Euro zone is in crisis. Time for Plan B (Jan 13th 2011)

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Time for Plan B

The euro area’s bail-out strategy is not working. It is time for insolvent countries to restructure their debts

Jan 13th 2011 | from PRINT EDITION (http://www.economist.com/node/17902709?story_id=17902709)

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FOR a few weeks over the Christmas holidays, Europeans put their sovereign-debt crisis on hold. Now they are facing grim reality once more. Bond yields are spiking in an ever broader group of countries, just as the euro zone’s governments need to raise vast sums from the markets. On January 12th Portugal was forced to pay 6.7% for ten-year money—better than feared but a price it cannot afford for long. Yields for Belgian debt have jumped, as investors fret about its load of debt and lack of leadership. Spain is hanging on.

This mess leads to a depressing conclusion: Europe’s bail-out strategy, designed to calm financial markets and place a firewall between the euro zone’s periphery and its centre, is failing. Investors are becoming more, not less, nervous, and the crisis is spreading. Plan A, based on postponing the restructuring of Europe’s struggling countries, was worth trying: it has bought some time. But it is no longer working. Restructuring now is more clearly affordable than it was last year. It is also surely cheaper for everybody than it will be in a few years’ time. Hence the need for Plan B.

The initial response, forged in the rescue of Greece in May 2010, has been undone by its own contradiction. Europe’s politicians have created a system for making loans to prevent illiquid governments from defaulting in the short term, while simultaneously making clear (at Germany’s insistence) that in the medium term insolvent countries should have their debts restructured. Unsure about who will eventually be deemed insolvent, investors are nervous—and costs have risen.


The least-bad way to deal with this contradiction is to restructure the debt of plainly insolvent countries now. Based on this newspaper’s calculations (see article - below), that group should start with Greece and probably also include Portugal and Ireland. Spain has deep problems, but even with a big bank bail-out it should be able to keep its public debt at a sustainable level (see article - below). Italy and Belgium have high debt levels but more ample private savings, and their underlying budgets are closer to surplus. There is, thus, a reasonable chance that, handled correctly, euro-zone sovereign defaults could be limited to three small, peripheral economies.

The perils of procrastination

This newspaper does not advocate the first rich-country sovereign defaults in half a century lightly. But the logic for taking action sooner rather than later is powerful. First, the only plausible long-term alternative to debt restructuring—permanent fiscal transfer from Europe’s richer core (read Germany)—seems to be a political non-starter. Some of Europe’s politicians favour closer fiscal union, including issuing euro bonds, but they are unlikely to accept budget transfers big enough to underwrite the peripheral economies’ entire debt stock.

Second, the dangers from debt restructuring have diminished even as the costs of delay are rising. Eight months ago, when euro-zone governments and the IMF joined forces to rescue Greece, their determination to avoid immediate restructuring made sense. There were reasonable fears that default could plunge Greece into chaos, precipitate bond crises in the euro zone and spark a European banking catastrophe.



But the European economy, as a whole, is now in better shape. Banks have had time to build up more capital—and palm off some of their holdings of dodgy sovereign bonds to the European Central Bank. Greece and other peripherals have shown their mettle with austerity plans. Europe’s officials have created mechanisms to stump up rescue money quickly. And lawyers have been thinking about managing an “orderly” default. A sovereign restructuring could still spook financial markets—fear that it would spread panic makes Europe’s politicians shy away from it—but if handled correctly, it should not spawn Lehman-like chaos.

At the same time the costs of buying time with loans have become painfully clear. The burden on the countries that have been rescued is enormous. Despite the toughest fiscal adjustment by any rich country since 1945, Greece’s debt burden will, on plausible assumptions, peak at 165% of GDP by 2014. The Irish will toil for years to service rescue loans that, at Europe’s insistence, pay off the bondholders of its defunct banks. At some point it will become politically impossible to demand more austerity to pay off foreigners.

And the longer a restructuring is put off, the more painful it will eventually be, both for any remaining bondholders and for taxpayers in the euro zone’s core. The rescues of Greece and Ireland have increased their overall debts while their private debts fall, so that a growing share will be owed to European governments. That means that the write-downs in any future restructuring will be bigger. By 2015, for instance, Greece could not reduce its debt to a sustainable level even if it wiped out the remaining private bondholders.

How to change course

A cost-benefit analysis, in short, argues in favour of carrying out an orderly restructuring now. The debt reduction should be big enough to put afflicted economies on a sustainable path. Greece may have to halve its debt burden. Ireland’s may need to be cut by up to a third, with some of this coming from writing down bank rather than sovereign debt.

All creditors, including governments and the European Central Bank, will have to chip in. New rescue money will also be needed: to fund defaulting countries’ budget deficits; to help recapitalise these countries’ local banks (which will suffer losses on their holdings of government bonds); and, if necessary, to recapitalise any hard-hit banks in Europe’s core economies. The ECB and others should stand ready to defend Belgium, Italy and Spain if need be.

If Europe’s leaders stick to plan A, the debt crisis will continue to deepen. If they get on with restructurings that are eventually inevitable, they have a fighting chance of putting the crisis behind them. Plan B will require deft technical management and political courage. Thanks to its emerging-market expertise, the IMF has some of the former. It is up to Europe’s politicians to find the latter.

http://www.economist.com/node/17902709?story_id=17902709

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Bite the bullet

In the first of three articles on the euro zone’s sovereign-debt woes, we present our estimate of the burdens on the currency club’s four most troubled members

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THE euro zone’s strategy for tackling its sovereign-debt crisis is failing. A makeshift scheme was put in place in May to help countries that cannot otherwise borrow at tolerable interest rates. That lowered but did not remove the risk that a country may default for want of short-term funds. But the bond market’s nerves have been shredded again by the likelihood that from 2013, when a permanent bail-out mechanism is due to be in place, it will be easier to restructure an insolvent country’s debts. More worrying still for private investors, this seems set to give official creditors preference over others.

As a result, bail-outs are making private investors less rather than more keen to hold a troubled country’s bonds. As old debts are refinanced and new deficits funded by the European rescue pot and the IMF, the share of such a country’s debt held by official sources will steadily rise. That will leave a shrinking pool of private investors to bear losses if debts are restructured. And the smaller that pool becomes, the larger the loss that each investor will have to accept. Bond purchases by the European Central Bank (ECB) aimed at stabilising markets have further diminished the stock in private hands.

This perverse dynamic argues for a restructuring of insolvent countries’ debts sooner rather than later. But when is a debt burden too heavy to be borne? A first indicator against which to make that judgment is the ratio of gross public debt to GDP. Most rich economies, including the euro area’s most troubled, have large budget deficits and so will be adding to their debts for years. Today’s toll is not so important. What matters is how big the debt burden will be when it stabilises.

Column 2 of the table below shows The Economist’s estimates of the likely burden for the four most beleaguered euro-zone countries. To keep our projections as simple and objective as possible, we have imposed identical (and thus necessarily stylised) assumptions about growth and interest rates on all. Because all four countries suffer from a lack of competitiveness, a recovery in real GDP in the face of fiscal austerity will probably require a drop in wages and prices. For that reason, we assume that nominal GDP falls before recovering to its 2010 level. The interest rate on new debt is pegged at 5.25%, a bit less than Ireland will have to pay on its rescue funds from the European Union and the IMF.

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We assume that it takes five years of tax increases and spending cuts for each country to reach a primary budget surplus (ie, excluding interest payments) large enough to stabilise its ratio of debt to GDP. The required austerity varies: Ireland has already endured a lot of pain but still has most to do (see column 3).

The depth of the mire

To avoid charges of spurious accuracy, we have rounded down our estimate of the stable debt burden to the nearest five percentage points. On this basis Greece ends up with a debt-to-GDP ratio of 165% by 2015. Ireland’s projected burden is 125%, Portugal’s 100% and Spain’s 85%. Only Japan has a larger burden than Greece, and its government can fall back on a big stock of liquid assets and wealthy domestic savers who hold almost all public debt. Even at the subsidised interest rates we assume, Greece would pay 8-9% of its GDP in interest by 2015, mostly to foreigners. For a small country with a shaky economy, that is unbearable: Greece looks bust.

Spain, though, is probably solvent. On our estimate its prospective debt burden is similar to those of “safe” France and Germany today. A worst-case scenario in which the government had to cover enormous losses at the country’s banks (see article (http://www.economist.com/node/17902827)) would leave its debt burden close to, but not above, the limits of what Spain could sustain at current interest rates.

Ireland and Portugal are less clear-cut cases. A public-debt ratio in three figures might be tolerable at interest rates of 4% or so, but would be too costly to bear at today’s bond yields. Two other euro-zone countries, Belgium and Italy, already have public debt of 100% of GDP or more and do not (yet) suffer painfully high yields. But both are quite near to primary budget balance and depend far less on foreign capital than Greece, Ireland or Portugal (column 4). Belgium’s economy is small but closely aligned with Europe’s strong core. Like Japan, Italy benefits from scale. Its large bond market attracts investors who prize liquidity; its public revenues are backed by a big, diversified economy.

Debt burdens may turn out to be higher. Ireland’s government is using its liquid assets to bolster its banks’ capital. But if losses on property loans and mortgages are worse than hoped, they could add up to 10% of GDP to our estimate of its debt burden. Portugal says its banks are sound. But the combination of capital inflows and low productivity hints at wasteful investments and a lurking bad-debt problem.

Greece provides the best example of why it is wise to write down unbearable debts sooner rather than later. Investors typically take losses of one-third to one-half of the value of bonds when sovereign debts are restructured. Greece would need to halve its debts to reduce its burden to a tolerable 80% or so of GDP. If the pain were delayed until the end of 2013 its debts would have to be written down by ?185 billion ($239 billion) on our reckoning. Were official creditors repaid in full, private investors would be left with nothing: only ?183 billion of the Greek bonds issued before the bail-out would mature after 2013, according to Bloomberg. (That is unlikely. In past restructurings bilateral official creditors, but not the IMF, have taken a hit. Still, the longer the delay the more private investors lose.)

A Greek default would be the first by a rich country since 1948. It would be shocking but feasible. Restructurings by several poorer ones, from Uruguay to Belize, provide a legal case history for how to do it. Two factors may make it easier. First, the bulk of “peripheral” Europe’s debts are issued under local law, which some lawyers say can be changed retroactively to add clauses binding all creditors to a deal agreed on by a big majority. Second, the ECB could induce commercial banks to seek a swift agreement by refusing to accept “old” bonds as collateral. The lawyers think a Greek restructuring could be completed in six months. It must be done eventually. It would be better not to delay.

http://www.economist.com/node/17902803

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Under siege

Quantifying the difficulties of a country’s banking system

SPAIN’S public debt, less than two-thirds of GDP last year, is not especially large. Yet financial markets fear that its government may, like Ireland’s, have to find enormous sums to support the country’s banks. The funding markets briefly welcomed some Spanish lenders after European stress tests last July. But doubts about the financial system have resurfaced with vehemence. Spanish banks, and their regulator, are feeling hard done by.

Only the strongest banks have access to wholesale markets, and at high cost. This year the system is due to redeem some ?90 billion ($116 billion) of debt, 45% of it by the two largest banks, estimates Barclays Capital. Banks continue to reduce their reliance on European Central Bank funds, thanks to improved access to the short-term repurchase (“repo”) market. But tapping stable, longer-term financing is essential.

Perception is much worse than reality, says Miguel Fernández Ordóñez, the governor of the Bank of Spain. He reckons the country’s unlisted savings banks will need no more government-assisted capital this year than the ?10.6 billion already committed by the state’s ?99 billion Fund for Orderly Bank Restructuring (FROB).

Investors think that looks optimistic. The debate in the market is not about whether Spanish lenders will need more capital, but about how much. The list of worries is long. Concerns about the banks affect sovereign debt, which in turn affects the banks in a vicious circle. Banks’ profitability is sinking, partly because lending margins are being squeezed by a scramble for deposits as a source of stable funding. Savings banks (cajas) are undergoing a thorough restructuring: complex mergers to cut costs have shrunk their number from 45 to 17.

The biggest source of concern remains Spain’s housing bust. Official data show a market deflating lethargically, with prices only 12.8% below their peak. Ireland’s spectacular bail-out of its banks, just months after they passed the stress tests, also rattled investors.

The parallels with Ireland are overdone: Spain’s biggest banks, unlike Ireland’s, are serious businesses. Still, Spanish banks have ?323 billion (the equivalent of 31% of GDP) in loans to property developers. Add in construction, and the exposure rises to 42% of GDP. By the end of 2010 Spanish banks had already made ?87 billion in provisions for bad loans.

There is no consensus on how much more capital is needed. Moody’s, a ratings agency, estimates that banks may require another ?17 billion to push their tier-1 ratio to 8%. UBS says that they could need up to ?120 billion to regain the confidence of funding markets.

What would a doomsday scenario look like? Taking the Bank of Spain’s basic “adverse” scenario and adding an Irish-scale calamity from loans to developers and builders, the banking system’s gross losses would be ?270 billion, about ?60 billion higher than the central bank’s figure. If lenders then made only half of the profits and capital gains in the Bank of Spain’s scenario, they would have to find ?140 billion in new capital, or 13% of GDP, to achieve a tier-1 ratio of 10%. Relative to the size of the economy, this is still far less than the cost of the Irish bail-out.

The actual exposure to pure property development is smaller than the official numbers suggest, says Arturo de Frias, an analyst at Evolution Securities, because of the way loans are classified. He thinks the banks can absorb losses through their ongoing profits, while the cajas will need to raise around ?50 billion of new capital.

The Bank of Spain has asked lenders to disclose quarterly details on exposure to property, including collateral, starting with their annual results for 2010. Any sign that the cajas can raise money without government support would also help. Bankers are expecting a few more mergers this year. A change in the law has made it easier for outsiders to invest. But with listed Spanish banks already cheap, cajas would have to sell shares for a song to attract interest.

The Bank of Spain says it wants to minimise the use of public money, and the FROB has raised just ?12 billion so far. Time may yet prove Mr Ordóñez right. But if doubts persist, for both banks and sovereign, he may not have much time.

http://www.economist.com/node/17902827

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Still scary

Portugal has looked increasingly in need of a bail-out. Firm demand for a bond auction this week cannot mask deep problems with its public finances

FILM-INDUSTRY lore has it that small-budget movies have a better chance of commercial success if they avoid clashing with the release of big-studio blockbusters and if they can generate lots of initial audience interest. A similar principle applies to small and indebted countries that need to raise a lot of money in a crowded bond market. A successful first auction of the year reassures investors; and early fund-raising is advised to avoid the rush of bigger countries to the market.

The buzz about Portugal’s first bond auction of the year, on January 12th, had been so bad that even a sale at steep interest rates could be hailed as a triumph. Portugal met its target of ?1.25 billion ($1.62 billion) by selling bonds maturing in 2014 and 2020. Both offerings were oversubscribed. Fernando Teixeira dos Santos, the finance minister, spoke afterwards with the relief of a director whose new film had opened well. “The success of today’s issue shows that Portugal has the necessary conditions to finance itself in the market at prices that are not only acceptable, but favourable in the current climate,” he gushed. About 80% of the bonds were bought by foreign investors, he said, putting paid to suspicion that the issues had been sold to local banks.

But Portugal paid dearly for its success: the yield on the June 2020 bond was a whopping 6.7%. Granted, that was lower than the 7% at which ten-year bonds had traded earlier in the week (see chart 1), before reports of heavy purchases by the European Central Bank (ECB) pushed the yield down. But it is unsustainable for a country whose public debt is high and rising. Unless its borrowing costs plummet, Portugal will eventually have to seek rescue funds from its euro-zone partners and the IMF, as Greece and Ireland have already been obliged to do.

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Portugal insists it does not share those countries’ weaknesses, even if it too is small, sits at the fringe of the euro zone and has rickety public finances. Greece’s main sin was fiscal laxity, Ireland’s an almighty property binge. Both countries enjoyed fast GDP growth when credit was cheap. Portugal was different. It had a brief growth spurt in the run-up to joining the euro in 1999, as its borrowing costs fell. Its main frailty has been a steady loss of wage competitiveness, which began in the 1990s. This is reflected in a stubbornly large current-account deficit and a lost decade for the economy (see chart 2). Feeble GDP growth has made it hard to keep public finances on track. The budget deficit has averaged 4.6% of GDP in the past decade.

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The country has also had some bad luck. In the 1990s the Uruguay round of world trade talks lowered tariffs on cheap textile imports from Asia. That hurt Portugal, then the European Union’s sweatshop. China’s entry to the World Trade Organisation in 2001 put further pressure on Portuguese firms. Attempts to move up the export value chain have been frustrated. A big Volkswagen car factory that opened near Lisbon in 1995 is said to be one of the company’s most productive. But the expansion of the EU in 2004 diverted that sort of foreign direct investment away from Portugal towards eastern countries closer to Europe’s industrial heartland.

All the while a steady inflow of cheap credit has pushed the country’s net foreign debts to more than 100% of GDP. Much of the foreign borrowing is funnelled through Portugal’s banks, whose credit lines depend on the standing of the state. The banks have been all but frozen out of capital markets since Portugal’s sovereign debt was downgraded last spring, and are now heavily reliant on the ECB.

The national central bank has said that Portugal’s banks are “resilient and well capitalised”. Even so, there is a nagging fear that a country that has seen such huge capital inflows may not have used all the money wisely. One source of concern is Portugal’s fetish for infrastructure. Urban rail systems have been built. New toll roads and ports were deemed necessary to address a weakness in the economy—its distance from Europe’s main markets. Low rates of traffic suggest that some of these projects are unprofitable.

Some local analysts believe radical economic surgery to put exporters first is needed, so that Portugal can service its overseas debts. That would require a faster relaxation of stringent rules on hiring and firing, as well as dismantling of the sector-wide pay deals that keep labour costs high. It would also mean deregulation of service industries, whose elevated charges raise exporters’ costs. The government has made some reforms but at a leisurely pace.

Modest achievements are talked up. José Sócrates, the prime minister, said this week that Portugal’s 2010 budget deficit would fall “clearly below” the government’s target of 7.3% of GDP. Portugal was one of the few EU countries to cut its deficit by more than two percentage points in 2010, he said. Yet revenues booked from the transfer of Portugal Telecom’s pension funds to the state explain much of the improvement. The dilatory pace of fiscal consolidation is unlikely to assuage investors for long. The auction’s success may offer only temporary respite. Investors in the euro zone’s bond markets have seen the film before.

http://www.economist.com/node/17902815

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Countries should analyse carefully and weigh whether it's worth fighting the panic
Laurence Kotlikoff wrote on Jan 13th 2011, 20:23 GMT

INSOLVENCY is always in the eyes of the creditor. If enough creditors decide the PIIGS (note: I use this acronym as a shorthand for Portugal, Ireland, Italy, Greece, and Spain, not to cast aspersion on these countries or their people) can't repay, their borrowing costs will rise to the point where they can't, in fact, repay. So we have multiple equilibria here, with no sure way to know ahead of time which equilibrium will prevail. Small pieces of adverse news could flip the situation toward default. Who, after all, wants to be the last lender to a failing enterprise, be it a company or a government?

The fact that the PIIGS' borrowing rates and sovereign-debt CDS prices have, of late, risen to fairly high levels certainly raises the prospect of default. But default could put European banks underwater (they hold much of the PIIGS' debt) and lead to a massive run on the banks. European Central Bank efforts to stop the run by printing money may simply reinforce the run because, with the prospect of inflation or hyperinflation, everyone will want to get his or her money out and spend it before prices take off. So here we have another situation of multiple equilibria.

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Debt restructuring should be paired with bank recapitalisation
Viral Acharya wrote on Jan 13th 2011, 20:45 GMT

ON BALANCE, when an insolvency threat is imminent, it is a good idea to restructure earlier rather than later. This applies to many countries on the European periphery, based on market estimates and structural parameters of their economies. There are two critical issues, however, that need to be kept in mind: one, is about the banking sectors, and two, about political economy.

First, much of the sovereign debt is held by banks of stronger countries in the euro zone. To the extent that European stress tests—and other measures—have not led to recapitalisation of banks sufficient to deal with these losses, there remains an uncertainty about the risk of contagion from putting haircuts on sovereign creditors. Non-inclusion of banking book holdings of sovereign debt for haircuts in European stress tests was an implicit recognition by regulators that this would have led to substantial capital shortfalls. This problem can be solved: do a serious stress test that takes account of such haircuts on banking book sovereign bonds, recapitalise banks, and then enable a restructuring of sovereign debt. To the extent that a country's own banks hold its debt, this problem is trickier. A default by the sovereign could trigger a run on the banking system. But again, a sovereign restructuring following an adequate recapitalisation of the financial sector is necessary.

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Europe should reduce its debt burden as quickly as possible
Michael Pettis wrote on Jan 14th 2011, 13:22 GMT

THERE are largely two ways forward for much of peripheral Europe. One involves high unemployment, economic contraction, and wage and price deflation stretching out for many years. The other involves debt restructuring, and perhaps temporarily abandoning the euro, with significant principal reduction. Which way each country chooses is ultimately a political decision about which group of economic agents will bear the brunt of the adjustment cost—the working classes through unemployment, the middle class and small businesses through taxes, or creditors.

Since eventually electoral politics will limit the cost to the working and middle classes, and flight capital and tax evasion will do so for small businesses, this leaves creditors. Sooner or later creditors are going to have to accept a significant reduction of the obligations owed to them. The sooner this happens the better. The idea that the afflicted countries can implement reforms that will eventually allow them to grow out of their debt burden is a mirage. Every debt crisis, including most notoriously Argentina in 2001, has evoked the same claims and it almost never happens.

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It is still time to emphasise fiscal consolidation
Gilles Saint-Paul wrote on Jan 14th 2011, 13:27 GMT

THAT spreads are so high on a number of European sovereign borrowers is a paradox. From an arithmetic point of view, a debt of 200% of GDP is perfectly sustainable. At a 2% growth rate and a 4% interest rate, all you need is a primary budget surplus of 4% of GDP.

So why are markets so nervous? It may be due to irrational pessimism but also because markets are factoring in some unpleasant scenarios. If growth remains slow or even negative while real interest rates rise again due to the appetite for capital of emerging economies, then public debt could grow very fast. Furthermore, markets may doubt the political feasibility of achieving the primary surpluses that are required for fiscal consolidation. On the revenue side, tax rates are very high in many European countries. Additional tax hikes will harm growth, induce tax evasion, and may only have a small effect on revenues. Some studies even suggest that some countries are at the top of the Laffer curve for some categories of taxpayers. This means that the maximum feasible revenue is already extracted from those people. On the expenses side, there are entrenched interests that benefit from some expenditure categories and prefer to shift the burden of adjustment to other groups. The outcome of this political game is that expenditures are not reduced. For example, France has run a deficit in every single year since 1978.

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Rushing into restructuring would be a big mistake
Michael Heise wrote on Jan 14th 2011, 14:13 GMT

DEFINING the point at which a sovereign is "insolvent" is a tricky business. A country's ability to repay its debt hinges on a host of factors: future growth, the interest rate demanded by capital markets (the measure of market confidence), the willingness of domestic savers to hold their own government's paper. A debt-to-GDP ratio in the region of 130%, as in Greece, does not mean the game is up (see Japan), particularly if the country concerned is pursuing reform policies geared to restoring growth and fostering confidence. And this is the path Greece, along with others, is now on.

To rush into restructuring now would be a big mistake. It would spread like wildfire across Europe, in the process locking the affected countries out of the capital markets for the foreseeable future. We should not throw in the towel before the medicine has had a chance to work. Far better to stick to plan A and take stock again in 2013.

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Fix the banking system, and the sovereign debt crisis will fix itself
Hyun Shin wrote on Jan 15th 2011, 18:04 GMT

ALTHOUGH the euro zone has a near-balanced current account with the rest of the world, it has wide imbalances within its own borders. Countries such as Spain and Ireland have financed their (housing bubble-induced) current account deficits through their respective banking systems, meaning that their banks are heavily reliant on wholesale funding—typically from banks in creditor countries such as Germany and the Netherlands. The run on Northern Rock in 2007 woke everyone up to the perils of wholesale funding when the banking system is deleveraging. Were it not for the European Central Bank's lifeline, the periphery's banking sectors would have been vulnerable to crippling runs long before today.

Debt restructuring should be evaluated in this light. In Europe, banks are large creditors to sovereigns. Any restructuring or hint of impending restructuring may tip the banking system into the familiar downward spiral of deleveraging and recoiling from risky positions, leading to spiking CDS spreads, which leads to further deleveraging, and so on. Such runs are familiar from emerging market crises and, as there, are essentially banking sector crises. Restructuring, without fixing the banks first, is playing with fire. Remember that creditors are not the fabled Belgian dentists or Italian widows. They are, instead, leveraged players who will attempt to hedge their way out of trouble. But their hedging (e.g. by buying CDS on sovereigns or other banks) increases distress for others. Whatever their motives, their actions are identical to those of the nefarious speculators that politicians are fond of blaming for the crisis.

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There's a strong moral and political case against restructuring
Harold James wrote on Jan 15th 2011, 18:12 GMT

FISCAL consolidation in the Mediterranean countries might just do the trick and allow—at great cost—a return to normal financing arrangements. The cutting of the currently unsustainable interest rate premia demanded by the market will depend on an effective EU response. But if market nervousness persists and interest rates remain high relative to rates for secure German debt, the debt burden will rapidly become unsustainable. So it might be a good idea for the EU as a "plan B” (or more appropriately as a "plan D”) to prepare a mechanism that spells out how debt can be trimmed. Many economists have argued this case on the basis of arithmetical calculation, extrapolating current interest rates.

But the European Central Bank, notably ECB board member Lorenzo Bini Smaghi, has elegantly spelled out the case against debt reduction—and that is a case that is politically significant and deeply moral. Indeed, the principle of not reneging on public debt is deeply intertwined with the development of legal security, representative government, and modern democracy. The experience of wartime inflations and de facto defaults in the 20th century made the theme of responsible finance a crucial part of a new European consensus. A foundation of the European integration process was a recognition of the importance of a stable currency to political legitimacy.

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Stop pretending default isn't necessary, start preparing for it
Paul Seabright wrote on Jan 15th 2011, 18:16 GMT

IT HAS long been evident that, barring a miracle economic recovery, some countries in the euro zone were going to default on some part of their sovereign debt. It has also long been evident that an orderly debt restructuring would be vastly preferable to a disorderly default triggered by a market panic. Unfortunately politicians have perceived their interests as lying in the perpetuation of the belief that restructuring could be postponed, and indeed had to be postponed at all costs because it would threaten the very existence of the euro. This is nonsense: default on a debt denominated in a dollars does not threaten the very existence of the dollar. Unfortunately, talk of the mythical consequences of debt restructuring has made it difficult to face up to the very real consequences of debt restructuring. Many of the holders of the most doubtful sovereign instruments are banks whose insolvency might in turn be triggered by a default on sovereign debt, so that their balance sheets would need to be restructured in turn. This in turn would reveal to European voters that the banking crisis they were told had been solved has in some respects only been shelved.

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Limited benefits to default without a tighter fiscal union
Michael Bordo wrote on Jan 17th 2011, 13:43 GMT

EUROPE needs to move as quickly as possible in the direction of creating a fiscal union as exists in the US, Canada and Australia. That means having eurobonds which are backed by all the members of the currency union (like US Treasuries), fiscal transfers and tough fiscal rules on the members (structural balanced budgets), and structural reforms. If that isn't done then the European crisis will drag on. Even if global recovery helps raise tax revenues, some of the peripheral countries, especially Greece (but also Ireland and Portugal) will continue to replicate the 1930s if they continue to go the deflation route that Keynes warned against.

Without these reforms, these peripheral countries would be better off leaving the euro and devaluing their currencies, as they used to do. Debt restructuring (managed default) is an alternative to leaving the euro and devaluing. but that route is not without very significant costs. Moreover it is doubtful that debt default without moving towards a fiscal union will end the problems of the weaker members of the euro zone.

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Restructuring is necessary to address a solvency crisis
John Makin wrote on Jan 17th 2011, 13:48 GMT

THERE are several insolvent countries along Europe's periphery. Their debt levels are unsustainable in a specific sense. Attempts to reduce their debt-to-GDP ratios by cutting deficits actually have increased the ratio of debt to GDP by slowing growth for countries with an already high—over 100 percent—debt to gdp ratio.

Restructuring—cancellation of some of the liabilities—is unavoidable. That is a solvency problem.

http://www.economist.com/economics/by-invitation/questions/it_time_european_debt_restructuring