One of the undeniable features of the European debt crisis is the tendency to obscure, verbally and politically, the real issues at play. Euphemisms, statistical gimmicks, meaningless institutional squabbling, undecipherable acronyms, and plain double talk proliferate as part of the debate.
In my experience as central-bank governor in Argentina during the worst financial crisis in our history, at the beginning of this century, I learned how useful it is to cut through the fog in order to rebuild credibility and to allow a more lucid evaluation of the outlook. While there are few similarities between Greece’s present debt situation and Argentina’s in 2002, it is possible to reduce the recent talk of a default to four basic issues and make some predictions.
The nature of the debt problem in peripheral Europe is structural. Since it doesn’t reflect a temporary liquidity squeeze, the approach adopted so far can’t resolve it. The strategy in progress has been to pile new debt upon the existing stock. New loans are used to pay old debt, in addition to financing remaining fiscal gaps. This is why the Ponzi scheme analogy is appropriate. And while the pyramid is growing, the share of peripheral debt held by state-owned institutions also keeps getting bigger. This means that when it all finally collapses, it is the taxpayers of Europe, and the world, that will bear the full cost.
The pyramid may continue to grow for a while, particularly if the cement used is public funds. But it is an unstable construction because European bailouts are becoming politically questionable and because throwing International Monetary Fund money into the Ponzi scheme is raising objections. This strategy is only making the situation worse.
The IMF has performed badly in this crisis. Its programs are bound to fail because their design is profoundly flawed. They contain two basic blunders. First, they have wrongly assumed that peripheral countries could return to the voluntary capital market next year. Today we know that Greece’s ability to borrow 30 billion euros ($43 billion) in 2012 is nothing but a fantasy. The programs, therefore, remain unfinanced. And the situation promises to be even more difficult in 2013 if the perverse permanent-bailout mechanism being designed is adopted.
Second, programs have been based on dreamy debt sustainability scenarios in which countries outgrow their debt under severe fiscal tightening. But since these austerity plans cause deep recessions, the debt/gross-domestic-product ratios increase over time in all peripheral nations. How this squares with sustainability, and how the macroeconomics add up, is hard to comprehend.
One proposed solution has been the sale of state assets. But currently this would result, at best, in fire sales. If there is low demand for Greek debt, why would investors want the country’s equity? The Latin American experience is that privatization has been, in general, good for efficiency and productivity, but never resolved a fiscal structural imbalance.
All this shouldn’t detract from the need for fiscal and structural adjustments as part of a long-term solution. But there is no long-term stable solution without debt relief, which, in plain English, means default. There are many ways of defaulting, but it is evident that without a significant haircut for bond investors there is no way out. The real question isn’t whether, but when and how.
In this context, two issues arise: regaining market access and contagion. On the first, experience indicates that it is easier to regain market access after a well-coordinated debt-burden reduction than it is before. The example of Uruguay comes to mind. And Argentina, with still pending concerns, could access the market today, if it wished, at half the Greek spread and below Portugal’s and Ireland’s. Another more recent example is the Vienna Initiative, a coordinated strategy used in Eastern Europe to prevent the withdrawal of cross-border banks during the financial crisis. It could be adapted to the periphery to help with a debt restructuring.
Regarding contagion, it is undeniable a credit event in Greece would cause political contagion in Ireland and Portugal. But once it happened, it may even relieve the pressure on Spain and other potentially compromised sovereigns. Contagion through the deterioration of bank balance sheets should be addressed by recapitalizing affected lenders within a program financed by the resources directed today to increase the pyramid of debt.
The institutional crisis-management setting is in disarray: The European Union wouldn’t oppose a default (if it could use a different word); the IMF demands financial assurances for next year; and the European Central Bank is ardently opposed to any form of debt relief. The most likely scenario is that the ECB will, again, make a U-turn before reaching the abyss (as it did with secondary bond-market purchases). The ECB threats to cut Greek banks from access to liquidity in case of default are very dangerous, and ultimately not credible, because it could trigger an accelerated bank run and detonate a banking crisis, including the possibility of a deposit freeze similar to the one that was such a disaster in Argentina. This would have more potential to damage the euro than any credit event.
As for the Argentine experience, it is important to remark that, while without the default the economy wouldn’t have been able to recover as it did, the experiences aren’t directly comparable. Argentina was able to devalue its currency and was also helped by a big improvement in terms of trade and significant fiscal adjustment. But there is an important lesson. Postponing inevitable actions increase the cost of eventual adjustment. At the time of the default, Argentina’s output had already declined by more than 10 percent. A timely and friendlier negotiation aimed at obtaining debt relief would have saved the country several years of pain.
The current European strategy, if there is one, seems to be to delay the day of reckoning. It could, however, be useful, if the time gained is utilized to prepare for the inevitable default. Just muddling through, in the mist of a cacophony of contradictory statements that further erode the credibility of the crisis-management framework, only creates uncertainty and is a recipe for major disaster.
By Mario I. Blejer
Mario I. Blejer is a former governor of Argentina’s central bank, was a senior adviser to the International Monetary Fund and is currently the vice chairman of Banco Hipotecario SA. The opinions expressed are his own. ― Ed.