Saturday, May 11, 2013

Is it necessary to prepare an organised default on European debt ?

Translated into English from : ''Faut-il se préparer à organiser un défaut de la dette en Europe ?'' (Atlantico.fr ; Published May 10, 2013)

A scenario for catastrophe

Mario Soares, former President of the Portuguese Republic, had called on April 12 for a default on Portuguese sovereign debt. He also demanded an end to the destructive austerity program imposed by the IMF and the European Union. Are we headed straight for disaster ?

Mario Soares, former president of Portugal (credit : Atlantico.fr)

Gaspard Koenig et Nicolas Goetzmann

Gaspard Koenig (@gaspard2012) directs the think tank GenerationLibre. He is also Vice-President of the Liberal Democratic Party.

Nicolas Goetzmann is Macroeconomic Strategist and author of a report on European monetary policy on behalf of Fondapol.

Atlantico : Mario Soares, historical figure of the Portuguese democratic revolution and former President of the Portuguese Republic, called on April 12 for a default on Portuguese sovereign debt.

Calling on opposition parties to overthrow the government, Mario Soares has demanded an end to the destructive austerity program imposed by the IMF and the European Union.

"Portugal," he said, "will never be able to pay its debts. If you cannot pay, the only solution is not to pay."

The hypothesis of a European cross-default is a disaster to be avoided at all costs or an option that we must now seriously consider - and perhaps even anticipate ?

Gaspard Koenig : Today, to my knowledge, only Michel Rocard had the courage and intelligence to publicly consider such a scenario. Obviously, with an average debt/GDP ratio exceeding 100%, the OECD countries are entering a unique historical situation in peacetime. We approach an "unsustainable" threshold when refinancing the debt becomes too expensive. European countries have fully known a variety of situations, and the fundamentals are the same : a welfare state built in the post-war era and out of control in recent decades. Even Germany is over 80% ! One can argue ad infinitum the study by Reinhart and Rogoff, the fact remains that such a level of debt is bad for the economy of the country, if only because the share of budget spending on refinancing of debt are increasing (compressing other parts of the budget). And I would even add : bad morale ! Nietzsche wrote timeless texts on the "guilt" that comes from debt. In France, a discussion about debt continue to be postponed.

Last, a balance holds only because of exceptionally low interest rates, due to the abundance of liquidity in the markets. But it is a house of cards. In the case of France, many international investors are now starting to sell their holdings of government bonds. As soon as money will find its price, many countries find the knife to her throat. We must prepare now.

Nicolas Goetzmann : The serious consideration to a default in France seems to be the culmination of the current wrong reasoning on austerity. This reasoning of the debt situation caused the crisis, then it its consequence. In other words, when considering such an option, we try to treat the crisis by attacking the symptoms rather than its causes. That is why this option is a mistake.

The cause of the crisis is the lack of growth resulting from the tight monetary policy pursued by the ECB. This policy is a powerful brake on economic development, the consequence is the explosion in the level of debt to GDP. The rising level of debt is not the cause of the recession, it is its consequence.

Thus, considering a default represents the end of a fallacy, that's why this solution seems unthinkable. It would look like an amputation performed on a patient following a misdiagnosis. France has the means to achieve to be the most powerful economy in Europe in the medium term, a default would be an admission of impotence, as well as an inability to understand the crisis we are experiencing.

What does history teach us about the consequences of a country that is in default ?

Nicolas Goetzmann : I flip the question, wondering what kind of state goes into default. These are second or third world economies, and whose institutions are not necessarily the most successful. Make predictions about a French default, which is the sixth-largest world economy, is useless, the consequences are unpredictable. We can not seriously consider a default by a country of this size can be compared in the same way as by Zimbabwe in 2006 and by Argentina in 2002.

Gaspard Koenig : It tells us that everything is possible ! Disasters occur mainly in the case of unilateral repudiation of debt or chaotic defaults motivated not by "inability to pay" of a State, but by a "refusal to pay" are most often related to political or ideological considerations (recently : Ecuador). But in the case of a limited and orderly default, investors are usually reassured that the debt curve returns to a sustainable path, and therefore the prospects for future repayment paradoxically become better (of course, restructuring must be accompanied by structural reforms). This was powerfully demonstrated by Bulow and Rogoff in their widely cited 1989 paper: "Debts That Are Forgiven Will Be forgotten." A typical example of this kind of "friendly" restructuring is Uruguay, which led in 2003 a restructuring accepted by 93% of its creditors. Rates returned to an almost normal level immediately after the closing of the bond exchange !

Finally, do not forget that revolutionary France itself defaulted in 1797 (the "bankruptcy of two-thirds"). Obviously, many pensioners had been ruined : it is a political choice. But the accounts of the country had been cleaned and then recovered.

How could one organize such a default ? Under what conditions could it be organized so as not to cause a financial disaster ? Should it necessarily be coordinated ?

Gaspard Koenig : According to our calculations, over two-thirds of the French debt is held by investors in the euro area (including domestic). It is clear that restructuring will create a chain reaction in Europe. The trend is in an obvious way. Yesterday Greece, Cyprus today, tomorrow Slovenia, then Portugal, Mario Soares has suggested, and Italy ? From there, everything can go very fast. It is therefore necessary to monitor and anticipate the process at European level.

The mechanism we propose for this cross default is inspired by the 2011 simulation by the "German Sages" (a group of economic advisers). The Sages offered to share refinancing from public debt exceeding 60% in a "redemption fund." Just replace "refinancing" by "restructuring" : the fund could be called "European Sinking Funds" - could offer its shares in exchange for existing debt (for the portion exceeding 60% of GDP) and on that applying a certain level of "haircut." Thus, Member States would benefit from increased financial margins to achieve their goals of debt reduction.

The European Commission announced in February 2013 the creation of a group of experts to consider the idea of ​​the Fund for redemption. The experts therefore broadened their thinking and calculations to the idea of ​​a Sinking Fund !

Nicolas Goetzmann : The condition to avoid a financial disaster is not to proceed to a default. The condition to avoid is the correct diagnosis of this crisis and to review the mandate of the ECB in depth, so that it finally takes into account unemployment and growth as an objective of monetary policy. This solution allows both boosting growth while reducing the level of debt, and will not cause hyperinflation, some seem to suggest. I do not see hyperinflation, neither in the United States, nor in Japan, nor in the United Kingdom, for the simple reason that monetary policy is not "unbridled" - it is simply balanced between control prices and full employment.

What legal, financial and economic risks arise as a result of such a process ? An explosion of the euro is inevitable ?

Nicolas Goetzmann : If you are seriously considering a default, it seems also appropriate to get the luggage ready in the euro zone. If the real purpose of the default is to get out of the euro zone, I would advise to find another way. A default, it is the opening to unknown territories, both in financial terms and in political terms. The French financial sector is of prime importance in the world, it is again a systemic risk. In addition, a default is also a disavowal of political power in place of its past actions. This is a very good breeding ground for populism of all kinds. (emphasis added)

Gaspard Koenig : In legal terms, the Greek case has shown that restructuring is quite possible in the euro zone, and the more so that the debts are issued by local law. The greatest risk are banks. According to our calculations, the French banking system could recover without recapitalization a certain level of "haircut" (around 25%) of all debts of the "Southern" countries (France, Belgium, Italy, Spain, Portugal, Greece, Ireland). Of course, the analysis needs to be done for the entire European banking system.

Restructuring will not cause, but avoid the explosion of the euro. It is indeed the only alternative to traditional means of mopping up the debt : inflation and/or devaluation now rendered impossible (rightly in our view) by the European treaties.

In contrast, could a debt restructuring cause a "beneficial moral shock" for Europe ?

Gaspard Koenig : This is the only way to escape the stupid dilemma between growth and austerity ! A restructuring will cause generational arbitration : investors (generally those who have raised the debt - through their representatives - the last thirty years) pay through their life insurance and mutual funds, while new entrants will be eligible for a new life. Politically, everything will - finally - be : Governments will be weakened if a new political situation is inevitable, with strong liberal reforms that drastically decrease the weight of the state in the economy ... and in our lives. This will be the moment when the Generation 68 will pass the baton to Generation Y and the last chance for Europe to reinvent its economic and social model.

Nicolas Goetzmann : I compare this to a wrongful operation of an amputee patient. Amputation may be the basis of a "beneficial moral shock," but the price seems high. Again, debt is not the cause of that through which we live, and, although the patterns of use of debt should be dropped, this is not the problem today.

Japan will resume growth despite the level of 245% of debt to GDP simply because its authorities, after 20 years of wandering, have made the right diagnosis : money. We must follow the same path, and we will get growth. The return to growth will generate operating margins to reach the (appropriate)* debt (level)* of the country. It would be absurd to persevere in this vision (a structured default as a resolution)* of the debt crisis.

* Note : added to give Mr. Goetzman's final comments clarity

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