The Seven-Year Ditch

PRINCETON – There are historical precedents for sovereign-debt defaults by the countries of Europe’s southern periphery, but they are not instantly attractive ones. Dealing with seemingly intractable problems often takes time. And it is difficult – especially in a democracy – to be patient. The most obvious parallel to Europe’s current woes is the Latin American debt crisis of the 1980’s. In August 1982, Mexico threatened to default, and was quickly followed by other large borrowers, notably Argentina and Brazil. A default contagion would have brought down the banking systems of all the major industrial countries, and caused the world to relive something like the financial crisis of the Great Depression. What followed was a seven-year play for extra time. The initial approach was to link policy improvements in the borrowing countries not only with help from international institutions, but also with additional lending from the banks – which seemed to defy the most elementary canons of sensible bank behavior. Three years after the outbreak of the Latin American crisis, United States Treasury Secretary James Baker announced a systematization of the initial response. It was not very imaginative: Banks and multilateral development institutions should all lend more, and the debtors should continue their efforts to improve their macroeconomic policies. The Baker Plan was a universal disappointment. Growth faltered again, and the International Monetary Fund actually reduced its lending. More than three years passed before new US Treasury Secretary Nicholas Brady set out a more satisfactory program, in which banks would be given a menu of options that included lower interest rates on the debt and a hefty discount on the principal. If creditor banks were unwilling to accept some form of restructuring, they would have to put in new money. The lending of the international institutions might also be used for buying back discounted debt. Brady’s plan looked like a great success. Confidence returned, capital flight from Latin America was reversed, and capital markets became willing to provide financing again. Inevitably, the Brady Plan looks like a good model for southern Europe. Why not avoid seven years of misery, and begin some similar rescue operation now that could lead to a return to economic vigor and dynamism? The most obvious answer is that at an earlier stage in the Latin American saga, the banks simply could not have afforded to take such losses on their capital. They needed to fake it for seven years in order to build up adequate reserves against losses. The initiative for the Brady Plan did not come from the official sector at all. It was the willingness of some large financial institutions to trade in discounted debt that established a market that could clear out the legacy of past mistakes. Two institutions, in particular, took the lead: Citicorp in the US and Deutsche Bank in Europe. Their CEOs at the time presented their actions as being motivated by far-sighted benevolence and a concern for the well-being of the world as a whole. That may have been plausible, but the two banks also wanted to demonstrate publicly that they had better balance sheets than their weaker rivals. In Germany, the Dresdner Bank and the Landesbanken could not afford to take such a hit. Moreover, despite the obvious “reform fatigue” of Latin American electorates, the debtor countries had engaged in a substantial measure of reform. Before the Brady Plan was announced, Mexico had accepted a wide-ranging Pact of Economic Solidarity and Growth, which immediately improve investor confidence and reduced sky-high domestic interest rates. The final move to solve the debt problem came in the aftermath of international currency adjustment. One of the problems that had made the crisis more difficult after 1982 was the US dollar’s appreciation. Likewise, today’s euro crisis is harder to resolve because of the euro’s strength in currency markets. The dollar’s slide after 1985 made the real burden of Latin America’s dollar debt much lighter. Calling for a European Brady plan today does not guarantee the necessary conditions for such a plan to succeed. On all fronts, there has not been much progress. There is certainly plenty of frustration about the implementation of austerity, and no real indication of the long-term sustainability of reform efforts in southern Europe. The problems of Europe’s banks are also far from being resolved. A truly competitive European banking system would provide incentives for the larger and stronger banks to take more risks in the hope of growing even larger and stronger. But, in the aftermath of the financial crisis, policymakers are too pre-occupied by the real problems posed by too-big-to-fail banks, and too terrified by the potential collapse of weaker banks, to allow such a solution. Recapitalization has not yet reached the point where there are enough strong banks. Finally, global uncertainty about currencies stands in the way of a solution. The euro’s strength, despite the magnitude of the eurozone’s difficulties, makes an export-led recovery strategy harder to realize. The common currency’s strength reflects problems elsewhere in the world, but a euro exchange rate that would enable the return of confidence and growth is no less elusive for that. Without the preconditions that made the Brady Plan work, simply transplanting a debt write-off would only augment uncertainty and fuel the political revulsion that already threatens to undermine European integration. And it may be that Europe – because of its relative prosperity – is less in a mood for the biblical seven lean years than was a much poorer Latin America in the 1980’s. Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. His most recent book is The Creation and Destruction of Value: The Globalization Cycle. Copyright: Project Syndicate, 2011. www.project-syndicate.org