BARRY EICHENGREEN: Here's The Alternative To All The Restructuring Chaos In Europe

After a year and half of delay and denial, Greece is about to restructure its debts.

This, by itself, will not be enough to draw a line under the eurozone’s crisis.

Greece will also have to downsize its public sector, reform tax administration, and take other steps to modernize its economy.

Its European partners will have to build a firewall around Spain and Italy to prevent their debt markets and economies from being destabilized.

Banks incurring balance-sheet damage will have to be recapitalized. The flaws in eurozone governance will have to be fixed.

The indispensable first step, however, is a deep write-down of Greek debt – to less than half its face value.

The burden on the Greek taxpayer will be lightened, which is a prerequisite for reducing wages, pensions, and other costs, and thus is essential to the strategy of “internal devaluation” needed to restore Greek competitiveness.

Forcing bondholders to accept a “haircut” on what they will be paid also promises to discourage reckless lending to eurozone sovereigns in the future.

Bringing us to the question of why it took policy makers a year and a half to get to this point.  The answer is that there are strong incentives to delay.

The Greek government, for which restructuring is an admission of failure, continues to hope that good news will magically turn up.

Likewise, French banks holding Greek bonds cling to whatever thin reed of optimism they can and lobby furiously against restructuring. European policymakers, for their part, worry that a sovereign-debt restructuring will damage the financial system and be a black mark for their monetary union.

The incentives to delay are myriad. The question is what can be done about them. Rather than resorting time after time to bailouts and delay, isn’t there a way to more swiftly and decisively restructure the debts of insolvent sovereigns?

One answer would be to add to future bond covenants contractual provisions that would trigger the necessary restructuring automatically. The concept is taken from the debate over bank reform, where there is an analogous problem of bailouts and bail-ins.

Because of the difficulty of putting banks through a bankruptcy-like procedure, there is an incentive, like that which arises in the context of sovereign debt, to postpone the painful process of imposing losses on bondholders and instead provide a bailout and hope for the best.

Contingent convertible bonds, or “cocos,” have been proposed as a solution to this problem. When a bank’s capital falls below a pre-specified limit, its cocos automatically convert from debt to equity at a fraction of their previous price. This bails in the bondholders and helps to recapitalize the financial institution in question.

Extending this idea to sovereign debt, government bond covenants could stipulate that if a sovereign’s debt/GDP ratio exceeds a specified threshold, principal and interest payments to bondholders would be automatically reduced. The idea is that if there is no adequate incentive to restructure once a crisis starts, it should be built in before the fact.

“Sovereign cocos” have the advantage that their activation would not constitute a credit event triggering the credit-default swaps written on the bonds. The existence of large quantities of CDS, together with uncertainty about who has written them, has fed the reluctance to proceed with restructuring. Sovereign cocos would assuage the fear of creating an AIG-like event, in which a too-big-to-fail underwriter is over-exposed.

Objections to the idea start with the question of whether there would be adequate demand for these novel sovereign-debt instruments. In fact, the success of banks in issuing cocos suggests that investors do have the appetite for them.

There is also a concern that the government might manipulate the debt and GDP statistics on which the conversion trigger is based. Outsourcing these figures’ calculation to an independent entity, such as the International Monetary Fund, could solve this problem.

There would be worries that adding cocos to sovereign bonds might raise governments’ borrowing costs. But the literature on related instruments known as collective-action clauses suggests that borrowing costs would rise only for governments approaching the limit of their creditworthiness – that is, close to the cocos’ trigger. And raising borrowing costs for governments with dangerously heavy debts – thereby discouraging them from further borrowing – is precisely what we should want to do.

Adding cocos to government bonds will require solving a host of technical problems. But not adding them is a recipe for more delay, more bailouts, and more chaos the next time the debts of a sovereign like Greece become unsustainable.

This post originally appeared at 24/7 Wall St.

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Barry Eichengreen: Europe Is On The Verge Of A Political Breakdown

Barry Eichengreen Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.

Europe is again on the precipice. The most recent Greek rescue, put in place barely six weeks ago, is on the brink of collapse.

The crisis of confidence has infected the eurozone’s big countries.

The euro’s survival and, indeed, that of the European Union hang in the balance.

European leaders have responded with a cacophony of proposals for restoring confidence.

Jean-Claude Trichet, the president of the European Central Bank, has called for stricter budgetary rules.

Mario Draghi, head of the Bank of Italy and Trichet’s anointed successor at the ECB, has called for binding limits not on just budgets but also on a host of other national economic policies.

Guy Verhofstadt, leader of the Alliance of Liberals and Democrats for Europe in the European Parliament, is only one in a growing chorus of voices calling for the creation of Eurobonds.

Germany’s finance minister, Wolfgang Schäuble, has suggested that Europe needs to move to full fiscal union.

If these proposals have one thing in common, it is that they all fail to address the eurozone’s immediate problems. Some, like stronger fiscal rules and closer surveillance of policies affecting competitiveness, might help to head off some future crisis, but they will do nothing to resolve this one.

Other ideas, like moving to fiscal union, would require a fundamental revision of the EU’s founding treaties. And issuing Eurobonds would require a degree of political consensus that will take months, if not years, to construct.

But Europe doesn’t have months, much less years, to resolve its crisis. At this point, it has only days to avert the worst. It is critical that leaders distinguish what must be done now from what can be left for later.

The first urgent task is for Europe to bulletproof its banks. Doubts about their stability are at the center of the storm. It is no coincidence that bank stocks were hit hardest in the recent financial crash.

There are several ways to recapitalize Europe’s weak banks. The French and German governments, which have budgetary room for maneuver, can do so on their own. In the case of countries with poor fiscal positions, Europe’s rescue fund, the European Financial Stability Facility, can lend for this purpose. If still more money is required, the International Monetary Fund can create a special facility, using its own resources and matching funds put up by Asian governments and sovereign wealth funds.

The second urgent task is to create breathing space for Greece. The Greek people are making an almost superhuman effort to stabilize their finances and restructure their economy. But the government continues to miss its fiscal targets, more because of the global slowdown than through any fault of its own.

This raises the danger that the EU and IMF will feel compelled to withdraw their support, leading to a disorderly debt default – and the social, political, and economic chaos that this scenario portends. In Greece itself, political and social stability are already tenuous. One poorly aimed rubber bullet might be all that is needed to turn the next street protest into an outright civil war.

Again, help can come in any number of ways. Creditors can agree to relax Greece’s fiscal targets. The limp debt exchange agreed to in July can be thrown out and replaced by one that grants the country meaningful debt relief. Other EU countries, led by France and Germany, can provide foreign aid. Those who have spoken of a Marshall Plan for Greece can put their money where their mouths are.

The third urgent task is to restart economic growth. Financial stability, throughout Europe, depends on it. Without growth, tax revenues will remain stagnant, and the capacity to service debts will continue to erode. Social stability, similarly, depends on it. Without growth, austerity will become intolerable.

Here, too, the problem has several solutions. Germany can cut taxes. Better still would be coordinated fiscal stimulus across northern Europe.

But the fact of the matter is that northern European governments, constrained by domestic public opinion, remain unwilling to act. Under these circumstances, the only practical source of stimulus is the ECB. Interest rates will have to be slashed, and the ECB will have to follow up with large-scale asset purchases like those recently announced by the Swiss National Bank.

If these three urgent tasks are completed, there will be plenty of time – and much time will be needed – to contemplate radical changes like new budgetary rules, harmonization of other national policies, and a move to full fiscal union. But, as John Maynard Keynes famously quipped, “In the long run, we are all dead.” European leaders’ continued focus on the long run at the expense of short-term imperatives may indeed be the death knell for their single currency.

This post originally appeared at Project Syndicate.

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