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Martin FeldsteinJune 22, 2011

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Jump to response by Raoul Ruparel
EUROPE • EUROZONE • FINANCE • GLOBAL ECONOMY
Postponing Greece’s inevitable default
Even though the Greek parliament has given the government some
breathing space with its vote of confidence late on Tuesday, a default
by Greece is inevitable. With a debt to gross domestic product ratio
of more than 150 per cent, large annual deficits and interest rates
more than 25 per cent, the only question is when the default will
occur. The current negotiations are really about postponing the
inevitable default.

If Greece were the only insolvent European country, it would be best
if its default occurred now. Cutting its debt in half and replacing
the existing debt with low interest rate bonds would allow Greece to
service its debt without the excruciating pain that would be involved
if it tried to service its current debt.

But Greece is not alone in its insolvency and a default by Athens
could trigger defaults by Portugal, Ireland and possibly Spain. The
resulting losses would destroy large amounts of the capital of banks
and other creditors in Germany, France and other countries. There
would be a drying up of credit available to businesses throughout
Europe and there could be a collapse of major European banks.

This inevitable contagion and its potential consequences for the
European financial system is the reason the European Central Bank is
determined to avoid a default at this time. The challenge, therefore,
is to find a way to postpone the defaults long enough for the banks
and other creditors to withstand the write-downs of bond values if
Greece, Portugal and Ireland default simultaneously.

The process is complicated by the German government’s position that it
will support the extension of more official credit now only if the
existing private creditors participate. The ECB insists that the
private creditor participation must be “voluntary” so that no
technical default occurs.

The essential feature of any solution is therefore for the existing
bondholders to “voluntarily” agree to capitalise the interest that is
now due and to provide new multi-year loans at a below-market interest
rate to replace the bonds that are now maturing. That should satisfy
the German demand for participation of private lenders while meeting
the ECB’s requirement that any adjustment be voluntary so that no
default is deemed to occur.

But how to get the existing creditors to agree to these terms? If it
is not to be mandatory, it must be in each creditor’s interest to do
this. Three things might make this possible.

First, if a bank does not capitalise interest and provide a new loan,
the old loan will default, reducing the bank’s accounting capital and
its ability to lend. Banks and other creditors will want to avoid
that. Second, the ECB has indicated that restructured debt that is the
result of a default will not be eligible as collateral at the central
bank while new loans that are voluntarily made will be. And, third,
there will be peer pressure among banks and other creditors to
recognise that they all benefit by avoiding a default.

Avoiding a loss of accounting capital, having an asset that can be
used as collateral with the central bank and acceding to peer pressure
may be enough to cause banks and other creditors to create new loans
at favourable rates. If not, further inducements from the ECB and the
European Union will be needed.

With time, the creditor banks and other financial institutions that
hold the debt of Greece, Ireland and Portugal will be able to sell or
otherwise transfer that debt to the ECB or other potential buyers and
to accumulate earnings to build up their capital ratios.

When the ECB eventually determines that major creditors have reduced
their holdings of the impaired debt by enough so that, in combination
with their increased capital, they are able to withstand substantial
debt writedowns, the ECB will allow Greece, Ireland and Portugal to
have a simultaneous default in which they restructure their existing
debt to levels that they can comfortably service.

This type of plan worked well for the Latin American debt in the
1980s, culminating with the substitution of Brady bonds for existing
debts.

There is of, course, no guarantee that this will work for the
eurozone’s peripheral debtors. A major uncertainty is whether Spain
will also need to restructure its debt. Although the debt of Spain’s
central government looks manageable, the impaired assets of the
Spanish saving banks and the debts of the individual regions may make
the eventual total obligations of the central government impossible
for Madrid to service. And Spain’s potential debts are larger than the
other three nations’ impaired sovereign debts combined.

There are two further problems that will make it difficult for this
strategy to work in Europe. First, the contractionary fiscal policies
that are decreasing aggregate demand and GDP in these countries cannot
be offset by the expansionary effects of currency devaluations as they
were in Latin America. Moreover, even when the debt overhang is
eliminated, the peripheral countries will not be competitive in world
markets at their existing exchange rates. As members of the eurozone,
they cannot devalue.

So settling the debt problem would still leave these countries with
the large current account deficits that now exist and that will
continue to exist in the future.

The writer is professor of economics at Harvard University and former
chairman of the Council of Economic Advisers and President Ronald
Reagan’s chief economic adviser.