European Affairs



Regarding a possible default by a eurozone member state, it is worth noting that this would not be the first time in modern history when only part of the state sector unit using the same currency is confronted with default. A notable example (from the other side of the Atlantic, as it happens) is New York City in 1975. President Gerald Ford at first refused a bail-out, an attitude characterized by a Manhattan tabloid with this headline: “Ford to City: Drop Dead”. Ultimately, both the federal government and the New York state government provided loans – and New York City survived, revived and prospered (albeit under strict budgetary supervision by the lenders) without permanent damage to the U.S. currency or the national economy.

In the eurozone today, the main candidate for a “default” is Greece. The prospect of Athens being forced into a “restructuring,” as it probably would be called, has been repeatedly ruled out by every official body in Europe. But the Greek fiscal squeeze-down to sustain the current debt level surpasses any reasonable limit to be sustainable, and the borrowing rates have risen to high levels suggesting that the markets have already priced in a default.

If a formal restructuring comes, it will certainly be messy and would carry costs for many parties. But it would not break up the eurozone. In fact, it might open the way to gains for Greece and therefore for its partners.

To understand this forecast, it is useful to recall what European policymakers have done and not (yet) done in response to the crisis.

The eurozone has implemented substantial reforms to its deficient governance system, so going forward, the improved coordination, cooperation and surveillance will help alleviate threats of a new (or renewed) crisis. Europe has set up its own “European Monetary Funds,” a term used here to cover the EFSF, EFSM and ESM -- acronyms that non-economists are unlikely to keep in their minds. The point about these funds is that they exist to provide lending to sovereign member states in need. Greece and Ireland have received sizeable loans from European partners and the International Monetary Fund, totaling €110 billion and €67.5 billion, respectively, and Portugal has just followed with a bail out request that will reportedly amount to €80 billion. Disbursement of these loans is conditional on the implementation of comprehensive economic programs aimed at ensuring fiscal consolidation, structural reform and support for the financial system.

The European Central Bank (ECB) has crossed the borderline between a monetary and a fiscal authority by implementing a controversial program to buy Greek, Irish and Portuguese government bonds, with a total current market value of about €77 billion. Even more importantly, as Irish and Greek banks became unable to borrow from other banks to compensate for their own melting deposits and assets, the ECB along with national central banks gave them a lifeline amounting to about €165 billion for Irish banks and €100 billion for Greek banks. Surprisingly, central banks, which emphasize transparency as a key principle for effective policy making, are withholding information Emergency Liquidity Assistance (ELA), which is lending granted by the national central bank on its own initiative and is not subject to ECB collateral requirements. These numbers are therefore estimates.

All these combined measures were not sufficient to stave off of the eurozone sovereign debt-crisis. Why weren’t they enough? There are three main reasons. First, EU responses have failed to recognize the possibility of insolvency: instead, they all treated the problem as a presumably temporary “liquidity shortage.” Second, they failed to address systemically the interdependence between banking and sovereign crises and the cross-country interdependence that ensues from banks in one country holding large amounts of what turns out to be “sub-prime” debt in another. Lastly, they have been reactive rather than proactive, squandering credibility because of inadequate initial and belated responses.

Taking the first issue, the reluctance to face up to the possibility of “national bankruptcy,” there is a fact of life in finance, practically as strict as a law of physics: if something is unsustainable, it will not be sustained. In principle, of course, any fiscal situation could be sustainable because governments have the right to raise taxes, reduce public expenditures and sell off state-owned assets. But these measures have economic, political and social limits. Markets also play a crucial role: they may charge too-high interest rates reflecting the borrower’s loss of credibility and thus, by their own actions, drive a possibly still-solvent country into insolvency. In practice, this means that the fiscal tightening required to restore equilibrium in Greece and sustain the current debt level is over any reasonable limit. So markets have denied funding. In that sense, a default can be said to be under way already.

(Ireland and Portugal are in a different situation, in my view: they face significant challenges, but it is possible to see a “reasonable” amount of adjustment that could put their public finances back on a sustainable path.)

In that sense, even New York City in the mid-seventies proved manageable with “reasonable” burdens: the lenders imposed a financial control board of the sort that accompanies defaults in countries such as Argentina. The board required deep cuts to services, a more transparent budget process and several years of budgetary oversight. With that system, the city eventually paid back the loans.

The Greek case is fundamentally different: debt is expected to reach about 160 percent of gross domestic product in a country with weak institutions, weak tax-collection capability, social unrest and a loss of confidence. So far, any proposal for a “default” or “debt restructuring” has been met with vehement denial from European and Greek policymakers and official IMF circles. (Recently, Der Spiegel magazine reported that the IMF is now demanding Greek debt restructuring, though this was denied by the IMF’s spokeswoman.)

One reason for the denial is political. It would be considered shameful for Europe to have a default in the eurozone. Even if this attitude is strongly held, we have seen economic necessity over-turning political will-power. In early 2010 eurozone policymakers harshly denied possible IMF involvement, only to call for it within months when it had to become part of the EU-led rescue package.

A second motive is fear about the domestic economic consequences of a default. A sovereign default would reduce the overall wealth of the country’s citizens since the value of their bond holding would be reduced, thereby lowering domestic demand as an engine of growth. In reality, a “restructuring” might not have that much additional impact now, since the market prices of Greek government bonds have already fallen substantially and reduced the value of Greek citizens’ holdings. A related risk involves the banking system: since the domestic banks are ultimately guaranteed by the state, a sovereign default might undermine trust in banks and lead to a run on the banks and a full-blown depression-style banking crisis – and that might lead to an economic crisis. This is a fair point and a real concern.  But the implicit response need not be an ostrich-like attitude of putting one’s head in the sand in order to see nothing. A better response might be to strengthen Greeks banks, perhaps by selling them to major European banking groups or by reorganizing them in other ways. And, of course, Greek banks and financial institutions should get continued ECB lending and perhaps even EU guarantees as part of any restructuring package.

A third principle reason for fear of default is the fear from contagion and spillovers to other eurozone countries. If Greece defaulted, markets could panic, denying funding for other weaker countries and pushing them into default, too. An attempt to pull off a “concerted default” by several peripheral countries at once could lead to a renewed banking crisis in core eurozone countries such as Germany and France since their banks are exposed by their loans to the governments (or to banks backed by their governments) in these peripheral eurozone sovereign member states.

Indeed, this is the most difficult risk to handle. But European policymakers could do a lot to reduce this risk. First and foremost, they should dispel the fog of doubt surrounding their banks by conducting proper stress tests and then by recapitalizing the banks that need it. (It is more complicated but possible to find a way of doing this for distressed cross-border banks.)  Second, they should assess eurozone nations’ fiscal sustainability more lucidly and draw a clear line between solvent and insolvent countries. All insolvent countries should face a restructuring. But all solvent countries should be provided with any needed liquidity.

What would a default/restructuring look like? For one thing, a very difficult legal issue would arise about the order in which debts are repaid. Currently, bilateral government loans to Greece do not enjoy formal seniority status. Yet it would be unthinkable to cut the repayment to EU members who helped with the “bail-out” of their sinking partner, especially since the IMF, which provided parallel loans, enjoys “senior creditor status” putting it at the head of the line to get repaid. This will be a challenge for creative lawyers to meet.

Private creditors are bound to find themselves in a messy situation with any national debt restructuring. There are no “bankruptcy procedures” for countries along the lines of provisions for corporations and individuals that cannot repay their debts. There will be litigations and uncertainties. The government will not be able to borrow from the markets for some time (it took several years for Russia, Argentina and other defaulting countries to get back credit ratings and credibility enabling them to resume selling bonds into the market.) As long as this “credit-worthiness” problem persists on the open market, official creditors such as the IMF and European partners would need to continue providing liquidity to the stricken country. If restructuring is managed well and the external support continues to be provided for the banking system in a country in default, it would soften the impact of the process on the overall economy.

In fact, restructuring could even accelerate economic growth. For one thing, restructuring could end the uncertainty that currently is hampering private investment and consumption in countries in the situation of Greece. The result could be a revival of private economic activity. Secondly, the end of uncertainty and speculation about the outlook for a country in Greece’s circumstances would bring a fall in the high borrowing-costs currently being charged for loans to the sovereign government and to private enterprises and individuals in the country. A revival of Greek economic growth would of course benefit the rest of the eurozone as well.

Restructuring is not a free lunch – far from it. It always has to be paid for in various ways. For example, if a country gives its creditors “ haircuts” by refusing to pay them back in full as part of the restructuring, it should also seek to ensure that they stand to benefit and even recoup some of their losses if the restructuring leads to an economic revival.  This can be done, for example, by offering bonds that are indexed to GDP and thus pay more if there is an upturn in economic growth. A country such as Greece, in a default, should also be prepared post collateral as a guarantee of repayment for any new debt instruments it uses. And, of course, restructuring would not dispense a government such as Greece from continuing its ambitious fiscal adjustment and structural reform programs and the reform (and possible privatization) of state-owned assets.

What about the impact of a default by a eurozone member on the eurozone as a dimension of European unity? It is frequently asserted and taken for granted that the eurozone would break up, at least partially, in the event of a sovereign default by one or more of its members.

I doubt it, for several reasons. Take the case of a hypothetical default by Greece followed by its departure from the eurozone. Returning to its national currency, Athens could be expected to let the drachma depreciate as a way of gaining competitiveness, boosting exports and drawing more tourism.  Those would be gains for the economy. But there would be very strong offsetting factors on the downside. Since the current liabilities of corporations and households are denominated in Euros, they would become increasingly expensive to pay off in depreciating drachma that were losing value against the euro. A worsening exchange rate could push much of the country’s private sector into bankruptcy and lead to extensive litigation against “bad debtors” in the country. That would stress the country’s banks – in this hypothetical case, Greek banks -- much more than the restructuring of the sovereign debt. It would constrain any bank lending for many years. As these “new” drachma depreciated, inflation would rise, and Greece’s central bank, with its credibility already in doubt, would be compelled to raise real  interest rates to very high levels. Economic history tells us that such a chaotic environment is bad for growth.

Stronger eurozone economies have no interest in leaving the eurozone either. Germany, for example, has a strong incentive to remain inside even a struggling eurozone: if it returned to the deutschmark, its national currency would promptly appreciate excessively, halting the German recovery. A complete break-up of the eurozone would hurt all the countries involved in ways of the sort outlined for Germany and for Greece.

Also at risk, of course, would be the political dimension of the euro as the high-water mark of the political and economic integration process of Europe.

Markets seem to have dismissed the risk of a eurozone collapse. The euro has been strong against the dollar, and continues to be very strong – well above the exchange rate reached in 2010 and especially above the historical lows of 2001. In 2001 one euro was worth less than one U.S. dollar while these days it costs more than $1.40.

Certainly, the eurozone has a lot of homework, including efforts to improve the integration and flexibility of its single market(s) for labor, goods and services. The eurozone needs to shore up its banking system.

And, obviously, it should be prepared for the eventuality of sovereign defaults.

Even if that materializes in the end, it should not mean the end of the eurozone itself.


Zsolt Darvas is a Research Fellow at Bruegel (Brussels European and Global Economic Laboratory)