the banks. For this to happen, there is only one solution: Europe needs to strengthen its banks! Greece lived beyond its means, but in Ireland and Spain it is the banks that are the problem. The euro crisis is first and foremost a banking crisis.”