How to save the eurozone

October 9th, 2012

July 18, 2011

With last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase. Where the crisis had been existential for small economies on the periphery of Europe but not systemically threatening to either the idea of European monetary union or to the functioning of the global financial system, it now threatens both European integration and the global recovery. Last week’s drama over bond auctions in Europe’s third leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency. It is to be hoped that European officials can engineer a decisive change of direction but if not, the world can no longer afford the deference that the International Monetary Fund and non-European G20 officials have shown European policymakers in the past 15 months.

Three realities must be recognised if there is to be a chance of success. First, the maintenance of systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish not a policy. US policymakers were applauded for about 12 hours for their willingness to let Lehman go bankrupt. The adverse consequences of the shattering effect that had on confidence are still being felt now. The European Central Bank is right in its concern that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence. Those who let Lehman go believed that because time had passed since the Bear Stearns’ bail-out, the market had learnt lessons and so was prepared. In fact, the main lessons learnt were on how best to find the exits, and so uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates currently charged by the official sector for credit – let alone the private sector – would involve burdens on Greece, Ireland and Portugal comparable to the reparations’ burdens Keynes warned about in The Economic Consequences of the Peace.

Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies, but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates are likely to become insolvent at higher interest rates, putting further pressure on rates and exacerbating solvency worries in a vicious cycle. This has already happened in Greece, Portugal and Ireland, and is in danger of happening in Italy and Spain.

In short, the approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative. Assertions that the most indebted countries can service their debts in full at current interest rates only undermine the credibility of policymakers when they go on to assert that the fundamentals are relatively sound in Spain and Italy. Further lending at premium interest rates only increases the scale of the necessary restructuring. It is reasonable to argue that the recognition of debt unsustainability in Greece has been excessively deferred. It is not reasonable to argue that Greek reprofiling or restructuring alone will address a general crisis of confidence.

A fundamental shift of tack is required, towards an approach focused on avoiding systemic risk, restarting growth and restoring arithmetic credibility rather than simply staving off disaster. The twin realities that Greece, Italy and Ireland need debt relief and that the creditors have only limited capacity to take immediate losses, mean that all approaches require increased efforts from the European centre. Fortunately, the likely consequence of doing more upfront is a lower cost in the long run. The details are less relevant than having an appropriate approach overall, aligned with EU political realities. But some elements are crucial to any viable strategy.

European authorities must restate their commitment to solidarity as embodied in a common currency and recognise that the failure of any European economy is unacceptable. If they can find the political will, the technicalities of a policy response are not that difficult. But it should include these further commitments.

First, for programme countries, interest rates on debt to the official sector should be reduced to a European borrowing rate, defined as the rate at which common European entitities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated, so there is no reason to charge a needless risk premium that puts the whole enterprise at risk.

Second, countries whose borrowing rate exceeds some threshold – perhaps 200 basis points over the lowest national borrowing rate in the euro system – should be exempted from contributing to bail-out funds. The last thing the marginal need is to be pulled down by the weak.

Third, there must be a clear commitment that, whatever else happens, no big financial institution in any country will be allowed to fail. The most serious financial breakdowns – in Indonesia in 1997, Russia in 1998, and the US in 2008 – came when authorities allowed doubt over the basic functioning of the financial system. This responsibility should rest with the ECB, with the requisite political support.

Fourth, countries judged to be pursuing sound policies will be permitted to buy EU guarantees on new debt issuances at a reasonable price, payable on a deferred basis.

These measures would do much to contain the storm. They would lower payments for debtor nations, protect states at risk from participation in rescue efforts or from shortfalls in market confidence, and ensure the ECB could continue backstopping the stability of European banks.

This leaves the question of what is to be done with sovereign private debt. Creditors gain nothing from breakdown. Some will want to sell out of their exposures at prices marginally above their current market value. Others, who are still regarding sovereign European debts as worth par, should be given appropriate, reduced interest rate longer maturity options. Debt repurchases are a possibility if the private sector accepts sufficiently large present-value debt reductions. But any approach should be judged on the sustainability of programme country debt repayments.

Much of this will seem unrealistic given the terms of Europe’s debate. It seemed highly unrealistic even 10 days ago that Italy’s solvency would come into substantial doubt. The alternative to forthright action today is much more expensive action – to much less benefit – in the not too distant future. The next few weeks may be the most important in the history of the EU.

The writer is Charles W. Eliot university professor and president emeritus at Harvard University. He was Treasury secretary under President Bill Clinton.

Copyright The Financial Times Limited 2012.