Eurozone debt crisis: To restructure or not?

In March, European leaders agreed a 'grand bargain' that was designed to restore flagging confidence in the eurozone. The deal, they hoped, would return the most troubled countries – Greece, Ireland and Portugal – to debt sustainability and prevent catastrophic contagion to other, larger economies such as Italy and Spain. Just two months after it was concluded, the grand bargain is already looking frayed. Yields on Greek, Irish and Portuguese government bonds have risen above the already unsustainable levels seen in March. Fears surrounding Spain and Italy, which had receded in 2010, are re-emerging. And political developments – at both European and national level – are sapping the markets' faith in the ability of policymakers to craft lasting solutions.

The grand bargain's failure is no real surprise. The reason is that it fudged the answer to the central problem currently facing the eurozone: whether the indebted periphery should be bailed out or allowed to default. What the deal essentially did was to institutionalise IMF-type programmes (without the currency devaluations that usually accompany them). Creditor countries assented to the creation of a permanent financial assistance mechanism to provide bridging loans to the debtor countries, at rates well above the mechanism's cost of funding. In return, the debtor countries committed themselves to programmes of economic reforms designed to raise their long-term growth rates and to place their public finances on a more sustainable footing.

If the debtor countries only faced a liquidity crisis, such an arrangement would stand a decent chance of working. The problem, however, is that some of the debtors are almost certainly insolvent. The result is that extending bridging loans (at relatively penal rates) is little more than a short-term palliative. It buys time by easing cash flow in the short term, but does nothing to restore the weakest countries to debt sustainability. To call such an arrangement a 'bail out', moreover, is a bit of a misnomer. It is true that taxpayers in the core countries are taking on credit risk via the bridging loans. But contrary to popular perceptions, citizens in the debtor countries are emphatically not receiving 'hand outs' from taxpayers in the creditor countries.

It is unsurprising, then that the unpleasant choice facing Eurozone leaders has not gone away. If some of the peripherals are indeed insolvent, then relief in one form or another – via bail out or default – is inevitable. A taboo of sorts was lifted when the possibility of restructuring (or 'reprofiling') peripheral country debt was discussed by finance ministers at a 'secret' meeting on May 6th. But the question remains as politically divisive as it is explosive. It divides the German government internally. And the European Central Bank (ECB) is so implacably opposed to the very idea that its president, Jean-Claude Trichet, walked out of the meeting at which it was discussed. What explains the ECB's hostility to the prospect of debt restructuring?

Partly, it reflects an odd theological attachment to the idea of creditor sanctity: come what may, debtors should pay. But it also reflects a legitimate fear of the consequences. There are 'known knowns': a restructuring of Greek sovereign debt, for example, would inflict losses on banks inside and outside Greece (at a time when many are still thinly capitalised), as well as on the ECB (which built up sizeable exposures to peripheral debt in 2010). And there are 'known unknowns': the ECB is not confident that a sovereign debt restructuring could be achieved without provoking 'another Lehman' – that is, a catastrophic loss of confidence in financial markets resulting in a pan-European banking crisis and contagion to countries such as Spain and Italy.

In the short term, the ECB is likely to have its way. Politicians are still too divided on the idea of restructuring for it to make headway. And the ECB has deterrents of its own. It has already indicated that it would not accept as collateral any bonds whose maturities had been extended under a 'soft' restructuring – a threat that, if carried through, would provoke the collapse of the Greek banking system. The eurozone will therefore have to fall back on the pretence that economic reforms and fiscal austerity can restore Greece to solvency. Huge pressure will now be placed on Greece to make progress with its privatisation programme, even if estimates of the receipts likely to be generated by the sale of state assets appear to be unrealistically high.

Confidence across the eurozone will not be restored by a Greek privatisation programme. To start with, it is not clear what application the medicine being prescribed to Greece has to a country like Ireland (which has a smaller state and a more flexible economy). In any case, countries across the eurozone's indebted periphery will not return to solvency if their economies continue to contract. In the meantime, the three countries that have been shut out of the government bond markets – Greece, Ireland and Portugal – look set to become wards of European and multilateral institutions: they will owe a growing share of their outstanding liabilities to bodies such as the IMF, the ECB, the European Financial Stability Facility and its successor.

All this could poison European politics without resolving the economics. Taxpayers in the creditor countries will grow increasingly angry with their own politicians as the size of their contingent liabilities to the indebted periphery increases. Meanwhile, citizens in the periphery could revolt at endless, and potentially quixotic, austerity programmes – particularly if these come to be seen as policies imposed by foreigners to rescue private investors abroad. With national politics becoming ever more toxic, the very scenario that the ECB wishes to avoid (contagion and a messy default) might become impossible to avoid. If such an event came to pass, moreover, taxpayers in the creditor countries would bear more of the losses than private investors.

The crisis will not abate until credible policies are agreed to restore the indebted countries on the eurozone's periphery to long-term solvency. Sadly, European policy-makers are not much closer to that objective than they were in March.