Why Europe Needs Automatic Haircuts

MUNICH – Having already agreed to double the AAA-rated lending capacity of the European Financial Stability Facility, the special fund created by eurozone states to provide assistance to troubled member economies, European Union countries are now discussing the conditions under which the EFSF’s funds will be made available. The crucial issue is the extent to which creditors will have to participate in rescue measures by accepting “haircuts” – that is, partial losses on their claims.

Representatives of overly indebted countries, and of countries whose banks are strongly exposed as creditors, argue that haircuts would destabilize the European financial system, generating contagion effects tantamount to a second Lehman Brothers crisis. But the European Economic Advisory Group at CESifo, a group of economists from seven European countries, has rejected this view in its latest report, just released in Brussels.

The group argues that a Lehman-like crisis cannot happen for the simple reason that it already did happen. In October 2008, a month after the Lehman collapse, the G-8 countries agreed to rescue all systemically relevant banks, while rescue facilities to the tune of €4.9 trillion ($6.7 trillion) were established worldwide – and are still largely intact today. Should one of these banks run into trouble because of a sovereign-debt default, the necessary rescue funds will be readily available. Another breakdown of the interbank market is therefore very unlikely.

Instead, the group’s report underscores the true risk for Europe: a return to the soft budget constraints – both private and public – and excessive borrowing that overheated its southern and western periphery and gave rise to destabilizing trade imbalances. Haircuts would contain this risk by encouraging closer alignment of each country’s interest-rate spread with its creditworthiness – the essential tool by which markets impose discipline on debtors.