By Peter Boone and Simon Johnson
Uncertainty about potential loan losses in Europe continues to roil markets around the world. For many investors, taxpayers, and ordinary citizens there is no clarity on the exact current situation – let alone a stable view about what could happen next. What should any friends of Europe — the US, G20, IMF, perhaps even China — strongly suggest that they do?
A good start would involve being honest on four points. There is nothing pleasant about the truth in such crisis situations, but continued denial increasingly becomes dangerous to all involved.
Greece is on the front burner. Currently on offer is a debt swap for private sector lenders that, once it goes through, will effectively guarantee 33 cents for every 1 euro in bonds that they currently hold. The downside protection here is attractive to banks – made possible by the fact they will now get hard collateral in the restructured deal (meaning that Greece buys the bonds of safe EU countries, like Germany, and holds these where creditors could get at them).
The first brutal truth is that this is a default by Greece and all attempts to deny this or use another word just muddy the waters.
Greece can probably afford to service debt restructured to this level – although that will depend also on the final terms of EU and IMF funding. But the second truth is that this is a wasted opportunity for Greece. It does not put their debt problems behind them and, most likely, they will be back to ask for further reductions in principal in the future.
The ice has been broken: The EU has agreed that a euro area member can default. Greece should now go all the way – aiming to end up with new bonds that have a 3 year grace period on interest and 10 year grace period on principal.
The third truth – and most difficult for many to stomach – is that, in the context of any such deeper debt restructuring, the Greeks should cut public sector wages across the board and bring down other spending to make their budget deficit much smaller immediately. They and the IMF need to assume another recession in 2012 and no growth for five years. They should aim to balance the primary budget on a cash basis in 2012 (since there would be no interest due, this would also mean they need no cash from any kind of lender). In this scenario, they could collateralize the new bonds with state property.
There is nothing particularly fair or at all just about this set of outcomes. Everyone in Greece is hurt now by the consequences of excessive spending, big deficits, and reckless lending (to the government) in the past.
The issue is: What are the alternatives? If it adopts some version of this deeper debt restructuring approach, Greece can stay in the euro zone and find its way back to growth (assuming the world economy does not go down again sharply). Its private sector will eventually rebound.
In contrast, if Greece were to leave the euro zone, its financial system would cease to operate – at present Greek banks depend to a great extent on support from the European Central Bank (for more background and the available numbers, see our recent Peterson Institute policy brief, Europe on the Brink; http://www.iie.com/publications/pb/pb11-13.pdf). Do not try to run any modern economy on a purely cash basis; the further fall in GDP would be enormous.
And if Greece pays its debts at the currently proposed level (33 cents in the euro), it will struggle to grow. The tax revenue needed to service that debt would burden businesses and households for decades – enterprising and productive people will move their fortunes and their futures elsewhere in the euro area or to the United States.
The fourth and most dangerous truth is that Italy and Germany are not ready for the next stage of the euro crisis.
Any further adverse developments in Greece will precipitate a run on Italy – involving investors selling Italian government debt. The European Central Bank is currently prepared to buy Italian bonds, to keep down interest rates below 6 percent.
The Germans are obviously very worried by this approach – hence the resignation last week of Jurgen Stark, who was the senior German representative in ECB management. He has been replaced by someone who is likely to take an even tougher line on bond buying.
Aside from the politics, the risk is that the euro loses credibility and falls steeply in value. The ECB thinks it can “sterilize” any bond buying by also selling its own bonds into the market – this would mean no net increase in the supply of money (just fewer Italian bonds and more ECB bonds being held by the private sector).
As a technical matter and in the short-term, the ECB may be right. But the ECB is taking on a lot of credit risk – if a big country defaults, the ECB would need to ask member governments to provide it with more capital and this is the kind of transparent fiscal hit that politicians hate.
And if ECB funding seems really unconditional, this just encourages countries not to be careful about their fiscal deficits. “Fiscal dominance” – meaning a central bank always buys up government bonds to keep interest rates down – is a recipe for big inflation.
Expect a great deal of shouting behind the scenes at the highest level in Frankfurt (ECB headquarters) and in European capitals. Instability seems unavoidable. Significant inflation may also follow – although first we will see serious recessions in the troubled European periphery, a ratcheting up of bond buying, and repeated political crises.
An edited version of this post appeared on the NYT.com’s Economix blog. It is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.