Forget about Greece for a moment. Just think about country X, which has lived well beyond its means for years thanks to loans from inattentive or foolishly optimistic lenders. When the crunch comes, the X-people will have to cut back on spending. And the X-lenders will generally suffer from the famous rule of banking: “Can’t pay, won’t pay.”
If Herman Van Rompuy, the president of the European Council, has his way, Greece is not going to be country X despite its weak government, bloated civil service and poor trade position. Van Rompuy said on March 25 that a vague new support agreement should “reassure all the holders of Greek bonds that the euro zone will never let Greece fail”. This default taboo should be reconsidered.
True, the Greeks might manage to tough it out. But it won’t be easy, even if the EU, the IMF and foreign investors are willing to help. A near miraculous economic recovery is required: from sharp recession and falling wages to fast growth. The euro makes the task more difficult, because Greece cannot stimulate growth through devaluation.
A limited default — rescheduling combined with modest write-downs — would make the task more manageable, besides appropriately punishing risk-blind lenders and complacent politicians. But Van Rompuy and many investors fear a sovereign default would start a chain reaction of panic and failures, perhaps breaking up the euro zone.
The worries are certainly not groundless, even if Greece’s 270 billion euros of debt is only 4 percent of all euro zone sovereign obligations. A write-down could reduce Greek banks to insolvency. Other fragile European banks would suffer. Other weak sovereign borrowers might follow, intentionally or not, creating a cascade of traumatic defaults.
But carefully planned debt write-downs could actually be less destabilising for markets than a long wait to see if Greece can struggle through. The uncertainty is distorting the euro zone’s politics and the euro’s value. A solution, even a bitter one, would calm nerves. And the risks of a Lehman Brothers II meltdown could be reduced by a three-pronged preparation.
First, the market needs to be softened up for bad news. For months, politicians such as Van Rompuy have been trying to persuade a doubtful world that Greek default is unthinkable. A change would cause a shock, but on reflection investors might actually welcome a more realistic approach.
Second, banks need to be kept in business. The Greek government does not have enough euros to rescue its own banks, so some tough but fair measures would be needed: converting bank debt into equity, freezing bank deposits and perhaps selling out to healthy foreign institutions.
Foreign banks holding Greek paper might need government help to get through write-downs. That path is well-trodden and it might ultimately prove less costly for other EU governments to help banks directly rather than offering indirect help through guarantees or loans to the Greek government.
Finally, other members of the euro zone with debt problems would need to get ready. Ireland, Italy, Portugal and Spain have already started to argue that they are fundamentally different from Greece. If their cases are persuasive, investors will not abandon these governments. But if one or more cannot avoid a debt restructuring, then delay will not lessen the eventual pain.
The Greek problem is important for the world, because the country has a particularly acute case of a common financial disease: debts that are too large to be serviced by current incomes. The leverage-fuelled global bubble in asset prices has left many individuals, some companies and a scary list of countries at credible risk of default whenever interest rates rise from their current ultra-low levels. The United States and the UK are certainly on the list.
The Van Rompuy solution, a combination of growth and frugality, can solve the problem, but only if creditors are patient and debtors are virtuous. Historically, the more common ways to cut debt loads have been monetary: straight write-downs of loans, inflationary increases in incomes or currency devaluations that reduce the real value of repayments to foreign lenders.
Debt overhangs are unseemly and all the monetary solutions are unpleasant. But default may not be the worst. In Greece and elsewhere, it shouldn’t be dismissed without first getting serious consideration.
