Tuesday, September 30, 2014
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Europe’s Time to Learn

PRINCETON – Crises are a chance to learn. For the past 200 years, with the exception of the Great Depression, major financial crises originated in poor and unstable countries, which then needed major policy adjustments. Today’s crisis started in rich industrial countries – not only with sub-prime mortgages in the United States, but also with mismanagement of banks and public debt in Europe. So what will Europe learn, and what relevance will those lessons have for the rest of the world?

Europe’s contemporary problems offer striking parallels with previous problems on the periphery of the world economy. In successive waves of painful crisis – in Latin America in the 1980’s, and in East Asia after 1997 – countries learned a better approach to economic policy and developed a more sustainable framework for managing public-sector debt. Today it is Europe’s turn.

The European crisis is coming full circle. Initially a financial crisis, it morphed into a classic public-debt crisis after governments stepped in to guarantee banks obligations. That, in turn, has created a new set of worries for banks that are over-exposed to supposedly secure government debt. Sovereign debt no longer looks stable.

One of the most important precedents is the debacle of Latin American debt almost 30 years ago. In August 1982, Mexico shocked the world by declaring that it was unable to service its debt. For most of that summer, Mexico, with a projected fiscal deficit of around 11% of GDP, was still borrowing on international financial markets, though at an increasing premium. Banks had reassured themselves with the belief that countries could not become insolvent. But then a wide range of inherently different countries seemed to line up like a row of dominos.

While Mexico had a petroleum-based boom in the wake of the second oil-price shock of the 1970’s, Argentina suffered from economic mismanagement under a military dictatorship that then staged its disastrous invasion of the Falkland Islands/Malvinas. Brazil had experienced an earlier version of its current economic miracle, with stunning growth rates financed by capital imports. But in the end, these very different circumstances produced a common and inherently simple problem: over-indebtedness.

A Latin American default would have brought down the banking systems of all the major industrial countries, causing something like a replay of the Great Depression. Exposure to Mexican debt alone represented some 90% of the capitalization of major US banks.

The solution that was eventually adopted was considered brilliant at the time, because it avoided formal default by any of the big Latin American borrowers (though Brazil briefly defaulted five years later, in 1987). It involved a combination of three elements: immediate international assistance, through the International Monetary Fund; severe domestic retrenchment, enforced by the highly unpopular conditionality of IMF programs; and additional financing provided by the banks.

There was no institutionalized write-down of Latin American debt until five years after the crisis, when a haircut no longer threatened banks’ stability. It was only at this moment that real lending for new projects could really begin. In the meantime, Latin America remained mired in what became widely known as “the lost decade.”

The contemporary European solution seems to be repeating the same time-buying tactics of the lost decade of the 1980’s in the developing world. There is the same combination of international support, highly unpopular domestic austerity measures (which are bound to set off major protests), and the apparent absolution of banks from financial responsibility for problems that they produced.

Major European banks – in the United Kingdom, Germany, and France – have, like their 1980’s predecessors, built up a gigantic exposure to what they erroneously thought was safe debt. A substantial immediate haircut on the sovereign debt of the vulnerable eurozone countries would be so destructive that it would set off a new round of bank panics. Recognizing this problem, banks can hold their host governments to ransom. That is why the crisis has become a challenge for the UK, Germany, and France.

The Franco-German initiative unveiled at Deauville in early November, which would require some possible measure of restructuring for debt issued after 2013, tried to avoid the immediate shock of a haircut. But the pre-announcement of possible write-downs still led to a major wave of uncertainty about banks.

A long-term alternative requires some capacity to write down debt where it has reached excessive levels. But it is also necessary to establish an iron-clad guarantee of some part of the outstanding debt, in order to remove fear of a complete write-down.

A mechanism for dealing in an orderly way with sovereign bankruptcy would be a major contribution to global governance, and to solving a longstanding problem of sovereign-debt markets. Such proposals were widely discussed in the 1990’s and early 2000’s, and IMF Deputy Managing Director Anne Krueger pushed a Sovereign Debt Restructuring Mechanism that would have offered a legal path to imposing general haircuts on creditors, thereby ending the collective-action problems that impede the efficient resolution of sovereign bankruptcy.

If Europe could show – in the worst possible scenario of sovereign default – how such a process might operate, uncertainty would be reduced and markets would be reassured. And, in the longer term, we would have a viable international model of how to tackle severe sovereign-debt problems.

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