A Loan and a Prayer

Greece is clearly insolvent. Even with a draconian austerity package, totaling 10% of GDP, its public debt would rise to 160% of GDP. Portugal – where growth has been stagnant for a decade – is experiencing a slow-motion fiscal train wreck that will lead to public-sector insolvency. In Ireland and Spain, transferring the banking system’s huge losses to the government’s balance sheet – on top of already-escalating public debt – will eventually lead to sovereign insolvency.

The official approach, Plan A, has been to pretend that these economies suffer a liquidity crunch, not a solvency problem, and that the provision of bailout loans – together with fiscal austerity and structural reforms – can restore debt sustainability and market access. This “extend and pretend” or “lend and pray” approach is bound to fail, because, unfortunately, most of the options that indebted countries have used in the past to extricate themselves from excessive debt are not feasible.

For example, the time-honored solution of printing money and escaping debt via inflation is unavailable to the PIIGS, because they are trapped in the eurozone straitjacket. The only institution that can crank up the printing press – the European Central Bank – will never resort to monetization of fiscal deficits.

Nor can we expect rapid GDP growth to save these countries. The PIIGS’ debt burden is so high that robust economic performance is next to impossible. Moreover, whatever economic growth some of these countries might eventually register is contingent on enacting politically unpopular reforms that will work only in the long run – and at the cost of even more short-term pain.

To restore growth, these countries must also regain competitiveness by achieving a real depreciation of their currency, thus turning trade deficits into surpluses. But a rising euro – pushed higher by excessively early monetary tightening by the ECB – implies more real appreciation, further undermining competitiveness.

The German solution to this conundrum – keeping wage growth below that of productivity, thereby reducing unit labor costs – took more than a decade to yield results. If the PIIGS started that process today, the benefits would be too long in coming to restore competitiveness and growth.

The last option – deflation of wages and prices – to reduce costs, achieve a real depreciation, and restore competitiveness is associated with ever-deepening recession. The real depreciation necessary to restore external balance would drive the real value of euro debts even higher, making them even more unsustainable.

Lowering private and public consumption in order to boost private savings, and implementing fiscal austerity to reduce private and public debts, aren’t options, either. The private sector can spend less and save more, but this would entail an immediate cost known as Keynes’ paradox of thrift: declining economic output and rising debt as a share of GDP. Recent studies by the IMF and others suggest that raising taxes, cutting subsidies, and reducing government spending – even inefficient spending – would stifle growth in the short term, exacerbating the underlying debt problem.

If the PIIGS can’t inflate, grow, devalue, or save their way out of their problems, Plan A is either failing or is bound to fail. The only alternative is to shift quickly to Plan B – an orderly restructuring and reduction of the debts of these countries’ governments, households, and banks.

This can happen in a number of ways. One can carry out an orderly rescheduling of the PIIGS’ public debts without actually reducing the principal amount owed. This means extending the maturity dates of debts and reducing the interest rate on the new debt to levels much lower than currently unsustainable market rates. This solution limits the risk of contagion and the potential losses that financial institutions would bear if the value of debt principal were reduced.

Policymakers should also consider innovations used to help debt-burdened developing countries in the 1980’s and 1990’s. For example, bondholders could be encouraged to exchange existing bonds for GDP-linked bonds, which offer payouts pegged to future economic growth. In effect, these instruments turn creditors into shareholders in a country’s economy, entitling them to a portion of its future profits while temporarily reducing its debt burden.

Reducing the face value of mortgages and providing the upside – in case home prices were to rise in the long run – to the creditor banks is another way to convert mortgage debt partly into shareholder equity. Bank bonds could also be reduced and converted into equity, which would both avert a government takeover of banks and prevent socialization of bank losses from causing a sovereign debt crisis.

Europe cannot afford to continue throwing money at the problem and praying that growth and time will bring salvation. No one will descend from the heavens, deus ex machina, to bail out the IMF or the EU. The creditors and bondholders who lent the money in the first place must carry their share of the burden, for the sake of the PIIGS, the EU, and their own bottom lines.