If there was ever a textbook example of how not to handle a sovereign debt crisis, it was Greece. Nearly a decade since Athens first asked for help from its euro zone partners and the International Monetary Fund, the Greek economy is still struggling to recover. Even after a steep restructuring, sovereign debt remains unsustainable. If Greece is not to be crippled by its debt load, European governments will have to accept further debt-reducing measures, on top of the maturity extensions and the cut in interest rates they have already agreed to.
So it's no surprise that one of the key debates on the future of the euro zone relates to how sovereign debt restructuring should be made easier. There is little doubt that forcing losses on creditors at an earlier stage, as some propose, would increase the chance that a program of financial assistance is successful. However, the euro zone should be wary of automatic triggers; they risk bringing on the very crisis they are designed to avert.
The debate on the future of debt restructuring in the euro zone largely involves two positions. The first, which is widely shared in Germany, sees an orderly debt restructuring mechanism as an essential next step for the currency union. When a country applies for financial help from the European Stability Mechanism (ESM), creditors should face some form of debt restructuring immediately. This would ensure a better distribution of risks between debt-holders and the ESM. The threat of a haircut will make investors more discerning in their lending, contributing to fiscal discipline within the euro zone.
Wolfgang Schaeuble, Germany's former finance minister, included many such ideas in a "non-paper" on the future of the currency union which he circulated upon leaving the ministry. A group of economists including members of the German Council of Economic Experts have advocated automatic mechanisms, linking different kind of debt restructuring decisions to the overall level of debt.
A second school of thought, including many academics and politicians in Italy, is deeply skeptical of the idea of debt restructuring. This view has been eloquently summarized by Guido Tabellini, a professor of economics at Bocconi University, in a recent column for VOX. Tabellini believes that markets are an imperfect mechanism for disciplining sovereign governments, since they tend to react too late and too suddenly. Furthermore, he argues that there is little evidence of moral hazard on behalf of governments: As shown by the Greek recession, the costs of a sovereign debt crisis are such that no government wants to go through them. Tabellini advocates creating a new form of bonds, linked to gross domestic product, which would face losses in the event of a crisis. "Traditional" debt would be senior to these bonds and would be left untouched.
While sovereign GDP-linked bonds are theoretically appealing, it is not clear there is market appetite for them. Even if there were, it would take many years to build a meaningful quantity of such securities. Meanwhile, new crises would have to be handled using old instruments.
At the same time, setting automatic thresholds for debt restructuring, as advisers on the German Council of Economic Experts are arguing, is not the way forward. For a start, there is no magic number at which debt becomes unsustainable: this depends on a variety of factors, including market confidence and who owns the majority of bonds. Secondly, setting an exact figure means making debt markets vulnerable to self-fulfilling prophecies, because investors would be reluctant to buy debt above that level. This idea would make more sense were all euro zone sovereigns to start at very low debt level. Several states, such as Italy and Portugal, have debt levels above 100 percent of gross domestic product: an automatic threshold would cause immediate instability.
There is little doubt that the euro zone should improve on its handling of sovereign debt crises. When a country's debt levels are unsustainable, reducing this pile is a precondition to ensuring that a country has better prospects of returning to growth. In the context of the euro zone, a debt restructuring mechanism is also a necessary step for building trust on the road to greater sharing of resources. If we want to ask countries to increase their contributions to the ESM, it is only fair to ensure that programs of financial assistance are run more effectively than was the case with Greece.
Changing the rules to force more losses on creditors is both fair and can contribute to a strengthening of euro zone institutions. However, authorities should retain a degree of discretion over when any restructuring is triggered. This combination of steeper penalties and flexible triggers would go a long way to prevent a repeat of the sorry Greek saga.
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