Here’s your Memorial Day assignment. You have been called to the table for top-level policy discussions in a large monetary union. One of the bigger countries in this union has a serious problem. Their exports are down slightly and there are some longer-run structural issues, but the immediate issue is (1) a housing bubble just burst, resulting in a big fall in tax revenue, (2) the political system seems paralysed, i.e., cannot raise other revenues or cut spending in any sensible fashion, and (3) the market for this government’s debt appears likely to turn very sour. Sounds like a classic fiscal crisis.
Here are your possible recommendations:
- Let them go bust. This is tempting, given the failure of the political class in this country to come to terms with its obvious problems. Also, this would presumably shake the rules of the system enough so they can finally raise revenue or cut spending sensibly. But this would also create dangers for other countries in your currency union, for example by increasing the risk premia on all debts. And a lot of poor people will get hit hard; you know that always happens in a free fall.
- Give them a big loan. This is, of course, what the political elite in this country would like – they are asking for money on easy terms, arguing that none of these current difficulties are really their fault. If you feel that at least some of their problems are temporary, a loan makes sense. But you’ll also want some conditions, meaning steps they should take to ensure you get paid back. If they don’t pay back (or can’t pay back for a long while), that creates costs for taxpayers in other (more fiscally responsible) parts of your union and what would be fair or politically sustainable about that? So what conditions do you want to impose negotiate towards?
- No conditions. You trust them and they are your friends. Hopefully, they will run things better in the future.
- Tell them to raise revenue and/or cut spending. They can decide; it is a sovereign country after all.
- Insist that they raise revenue. If doing so effectively is prevented by their constitution, they need to change the constitution.
- Tell them to cut spending any which way they can. This will hit the poor just like in the “go bust” scenario, but this way the country’s elite can blame you.
Underlying all this, of course, you have to take a view on the politics. What vested interests exactly have got them into this mess? Certainly, there was a big shock from circumstances outside their control, but this country’s policies were asking for trouble – any time you run a big housing boom, you are vulnerable to a dramatic slowdown (and loss of revenue). If you are going to lend money, don’t you want to feel that the loan will allow or even force the political equilibrium to shift ? Otherwise, won’t this country repeatedly run into the same kind of fiscal difficulties? This kind of fiscal crisis is always about powerful groups, but are we facing oligarchs or something else in this particular instance?
This missing option above, of course, is to give the country a loan at the same time as they restructure their debts, i.e., a form of debtor-in-possession bankruptcy financing. But the creditors to this country are also powerful at the level of the monetary union and perhaps in the more fiscally-responsible parts of that union – so count on these groups to oppose any debt write-downs. One argument they’ll use is that such restructuring will either trigger a panic or lead to higher borrowing costs for other member countries. So what are you going to do about that?
By Simon Johnson