SANTIAGO – Europe has long been menaced by the threat of two crises. The first would erupt with a successful speculative attack on a large eurozone country’s bonds, immediately jeopardizing the single currency’s survival. European Central Bank President Mario Draghi’s vow to do “whatever it takes” to prevent a sovereign default in the eurozone seems to have diminished that danger – at least for now.
The other looming danger is a growth crisis – a threat that has become increasingly serious. The ECB’s most recent macroeconomic forecast, which cut expected GDP growth for both 2012 and 2013, makes the threat all too clear: The eurozone will certainly contract this year, and grow by just 0.3%, at best, next year.
Europe persistently undershoots its growth targets because European policymakers persistently underestimate fiscal multipliers, pursuing austerity instead. And slower growth means lower revenues, which imply larger deficits and heavier debt burdens – at which point, as Wolfgang Munchau of the Financial Times and others have stressed, the entire belt-tightening exercise begins to look self-defeating.
This is all pretty worrisome. But things could get worse. The problem is not just that slow growth is driving up debt levels. It is also increasingly plausible that the debt overhang is itself becoming the cause of slow growth.
Few people want to go down that route, because it leads directly to the question of debt forgiveness. But the issue can no longer be ignored – and not just in the case of Greece.
The concept of a debt overhang has been around forever, but it became prominent during the Latin American debt crisis of the 1980’s. Like many aspects of that crisis, it is applicable to Europe’s situation today.
A debt overhang exists when a country’s debt is large enough that the benefits of adjustment and growth go entirely to the creditors. As the Nobel laureate economist Paul Krugman pointed out a quarter-century ago, a country in this situation will be unwilling to undertake additional painful adjustment, because it gets nothing in return. And, because the proceeds of any new investment will be taxed away to service existing obligations, the debt overhang discourages private investment and growth.
If the disincentive is large enough, then a larger debt burden may cause the country’s repayment capacity to fall. This gives rise to a debt-relief Laffer curve. For low levels of debt, increasing the debt burden increases the flow of payments that creditors get; but this relationship is reversed once the debt volume crosses a certain threshold. Reducing the face value of the debt is good not just for debtor countries on the “wrong side” of the curve; it is also good for creditors, who stand to get more of their money back.
But, while this neat theoretical construct clarifies the problem, figuring out where a country lies on its debt-relief Laffer curve is no easy matter. Many doctoral dissertations were written on this issue during the Latin American debt crisis of the 1980’s.
In retrospect, two things seem clear. First, Latin American countries did not start growing again until debt had been substantially reduced through a series of initiatives – the most important being the Brady Plan of 1989, under which Latin American countries enacted reforms in exchange for debt relief. Second, creditors who stayed in – by swapping old obligations either for new Brady bonds or for local equity – typically did very well.
Skeptics will reply that Europe is not Latin America, and that the interest rates levied on European governments today are much lower than what Argentina or Mexico had to pay back then. Perhaps. But many European countries are more indebted than their Latin American counterparts were.
France’s public debt is 90% of GDP and rising, and five European countries’ debt/GDP ratios are above 100%. Latin American countries had to seek debt reduction when their debt burdens were smaller. And the recent spike in the interest-rate spread on Italian government bonds should remind optimists that, with sovereign debt so high, many things can go wrong at any time.
More and more Europeans are coming around to the view that Greece needs to have its debt cut yet again, and that this time official claims on Greece should be cut as well. But few Europeans today believe that Italy, Spain or Portugal, much less France, will need debt reduction. Give them time. It was not so long ago that few Europeans could imagine a euro crisis.