A Brady Plan for the Southern Euro Zone: Choudhry
History is replete with strategists and policy planners who hoped that time would be on their side.
An appropriate term for this in many cases might have been "wishful thinking". An inability to appraise reality in an objective, logical fashion, has been a primary causal factor behind many spectacular failures, from Stalingrad to Saigon (failure for one side of course, the other side is usually an emphatic victor).
In the euro zone, there is no "other side" and there are no victors on the horizon, except possibly the long-suffering EU taxpayer.
The guiding principle of EU policy with regard to fiscal deficit problems in the southern euro zone has been one of wishful thinking: of hoping that the economies of the region and the stricken countries in particular would assume responsibility for the problem, thereby enabling government revenues to increase and start making budgets credible again.
In the meantime, investor sentiment has resolutely failed to improve.
From the crash to the start of the sovereign debt crisis and into 2011, EU policy makers have replaced "hope" with soothing words, bailout funds, and even bigger-sized bailout funds, yet markets have remained wary throughout.
The future is not looking rosy on any front.
The policy of no default, no change to euro membership and providing a bailout fund has not worked.
This is not a surprise when one considers that the level of debt in Greece and Ireland is such a high multiple of government receipts that there appears little likelihood that it can ever be repaid under current terms.
Rather than wait for the markets to force an outcome (which will happen once external investors stop buying even short-term T-bills, and which will be very messy), the EU is better off making a proactive decision to restructure and let markets digest that.
The idea of a "Brady plan" for the southern euro zone has been under discussion for some time, and has also found favour in parts of the academic community.
It involves pain for debtholders of the countries concerned, but arguably makes the wider fallout less extreme because it removes much of the current uncertainty.
Under the plan, one approach might be:
1. A percentage of existing debt is written off (say 30 percent), together with other restructuring measures, such as extension of maturities
2. The European Commission issues AAA-rated zero-coupon bonds to existing holders, to back the remaining debt, providing comfort that it will indeed be repaid (this is the "Brady" part, a method of proven efficacy)
3. The default is accompanied by the usual International Monetary Fund-style economic restructuring and privatization programs to bring the economies concerned onto a more sustainable basis.
In theory at least, these elements address the problem and a credible solution. They should also neutralize arguments about throwing certain countries out of the euro .
They will cause pain of course, principally amongst EU banks that hold sovereign debt from countries such as Greece, Ireland, Portugal and Spain, and banks that have sold protection on those sovereigns that do default (which triggers a payout on credit default swaps).
Such pain could create another banking crisis.
This is one reason that the European Central Bank has steadfastly refused to consider a debt default solution. But arguably at the aggregate level EU banks should be able to withstand these losses.
The EU-wide bank "stress tests" last year, another round of which is due to take place next month, suggest that the sector should withstand (say) a Greek default.
If there is no confidence in the stress test results, then that is an issue for reviewing in itself.
The alternative to proactive action could actually cause investors more worry.
Governments concerned about taxpayer reaction to more bailout payments may balk at any further support to the troubled southern euro zone, and if investors simply stop funding debt rollovers, the whole future of the euro comes into question.
Far better to adopt a plan that recognizes the extent of the problem, and presents a believable solution, rather than rely on wishful thinking and hope for future economic growth to come to one’s rescue.
Dr Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.