March 28, 2024

Economix: Economist Q.&A. on Europe’s Debt Accord

European leaders reached an accord Thursday to reduce Greece’s debt burden and prevent a collapse of confidence that has threatened to engulf some of the region’s largest economies. Economix has asked three prominent economists to offer their views on the accord and the effects it may have, intended or otherwise, in Europe and the United States. They are:

Simon Johnson, a professor of entrepreneurship at the Sloan School of Management at the Massachusetts Institute of Technology, a former chief economist at the International Monetary Fund and a Daily Economist here at Economix.

Carmen M. Reinhart, a senior fellow at the Peterson Institute for International Economics, an economic historian and the co-author of “This Time Is Different,” which chronicles 800 years’ worth of debt crises and sovereign defaults.

Laura D’Andrea Tyson

Laura D’Andrea Tyson, a professor of global management at the Haas School of Business, University of California, Berkeley, and national economic adviser in the Clinton administration. She, too, is a recurring contributor to Economix.

What effect is the European accord, including “selective default,” likely to have on Greece’s economy as it tries to recover?

Simon Johnson: The debt deal will help Greece, but likely not enough. The debt reduction that currently seems likely will be relatively small and the implied budget adjustment will be difficult.

Laura D’Andrea Tyson: The idea that, through backbreaking austerity measures, Greece could pay back its debt on time was a triumph of hope over reality. Greece was caught in a downward debt spiral, heading toward disorderly default and depression that would eventually necessitate its exit from the European Union. Now reality has taken center stage in the new European accord.

European leaders have now acknowledged that restructuring must play a role in the resolution of Greece’s debt crisis and they have outlined a comprehensive rescue plan that includes both a substantial commitment of additional official resources from the European Union and the International Monetary Fund and “voluntary” contributions from Greece’s private creditors, primarily European banks. Private creditors will be offered several options to restructure their holdings of Greek debt and public funds will be available to provide “credit enhancements” to encourage them to do so. This approach is similar to that of the successful Brady plan to restructure Latin American debt in 1989. The rating agencies have warned that the exercise of these options will likely trigger a selective default on some Greek debt.

The plan also calls for a significant infusion of E.U. funds for bailout loans to Greece, slashes interest rates on these loans and doubles their repayment period. The European Financial Stability Facility (E.F.S.F.), established during the first bailout effort in 2010, will be given substantial new powers including the authority to lend to euro zone governments to recapitalize their banks and to help them prevent future crises

Voluntary restructuring of Greek debt by private creditors and generous fiscal transfers from the European Union’s core economies in the form of loans with generous repayment terms may resolve Greece’s debt crisis but they will not by themselves address Greece’s long-term competitiveness problem. The new plan acknowledges this reality and calls for reallocating E.U. structural funds to support a European Marshall Plan for Greece. At least so far, there has been no indication of the amount that would be provided for this purpose, but the amount required is likely to be substantial and politically controversial in the core economies.

The reality is that given its current productivity levels and its current mix of activities, the Greek economy cannot compete at the current value of the euro. And the situation has been getting worse over time as the rise of other emerging market economies has eroded Greece’s competitiveness in lower-cost manufacturing while boosting the demand for exports from Germany and other core E.U. countries and driving up the euro’s value. If Greece were not part of a common currency area, it would almost certainly follow the successful adjustment path of other developing economies from a deep financial crisis — official assistance from the I.M.F. or another source of public funds; austerity; debt restructuring; and a massive nominal and real depreciation of its currency to boost its competitiveness and growth. But as long as Greece remains part of the euro zone, this option is not available. In lieu of this option, Greece will have to rely on structural policies to enhance its competitiveness, and such policies can take a very long time to produce their desired effects. In the meantime, Greece will continue to suffer from slow growth, high levels of unemployment, stagnant or falling wages and high levels of indebtedness relative to gross domestic product.

Carmen M. Reinhart: If the historic patterns that Ken Rogoff and I study hold true, the year that a country defaults is a difficult one, associated with uncertainty, confusion and recession. In many ways, the problems that emerge in the three-year period running up to the event show through in force in the year of default. Recessions typically are more severe, with output declines averaging nearly 5 percent, when the government defaults on both domestic and external debt, as Greece just did.

The good news is that these patterns also reveal that recovery (positive G.D.P. growth) begins the year after the default; prior output losses tend to be recovered within three years following the default. Of course, in this vast historical laboratory, nearly all the defaults were accompanied by currency depreciations — if not outright currency meltdowns — that swung the current-account balance from deficit to surplus and thus contributed to the recovery.

What are likely to be the challenges in carrying out the European plan?

Carmen M. Reinhart: Default or restructuring is “simpler” when the debt is held by a handful of banks or investors. Default episodes typically begin with a “reign of confusion.” Essentially, investors fight among themselves and use courts in different jurisdictions to claim the largest piece possible of a shrunken pie.

Events in Greece are unlikely to be any different in that regard. For starters, the list of institutions supporting the Institute of International Finance is far from comprehensive. For example, there is a notable absence of American banks and only a couple of British banks are on the list.

There are many challenges, but maintaining the prior status quo was not a feasible alternative. The fiscal position of Greece was unsustainable and investors have to be part of any viable solution.

Simon Johnson: The short-term market reaction will probably be favorable. But will Europe now show signs of strong growth, particularly for countries with large debt burdens? Or will growth slow at both the European and global level — implying it is harder to grow out of these problems?

Laura D’Andrea Tyson: There are many details of the plan that still need to be worked out and there are still significant disagreements among member states about these details — including the options that private creditors will be allowed to use for debt restructuring or the credit enhancements that will be offered to encourage voluntary restructuring. There is no guarantee that a cooperative voluntary debt restructuring involving many private sector banks with different regulatory authorities will be possible. Parliamentary approval for an expansion of new authorities under the European Financial Stability Facility will be required and is not guaranteed. The plan calls for the participation of the I.M.F. but the terms of its participation have not yet been agreed.

The plan explicitly states that Greece is in a uniquely grave situation and requires an exceptional solution. Other countries commit their “inflexible determination” to honor fully their sovereign debt — in other words, the plan’s provisions for voluntary debt restructuring by private creditors are limited to Greece and do not apply to other heavily indebted periphery countries like Ireland and Portugal. They would have access to E.F.S.F. loans on the same terms as Greece, but they would not have access to E.F.S.F. support to restructure their debt with private creditors. This may prove to be impossible to enforce if the contagion effects from the Greek crisis aggravate the debt crises in these countries. The commitment to treat Greece as an exceptional case may prove to be another triumph of hope over reality.

The plan does not expand E.F.S.F. resources and these may prove to be inadequate, requiring an additional infusion of funds in the future.

Finally, there may be significant political pushback against the plan both among voters in core countries that will be financing bailout funds and among voters in Greece that will continue to suffer from slow growth, high unemployment and years of fiscal austerity.

Why was the European Central Bank opposed to a selective default and why did it change its view?

Simon Johnson: The E.C.B. apparently feared consequences for the bond prices of other “peripheral” countries, including Italy. The view now must be that there is enough additional support in place to help any country that comes under market pressure. Let’s hope they are right.

Carmen M. Reinhart: At first, the E.C.B. mistook a chronic solvency problem for a temporary liquidity challenge. The denial phase was a long one, but that is typical in the run-up to default. Subsequently, the hope was that fiscal austerity and economic growth alone could do the job of bringing Greek public debt–to-G.D.P. back to sustainable levels. This was another aspect of denial, as the historical experience highlights some form of default or restructuring is an integral part (in addition to fiscal austerity) of the debt-reduction process for highly indebted economies.

Laura D’Andrea Tyson: The European Central Bank opposed restructuring options that might trigger a selective default in part because such a default would erode the value of the sovereign bond holdings the bank had already purchased or had accepted as collateral, in part because such a default would trigger a liquidity crisis in the Greek banking system that the E.C.B. could not address, and in part because such a default would erode the capital base of the European banks, necessitating more support from the E.C.B. It is also likely that the central bank used its opposition as a bargaining chip to keep pressure on the fiscal authorities of the European Union member states to provide more fiscal resources to recapitalize their banks and to fund official loans to Greece and other periphery countries. Both of these responsibilities rest with the fiscal authorities of the European member states, not with the E.C.B.

The new plan contains several features that address concerns of the central bank. It will be compensated for any losses it suffers on Greek bonds so it can continue to accept them as collateral in loans to Greek banks. The European Financial Stability Facility will provide the necessary compensation. As part of the new deal, the euro zone leaders agreed to provide funds to help recapitalize the Greek banks. Over all, the new plan will provide new fiscal resources and new fiscal authorities to address the Greek debt crisis, easing the pressures on the E.C.B. Finally, the plan reflects the central bank’s determination that Greece be treated as “an absolutely exceptional situation,” although it remains uncertain whether this will turn out to be the case.

What concerns does this raise about the effect on European banks?

Carmen M. Reinhart: European banks will, most likely, require further assistance from their respective governments in the recapitalization process. No doubt, it would be most efficient and transparent to deal with the holes created on European bank balance sheets on a unified basis. My expectation, however, is that national leaders do not have the appetite for another pan-European solution to a financial problem. In that case, much of the support from the governments to the banks will be done on a case-by-case basis, as weaknesses at individual institutions are revealed.

However, the “positive” feature of the Greek restructuring is that it did not spring up without warning when leveraged exposure to Greece was at its zenith. Historically, the most severe cases of financial contagion involved the element of surprise. With nearly two years of well-publicized debt difficulties and a string of rating downgrades in the process, this credit event can hardly be called a surprise.

What are the spillover effects of a selective default for financial firms and markets in the United States?

Simon Johnson: This is a big unknown. The direct links through bank loans and money market mutual funds do not imply big spillover effects. But the credit-default swap market is a big wild card. No one seems to have a good handle on either gross exposures or net exposures to anything that is classified as a “credit event.”

Carmen M. Reinhart: As noted, this event was signaled well in advance and appears to be embedded in market prices. However, the same was said of Lehman Brothers in September 2008. This time round, the direct exposure of U.S. banks to the government of Greece appears to be trivial. More worrisome, and much harder to ascertain, is the exposure of U.S. financial institutions, including money market mutual funds, to the European banks affected by the Greek default.

What does this move portend for the euro zone?

Laura D’Andrea Tyson: The new plan for Greece has been called a plan to save the euro. But if the new plan is not generous enough or does not take effect quickly enough, Greece may decide that the economic benefits of staying in the euro system are lower than the economic costs of exiting the system. In that case, the new plan will not succeed in saving the euro as it exists today.

Simon Johnson: The euro zone has bought itself some time. But unless the troubled countries now show strong growth, there is still trouble ahead.

Carmen M. Reinhart: More “selective defaults” or restructurings are likely to follow in the period ahead. Ireland and Portugal, notably, face severe challenges of their own (with or without a Greek restructuring). More broadly for the euro zone, the process of deleveraging, as Vincent Reinhart and I have stressed, is a multiyear process that takes up the better part of a decade in the wake of severe financial crises. As we documented, growth remains subpar and unemployment stubbornly high as deleveraging slowly unfolds. Excess debt affects both the public and private sectors; it is both a domestic and external debt overhang.

Article source: http://economix.blogs.nytimes.com/2011/07/22/economist-q-a-on-europes-debt-accord/?partner=rss&emc=rss

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