It's gut check time for Europe

by Jérémie Cohen-Setton on 30th April 2010

What’s at Stake: Instead of dealing with the eurozone's problems head on, European leaders have dodged, dilly-dallied, and obfuscated, apparently based on the delusional belief that Greece's debt crisis could be contained with no major reform to the Eurozone. Slapped by the invisible hand, European leaders raced on Thursday to complete their part of a long-delayed financial rescue package for Greece, hoping to head off a chain reaction against other heavily indebted European nations that could turn into a financial meltdown across the continent. Rumours that the package could be in the order of €100-120bn for three years have calmed down financial markets. The official announcement of the plan, including its details in terms of conditionality, is going to be one of the most important events in the 11-year history of Europe’s monetary union. By the end of it we will know whether the Greek fiscal crisis can be contained or whether it will metastasise to other parts of the eurozone.

Restructuring and Default

Daniel Gros argues that even the best adjustment program cannot be financed without some contribution by private creditors, i.e., some form of rescheduling. The only way out for Greece is thus to combine both elements: rescheduling its debt plus national agreements on wages and social expenditure. The current approach – concentrating only on the financing needs and fiscal adjustment in 2010, and leaving all the hard choices for later – will not work.

Mohamed El Erian argues that the Greek crisis has reached a level that now goes beyond fiscal sustainability as the stress morphs into a banking sector crisis endangering the entire private sector. He therefore concludes that unless rapid resolution is found, private sector involvement (PSI), that is restructuring will become inevitable.

Martin Feldstein, the historic euro sceptic, disagrees with the conventional view that there cannot be a default while still in the eurozone. Instead, Greece will default precisely because of its membership to the eurozone which prevents it from an orderly adjustment via the exchange rate.

Those restructurings have been discussed extensively but the best pieces of literature on the matter remain probably those of Federico Sturzenegger and Jeromin Zettelmeyer and Barry Eichengreen. An important lesson to keep in mind from previous episodes of debt restructuring/rescheduling is that the NPV losses of creditors are not always the mirror of NPV gains for the debtor.

Martin Wolf reviewing potential institutional change that could make the eurozone economic governance more effective reviews a number of options.  Interestingly, he suggests the recourse to an idea and a mechanism that Anne Krueger tried to promote while at the IMF: a sovereign debt restructuring mechanism (SDRM) that would provide a statutory framework for debt crises.

ECB nuclear option

Nick Rowe argues that the problem has become too big for the IMF, the EU or anyone to fix it without creating money. This can happen through the ECB but if it resists it, European governments will print their own money through the use of promissory notes (IOUs) to settle salaries and public sector arrears. Ambrose Evans-Pritchard and Jacques Cailloux make a similar point and argue that deadlocked European governments will ultimately force the ECB to respond. As the crisis moves from a sovereign one to a proper banking system one, it will make their case easier to push in the arcades of the ECB.

Jacob Funk Kirkegaard sketches the potential cost of a restructuring/default based on whether the default occurs if the bonds are owned by the banking system or by the ECB. His results suggest that the cost of default would be smaller for Germany if the bonds were held by the ECB given that their outright exposure through the banking system is larger (as a proportion of outstanding debt) than their paid up capital at the ECB (in relation to the overall capital of the ECB).

Reconsidering the euro breakup idea if bank runs happen anyway

Paul Krugman long though, based on Barry Eichengreen, that the idea of a euro breakup was a non-starter. Any move to leave the euro would require time and preparation, and during the transition period there would be devastating bank runs. But the Eichengreen argument is a reason not to plan on leaving the euro — but if the bank runs and financial crisis happen anyway the marginal cost of leaving falls dramatically, and in fact the decision may effectively be taken out of policymakers’ hands. Actually, Argentina’s departure from the convertibility law had some of that aspect. A deliberate decision to change the law would have triggered a banking crisis; but by 2001 a banking crisis was already in full swing, as were emergency restrictions on bank withdrawals. So the infeasible became feasible.

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