EC When Do We Decide That Europe Must Restructure Much Of Its Debt?

It is hard to watch the Greek drama unfold without a sense of foreboding. If it is possible for the Greek economy partially to revive in spite of its tremendous debt burden, with a lot of hard work and even more good luck we can posit scenarios that don’t involve a painful social and political breakdown, but I am pretty convinced that the Greek balance sheet itself makes growth all but impossible for many more years.

The history is, to me pretty convincing. Countries with this level of debt and this level of uncertainty associated with the resolution of the debt are never able too grow out of their debt burdens, no matter how determined and how forcefully they implement the “correct” set of orthodox reforms, until the debt is resolved and the costs assigned. Greece and Europe, in other words, have a choice. They can choose to restructure Greek debt explicitly, with substantial real debt forgiveness and with the costs optimally allocated in a way that maximizes value for all stakeholders, or Greece can continue to struggle for many more years as the debt is resolved implicitly, with the costs allocated as the outcome of an uncertain political struggle.

Until one or the other outcome, the country is not a viable creditor and it will not grow. There is no way to get the numbers to work. If Europe policymakers who oppose a rapid resolution of its debt crisis continue to prove as intransigent over the next few months as they have been in the past week, I suspect that they will only be able to pull off one of their goals, which is to embarrass Syriza and get it thrown out of office.

But I suspect that many European policymakers incorrectly think Syriza is as radical as it gets, and once Syriza is discredited, almost any alternative leadership would be better. I disagree. If Syriza is discredited, and the Greek economy continues to stagnate as I expect, the alternative could very easily be Golden Dawn or some other group of radical nationalists determined to blame foreigners for their problems, and Germany will have set itself up for much of the blame. It is ironic, because in my opinion Angela Merkel is not and has never been the bully that she is made out to be, and the main reason Germany seems to be running the show is that no one else has ever dared to disagree with her or to take any position of real leadership. For that reason she and Germany are being seen as far worse than they actually are.

And this is clearly not just about Greece. Everyone understands that Greece has already restructured its debt once before and received partial forgiveness — in fact once coupon reductions are correctly accounted for Greece’s debt ratio is probably much lower than the roughly 180% of GDP the official numbers suggest. Most people also understand that the Greek debate is not just about Greece but also about whether or not several other countries — Spain, Portugal and Italy among them, and perhaps even France — will also have to restructure their debts with partial debt forgiveness.

What few people realize, however, is these countries have effectively already done so once. This happened two and a half years ago at the Global Investment Conference in London when, on July 26, 2012, Mario Draghi, President of the European Central Bank, made the following statement:

When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro. And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

But there is another message I want to tell you. Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

As soon as Draghi made the statement to do “whatever it takes”, markets recognized that the ECB was in effect guaranteeing the bonds of EU member states whose credibility was in question, and yields immediately dropped. It is important to understand why this was effectively a kind of debt restructuring. With Draghi’s statement, there was an immediate transfer of wealth from the ECB — or, more appropriately from the group of countries behind whom the credibility of the ECB is maintained, and this means Germany above all — to the governments whose creditworthiness was in doubt.

Not only was their debt effectively restructured, in other words, but they were also granted partial debt forgiveness. I will explain this later, but I want to start off by making two points. First, Draghi’s promise was far from an optimal resolution of the European debt crisis, in part because it does not address the key issue of uncertainty, to which I will return. Second, there is an enormous amount of confusion about debt restructuring, especially at the sovereign level.

Many people believe that any sovereign debt restructuring, and its accompanying implicit or explicit debt forgiveness, is already an admission of failure, with moral and nationalist overtones. But as the implicit restructuring that occurred with Draghi’s promise to do “whatever it takes” suggests, debt restructuring is actually a process that involves increasing the value of the obligations and operations of the restructuring entity. It can be done well, it can be done badly, and it can be done disastrously, but it is a financial operation with a clearly defined goal of improving the overall wealth of stakeholders, and while it is reasonable that stakeholders negotiate the ways in which this additional wealth will be allocated, the negotiation should not prevent the restructuring.

In order to understand the differences between optimal and suboptimal sovereign debt restructuring it is necessary that we understand the relationship between the asset and liability sides of a balance sheets and how the interaction between the two create or destroy value. In this blog entry I hope to address the relevant issues. It will be divided roughly into three parts in which I want progressively to describe what an optimal debt restructuring should accomplish.

1. Why must Europe restructure much of its debt? The purpose of a debt restructuring is to make all parties better off by increasing the value of the associated instruments and improving future growth prospects for all the relevant stakeholders. Once the existing debt structure adversely affects future growth prospects and reduces the current wealth of the relevant stakeholders, it makes sense to consider ways in which the debt can be restructured so as to improve both current value and future growth prospects.
2. For most economists, debt is the way operations are funded, and the best debt is the cheapest. I am not suggesting that economists are unaware that certain debt structures are riskier than others, but for the most part they ignore the structure of the balance sheet and focus primarily on the way assets are managed. The moment debt levels become high, however, or create institutional distortions, they begin to affect, and usually constrain, value creation. Debt has four very separate and very important functions, and it is important to understand what they are before deciding what an optimal balance sheet looks like.
3. Once we understand the role and impact of the structure of the balance sheets, it becomes possible to describe what an optimal debt restructuring should accomplish.

Debt can be thought of as a moral obligation when a loan is extended from one individual to another, especially if there is no interest on the loan. But loans to businesses or to sovereign entities are business transactions, and they should be managed as such. The only moral obligation in restructuring sovereign debt, it seems to me, is for policymakers to fulfill their political responsibilities to do what is in the best interests of their citizens and to participate in a responsible way in the global community. The debt restructuring process is, in other words, morally neutral.

The decision to restructure debt

Normally the relevant characteristics of a bond issued by government are very clear. Needless to say most borrowing agreements specify a series of payments to be made in a specified currency on a specified date, but this is not what I mean when I say the relevant characteristics of a bond issued by a government are very clear. The clarity that matters is in the resolution of the debt.

Let me step back for a moment. Debt is always “resolved”, in the sense that either the obligor makes the contracted payments as expected and without difficulty or, in the case where it is unable to make the contracted payments, there will either be an equivalent payment absorbed by the creditor, in the form of losses and a write down, or some other entity will step in and directly or indirectly make the payment. Put differently, debt is always “paid”, if not by the borrower, then by someone else. The resolution of debt can be explicit, transparent and certain, or it can be non-transparent and uncertain, but however it occurs, debt is always resolved in a way that requires implicit or explicit wealth transfers from one or more entities.

This is true of both private debt and sovereign debt, and it is true whether the debt arises directly or in the form of contingent liabilities. However in the case of sovereign debt, all the costs associated with servicing and paying down the debt are ultimately assigned to different groups of stakeholders. These include workers and ordinary households, small and medium-sized companies, large companies and multinationals, wealthy households, or, especially in the case of countries with very large public sectors, local and central governments through asset liquidation and land sales. Stakeholders can even include foreigners, so in the case where a country’s external debt is restructured with partial debt forgiveness, the debt is “resolved” in part by wealth transfers from foreign creditors.

When I say that “normally” the relevant characteristics of a bond issued by a government are very clear, I mean that “normally” there is no uncertainty associated with how these payments will be resolved. The government runs a budget, in which expenditures are funded in a fairly explicit manner by tax collection and by borrowing, or sometimes by asset sales, and there is an assumption that the costs associated with servicing the government’s outstanding bond obligations will be met through normal budge operations. Governments also sometimes resolve debt by hidden means, by monetizing the debt or through financial repression, in which case it is usually middle class savers, most of whose savings are in the form of monetary assets, who end up paying for the debt.

As long as debt levels are not “excessive” and the government is believed to be solvent — which in the context of sovereign debt always refers to the ability of the government to service its contractual obligations at a cost that is politically acceptable — there is very little uncertainty associated with the resolution of debt servicing costs. Payments will be made out of ordinary budget operations and none of the stakeholders worry that the high debt-servicing cost will force unexpected changes in the way in which costs are allocated and the debt resolved.

Once debt levels are excessive, however, questions arise about the country’s solvency and about the steps the government will take to resolve the debt. This is the difference between a fully creditworthy borrower and one that is not – in the former case there is no uncertainty about how the cost of resolving the debt will be allocated and in the latter there is. As I will explain later, this uncertainty forces stakeholders to alter their behavior, and they do so in ways that always automatically either increase balance sheet fragility further, reduce growth, or both.

What makes matter worse is that when debt levels are excessive it is not just how the costs will be allocated that is uncertain. In most cases the amount of the obligation itself becomes uncertain. This is because depending on how economic circumstances evolve, additional contingent liabilities may be forced explicitly or implicitly onto the sovereign credit. When the government loses credibility, it is almost always the case that total debt ends up being even higher than originally contracted, and there are many reasons why this happens. A slowing economy, for example, may increase the number of bankruptcies that the banking system has to absorb, and because in many cases the banking system is already effectively insolvent, and must be explicitly or implicitly bailed out by the government, already high levels of sovereign debt will rise even further. If the country is forced to devalue the currency, to take another example, the value of external debt will soar, or if slower growth causes fiscal revenues to be less than expected and fiscal expenditures greater, debt will rise further.

This creates by the way a problem that is not sufficiently recognized in the debate about the European debt crisis. A debt crisis must be resolved quickly because there is a self-reinforcing component within the process that can be extraordinarily harmful. High levels of sovereign debt create uncertainty about how the costs of resolving the debt will ultimately be assigned. This uncertainty causes growth to slow by adversely changing the behavior of a wide variety of stakeholders in the economy (as I will describe later). As the economy slows, contingent liabilities within the banking system rise, tax revenues decline and fiscal expenditures rise, all of which push up sovereign debt levels even further and increase both the cost of resolving the debt and the uncertainty about how the costs will be assigned. The consequence of this self-reinforcing deterioration in the sovereign balance sheet is, at first, a slow grinding away of the economy until the market reaches some point, after which the process accelerates and debt can spiral out of control.