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The Euro Zone's Journey to Defaults

A story is told of a man sentenced by his king to death. The latter tells him that he can keep his life if he teaches the monarch's horse to talk within a year. The condemned man agrees. Asked why he did so, he answers that anything might happen: the king might die; he might die; and the horse might learn to talk.

European Central Bank
European Central Bank

This has been the eurozone's approach to the fiscal crises that have engulfed Greece, Ireland and Portugal, and threaten other member states. Policymakers have decided to play for time in the hope that the countries in difficulty will restore their creditworthiness. So far, this effort has failed: the cost of borrowing has risen, not fallen (see chart). In the case of Greece, the first of the countries to receive help, the chances of renewed access to private lending on terms that the country can afford are negligible. But postponing the day of reckoning will not make the Greek predicament better: on the contrary, it will merely make the debt restructuring more painful when it comes.

Greek debt is on a path to exceed 160 percent of gross domestic product. Unfortunately, it could easily be far higher, as a paper from Nouriel Roubini and associates at Roubini Global Economics notes. Greece may fail to meet its fiscal targets, because of the malign impact of fiscal tightening on the economy or because of resistance to agreed measures. The real depreciation needed to restore competitiveness would also raise the ratio of debt to GDP, while a failure to achieve such a depreciation may well curtail the needed return to growth. The euro may appreciate, further undermining competitiveness. Finally, banks may well fail to support the economy.

Given such a debt burden, what are the chances that a country with Greece's history would be able to finance its debt in the market on terms consistent with a decline in the debt burden?

Extremely small.

Assume that interest rates on Greek long-term debt were 6 percent, instead of today's 16 percent. Assume, too, that nominal GDP grows at 4 percent. These, note, are highly optimistic assumptions. Then, even to stabilize debt, the government must run a primary surplus (before interest payments) of 3.2 percent of GDP. If Greek debt is to fall to the Maastricht treaty limit of 60 percent of GDP by 2040, the country would need a primary surplus of 6 percent of GDP. Every year, then, the Greek people would need to be cajoled and coerced into paying far more in taxes than they receive in government spending.

What might persuade investors that this is sufficiently likely to justify funding Greece? Nothing I can imagine. But remember that 6 percent would be a spread of less than 3 percentage points over German bunds. The default risk does not need to be very high to make this extremely unappealing.

In short, Greece is in a Catch 22: creditors know it lacks the credibility to borrow at rates of interest it can afford. It will remain dependent on ever greater quantities of official financing. However that creates an even deeper trap.

Assume, for example, that half of Greek debt were to be held by senior creditors, such as the International Monetary Fund and the European stability mechanism, which is to replace the current European financial stabilisation mechanism in 2013. Suppose, too, that the reduction in debt needed to secure lending from private markets, on bearable terms, were to be 50 percent of face value. Then private creditors would be wiped out. Under such a dire threat, no sane lender would consider offering money on bearable terms. A take-over of Greek debt by official funders makes return to private finance even more unlikely.

If one takes seriously the view that any debt restructuring must be ruled out, advanced by Lorenzo Bini Smaghi, an influential Italian member of the board of the European Central Bank, official sources must finance Greece indefinitely. Moreover, they must be willing to do so on terms sufficiently generous to make a long-term reduction in the debt burden feasible. That is possible. But it is a political nightmare: the moral hazard involved would be enormous. Greece would lose almost all sovereignty indefinitely and resentments would reach boiling point on both sides. Non-European members would also prevent the IMF from offering such indefinite largesse. The burden would then fall on the Europeans. It seems unlikely that needed agreement would be sustained.

The alternative is a pre-emptive restructuring of the debt, perhaps next year. Since market prices tell us that this is what investors expect, it should not come as a shock to them. A restructuring ought to raise the country's creditworthiness and increase the incentives to sustain a programme of stabilization and reform. Moreover, with a planned, pre-emptive restructuring the authorities could also prepare the needed support for banks, both inside Greece and outside it.

Many ways of restructuring debt exist, some more coercive than others. Fortunately, 95 percent of Greek public debt is issued under domestic law, which should reduce the legal problems of enforcing the desired deep restructuring.

Needless to say, this would still be a big mess. Moreover, there is no certainty that a restructuring would return Greece to growth, since the country also suffers from a lack of competitiveness. Inside the euro zone, no simple way of resolving the latter weakness exists. The country may be doomed to prolonged deflation.

However unpopular restructuring might be, the alternative would be worse. The debt would then need to be financed indefinitely. This, then, would be a backdoor route into a fiscal support mechanism for members far more extreme than that for the states of the US. The saga is most unlikely to end with Greece. Other peripheral countries - Ireland and Portugal, for example - are also likely to find themselves locked out of private markets for a long time. In neither case is a return to fiscal health in any way guaranteed, given the extremely difficult starting points.

Overindebted countries with their own currencies inflate. But countries that borrow in foreign currencies default. By joining the euro zone, members have moved from the former state to the latter. If restructuring is ruled out, members must both finance and police one another. More precisely, the bigger and the stronger will finance and police the smaller and the weaker. Worse, they will have to go on doing so until all these horses can talk.

Is that the future they want?

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