European Union governments put up hundreds of billions of euros earlier this year to keep financially troubled members like Greece or Ireland from defaulting on their debts. Now Germany is pushing to let hopelessly indebted governments do exactly that — admit they can't pay and hit bond investors with the costs instead of taxpayers.
But Berlin may have a hard time winning approval for a crisis resolution mechanism when EU officials meet in Brussels on Thursday and Friday.
Chancellor Angela Merkel last week won backing from France for a way to let countries that use the euro go bankrupt in an orderly way that doesn't make financial markets panic or require costly bailouts that would be funded, German officials fear, largely by them.
France agreed to the proposal for a so-called permanent crisis resolution mechanism in exchange for Germany yielding to France's desire for more lenient rules for states that break the EU's debt and deficit limits.
German officials say they are stressing the importance this trade-off as they head for the summit, where the budget rules and the default procedure are on the table. Both rules and default procedure need to pass, they say.
Other governments are not only wary of changing EU treaties — a process that requires the backing of all 27 member states, sometimes by referendum. But it is also far from clear how such a mechanism would work in practice.
Merkel has come under pressure from taxpayers, who bridle at seeing their money put on the line to cover the excesses of less disciplined countries. Germany is the biggest contributor to the 110 billion euro emergency loan given to Greece, and to a 440 billion euro financial stability fund for the wider euro zone that would not be tapped unless needed.
Both those backstops are set to expire in 2013, when EU leaders will face tough choices. Either rich countries like Germany will continue bailing out their weaker neighbors, or borrowing costs for indebted countries will soar like they did earlier this year, analysts say.
By 2013, Greece's debt will likely stand at 150 percent of gross domestic product — an unsustainable level, many economists think.
"Germany can and will not give a simple extension" to the stability facility, Merkel said Wednesday. Instead, bond holders such as big banks and hedge funds should have to bear some of the costs of risky lending to a highly indebted country — either by rescheduling or accepting a so-called haircut, a reduction of the total sum they are owed.
But German officials have not said publicly what a permanent crisis resolution mechanism would look like, who would run it, and how it would be funded.
Economists working with developing countries have been struggling for decades to come up with a mechanism that would allow highly indebted countries to restructure their debts in an orderly fashion. But getting the myriad of private creditors — ranging from banks to hedge funds and international institutions — to agree on a deal without hurting the indebted government's future funding needs has been difficult.
In the euro zone, where countries are locked into a single currency, avoiding panic and contagion would be even more difficult.
"From my point of view there can be no such thing as an orderly default," says Marco Valli, chief euro zone economist at UniCredit. Once one eurozone country admits it can no longer pay, investors will rush to sell off their holdings in other indebted member states. "It's very easy to move from Greece to Portugal to Ireland," says Valli.
Others disagree. Thomas Mayer, the chief economist of Deutsche Bank, and Daniel Gros, director of the Brussels-based Centre for European Policy Studies, have proposed the creation of a European Monetary Fund to handle future debt crises.
Such a fund would first supply a country with emergency loans, based on strict requirements to cut down its spending.
But once it becomes clear that a country's debts have become unsustainable, the European Monetary fund would buy up its entire debt, at a maximum cost of 60 percent of the country's GDP. For creditors of a country with a debt load of 120 percent of GDP, that would mean a steep haircut of 50 percent.
The idea is that telling markets what the haircut will be would keep the defaulted bonds tradeable in secondary markets and prevent complete market chaos.
And the benefit to the creditors? "The only alternative for a private creditor would be a much bigger haircut," says Nicolaus Heinen, European economist at Deutsche Bank.
There's one key point in the European Monetary Fund proposal that states are unlikely to accept, says Kunibert Raffer, a professor of economics at the University of Vienna who has been researching orderly default mechanism for poor countries for more than two decades. In return for help, the fund would get to sign off on that country's spending decisions.
"This is very 19th-century," says Raffer. "Creditors would become the administrator of the debtor."
Instead, he proposes a mechanism modeled on bankruptcy regulations for municipalities in the U.S. These Chapter 9 bankruptcy rules, born in the Great Depression, make sure that creditor's restructuring conditions don't prevent a town or county from running essential services like schools or hospitals or giving up other fundamental political powers.
In contrast to the European Monetary Fund model, under Chapter 9 bankruptcy, the conditions for the debtor and creditors would be decided by an ad hoc arbitration panel, elected by all parties. The arbitration panel's decisions would be fairer and thus more likely to be acceptable to the indebted country and its creditors, says Raffer.