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The Debt Problems of the European Periphery
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By Anders Åslund, Peter Boone and Simon Johnson

Last week’s renewed anxiety over bond market collapse in Europe’s
periphery should come as no surprise. Greece’s EU/IMF program heaps
more public debt onto a nation that is already insolvent, and Ireland
is now on the same track. Despite massive fiscal cuts and several
years of deep recession Greece and Ireland will accumulate 150% of GNP
in debt by 2014. A new road is necessary: The burden of financial
failure should be shared with the culprits and not only born by the
victims.

The fundamental flaw in these programs is the morally dubious decision
to bail out the bank creditors while foisting the burden of adjustment
on taxpayers. Especially the Irish government has, for no good
reason, nationalized the debts of its failing private banks, passing
on the burden to its increasingly poor citizens. On the donor side,
German and French taxpayers are angry at the thought of having to pay
for the bonanza of Irish banks and their irresponsible creditors.

Such lopsided burden-sharing is rightly angering both donors and
recipients. Rising public resentment is testing German and French
willingness to promise more taxpayer funds. German Chancellor Angela
Merkel’s hasty and ill thought out plan to demand private sector
burden sharing, but only “after mid-2013”, marks a first response to
these popular demands. We should expect more.

Financial crises are actually not rare, and the rules for their
resolution are clear. The fundamental insight is that huge amounts of
financial losses, of seemingly real value, need to be distributed
across creditors, debtors, equity holders and taxpayers. The first
step is to bring the current budget deficit under control to achieve a
primary balance, which both Greece and Ireland are now attempting. The
second is to attract sufficient emergency funding, which the IMF and
the EU essentially have done. But in neither Greece nor Ireland is
that sufficient. They still have unaffordable debt burdens.
Therefore, one more measure is needed, namely a reduction of the
public debt.

The public debt can be contained in two ways. The first and preferable
option is that the state never nationalizes private bank debt as
Ireland has done. For Ireland, this opportunity has probably passed,
but other countries should be warned not to make the same mistake.
Kazakhstan’s refusal last year to bail out its major banks, despite
strong demands from the senior creditors of these banks, has proved a
far more successful path. Banks can and should go under if they have
failed. The state should only defend small and medium-sized depositors.

If the state has taken on too large debt, sovereign default is the
natural outcome. In their excellent book This Time Is Different,
Carmen Reinhardt and Kenneth Rogoff argue that 90 percent of GDP is
the highest sustainable level of public debt for a developed country.
This limit is not absolute, but there is little reason to believe that
Greece and Ireland would belong to the exceptions. As Germany and
France so sensibly, though perhaps not very cautiously, have argued in
public, the EU needs a facility for sovereign debt default.

Sovereign defaults are always contentious, but they don’t need to end
in catastrophic financial collapse. This is especially so in Europe,
as Lee Buchheit and Mitu Gulati have argued in a well-read paper on
“How to Restructure Greek Debt,” because over 90% of these debts are
issued under domestic law. Troubled nations, as part of their rescue
plans, can and should introduce legislation that permits a qualified
majority of creditors to change terms on outstanding sovereign and
bank debt, while protecting bank deposits. Such rules could, for
example, require 2/3 of non-protected creditors agree to a
restructuring plan. This reduces the risk that holdouts can prevent a
deal from being reached, but still gives creditors clear powers to
negotiate terms.

Well-planned debt restructuring will not cause a systemic financial
collapse. It is misleading to draw parallels from the chaotic
liquidation of Lehman Brothers for the outcome of debt relief in
Europe. The direct impact of debt relief for Greece, Ireland and
others is easily measured and managed. The debtors and creditors are
well known.

If Greece’s reform program included a write-down of 50% (in net
present value) on its debts, and they received an additional 20% of
GDP in bridge financing over the next three years, its debt burden in
2013 would be a comfortable 80% of GDP. As Greek debt already trades
below face value, the total additional losses to creditors could
amount to 35% of debt, or approximately 100bn euros. Ireland is
smaller so total costs should be less. This debt relief could be
conditional on successful implementation of IMF monitored programs,
similar to traditional Paris Club debt restructurings. Fears that
debt relief could spark panic selling and contagion in other debt
markets can be arrested through temporary interventions by the ECB,
and the EU needs to publicly declare strict criteria when debt
restructuring may occur.

Opponents to debt relief for Greece and Ireland are wrong to think
that Europe’s current strategy makes Europe safe from systemic
collapse. The implied risk of default on Spanish, Italian and
Portuguese debt rose sharply during the last month as concerns over
Ireland and Greece spread, and this in turn caused yields on related
bank debts to soar. The potential economic time bombs left in
Europe’s periphery are growing. They can and must be resolved.
Otherwise the economic and political risks might become overwhelming.

Anders Åslund, Senior Fellow at the Peterson Institute for
International Economics; Peter Boone, associate at the Center for
Economic Performance, London School of Economics and principal, Salute
Capital Management; Simon Johnson, Senior Fellow at the Peterson
Institute for International Economics and Professor MIT Sloan.