The Euro at Mid-Crisis

CAMBRIDGE – Now that the European Union and the International Monetary Fund have committed €67.5 billion to rescue Ireland’s troubled banks, is the eurozone’s debt crisis finally nearing a conclusion? Unfortunately, no. In fact, we are probably only at the mid-point of the crisis. To be sure, a huge, sustained burst of growth could still cure all of Europe’s debt problems – as it would anyone’s. But that halcyon scenario looks increasingly improbable. The endgame is far more likely to entail a wave of debt write-downs, similar to the one that finally wound up the Latin American debt crisis of the 1980’s. For starters, there are more bailouts to come, with Portugal at the top of the list. With an average growth rate of less than 1% over the past decade, and arguably the most sclerotic labor market in Europe, it is hard to see how Portugal can grow out of its massive debt burden. This burden includes both public debt (owed by the government) and external dent (owed by the country as a whole to foreigners). The Portuguese rightly argue that their situation is not as dire as that of Greece, which is already in the economic equivalent of intensive care. But Portugal’s debt levels are still highly problematic by historical benchmarks (based on my research with Carmen Reinhart). With a baseline scenario of recession or sluggish growth amid budget austerity for years ahead, Portugal will likely seek help sooner rather than later. Spain is a more difficult case. The central government is arguably solvent, but a significant chunk of municipal and provincial bank debt seems underwater. The big question in Spain is whether, as in Ireland, the central government will allow itself to be gamed into taking on private (and also municipal) debt. Here again, history gives no cause for optimism. It is very difficult for a central government to sit on the sidelines when the economy’s key players are on the brink of collapse. But bailouts for Portugal and Spain are only the next – and not necessarily final – phase of the crisis. Ultimately, a significant restructuring of private and/or public debt is likely to be needed in all of the debt-distressed eurozone countries. After all, bailouts from the EU and the IMF are only a temporizing measure: even sweetheart loans, after all, eventually must be repaid. Already facing sluggish growth before fiscal austerity set in, the so-called “PIGS” (Portugal, Ireland, Greece, and Spain) face the prospect of a “lost decade” much as Latin America experienced in the 1980’s. Latin America’s rebirth and modern growth dynamic really only began to unfold after the 1987 “Brady plan” orchestrated massive debt write-downs across the region. Surely, a similar restructuring is the most plausible scenario in Europe as well. It sometimes seems that the only eurozone leader who is willing to face the likely prospect of future debt restructuring is German Chancellor Angela Merkel. The Germans have been widely castigated for pointing out that Europe has no clear mechanism for sorting out sovereign (government) defaults, and that surely it needs one. Many pundits would have one believe that Ireland would have pulled through unscathed absent Germany’s blundering statements. That is nonsense. With huge private debts, falling house prices, and external claims on Ireland amounting to more than 10 times national income (according to the Reinhart-Rogoff database), there was never going to be an easy way out. Allowing European debt problems to fester and grow by sweeping them under the carpet through dubious theatrics can only make those problems worse. Indeed, only last July the eurozone made a big show of its financial “stress tests” of its banks, giving almost all of them, including in Ireland, a clean bill of health. Denial is a not a useful policy for dealing with a financial crisis. Europe’s debt problems should, in fact, still be quite manageable – provided the requisite write-downs and debt restructurings are implemented. Here is where the latest Irish bailout is particularly disconcerting. What Europe and the IMF have essentially done is to convert a private-debt problem into a sovereign-debt problem. Private bondholders, people and entities who lent money to banks, are being allowed to pull out their money en masse and have it replaced by public debt. Have the Europeans decided that sovereign default is easier, or are they just dreaming that it won’t happen? By nationalizing private debts, Europe is following the path of the 1980’s debt crisis in Latin America. There, too, governments widely “guaranteed” private-sector debt, and then proceeded to default on it. Finally, under the 1987 Brady plan, debts were written down by roughly 30%, four years after the crisis hit full throttle. Most post-mortems of the Latin American crisis suggest that all parties would have been far better served had they been able to agree on partial debt forgiveness much earlier. Latin America might have returned to growth far sooner than it did. Creditors might even have received more in the end. As European policymakers seek to move from one stage of denial to another, perhaps it is time to start looking ahead more realistically. As any recovering alcoholic could tell them, the first step is admitting, with Merkel, that Europe has a problem. Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.