There is something very unfair, even unseemly, about the bailouts currently being implemented in the Eurozone. The citizens of Greece and Ireland, the two countries rescued by the European Union so far, will be forced to suffer higher taxes, reduced government services and meager growth and job prospects under severe austerity plans imposed in return for the bailout money. But their bondholders are being protected. On one level, we could say that’s only proper. The Greeks and Irish are responsible for making their own messes, and now have to pay for them. But at the same time, it takes two to create a financial crisis. Those investors who bought Greek or Irish bonds took on risk as well when they loaned these governments money, and therefore bear their own share of the responsibility for Europe’s current debt woes. Shouldn’t the creditors pay for their mistakes, too?
The EU has decided the answer is yes. On Sunday, European ministers signed off on a framework for a permanent mechanism to resolve sovereign debt crises in Europe. You can find the details of the plan in a statement here. The envisioned process potentially shifts some of the burden of resolving these crises from taxpayers to bondholders, who would have to swallow losses on their investments. The idea brings an element of fairness into the efforts to quell Europe’s debt crisis.
But it could also be making that crisis worse. This latest effort to stem the contagion spreading through Europe shows just how limited the region’s options are becoming, and also highlights the trickiness of dealing with sovereign debt problems in a comprehensive and fair manner.
The new bailout system, called the European Stability Mechanism, was announced in the hope of calming investors by eliminating some of the problems inherent in Europe’s current rescue program. The plan would put an end to the ad hoc nature of the recent bailouts, which has only heightened market uncertainty, by putting in place a formal roadmap for handling future sovereign debt crises. More importantly, by introducing the idea of debt restructuring under certain circumstances, the new process would allow countries some debt relief. That could make the bailouts more sustainable by permitting the rescued governments greater flexibility in economic policy that could help return their economies to healthy growth. All in all, the plan is a step in the right direction.
However, the announcement of the permanent mechanism did zero to quiet the debt crisis. The bonds of Portugal and Spain continue to sink, and Italy is being dragged into the meltdown as well. Even Belgium’s borrowing costs spiked. What went wrong? First, the bailout scheme does nothing to address the immediate concerns of investors. It won’t alleviate the debt burdens of Greece, Ireland and the other weak economies of Europe in the medium term, and it doesn’t make it any more likely that these countries will be able to fix their finances and pay their creditors.
Secondly, and more importantly, the timing was terrible. Europe’s leaders took a big risk by choosing this moment to bring up the notion of debt restructurings. These restructurings would cause bondholders to suffer a “haircut” as part of the crisis-resolution process. Investors are already dumping the bonds of Portugal, Spain and Europe’s other weak links because they’re afraid they won’t get their money back; the last thing investors want to hear in such a tense atmosphere is that they may not get their money back. In an attempt to appease nervous investors, the EU ministers made clear that the new permanent mechanism won’t take effect until mid-2013, implying that bondholders won’t face loss-inducing debt restructurings for several years. But since none of the underlying issues facing Europe’s weak economies were addressed, investors simply don’t believe debt restructurings, and thus losses, can be avoided until 2013.
So the mere talk of debt restructurings has added fuel to the raging fire of contagion. Europe’s leaders again appear tone deaf to the realities of the euro crisis.
What’s more, the plan could lead to problems in the future. If investors know they could be on the hook in the event of a debt crisis, they’ll likely demand a higher price for buying sovereign bonds, possibly hiking up borrowing costs for governments across Europe. That could impose an even heavier burden on heavily indebted European governments. Ironically, in attempting to find a long-term solution to the euro crisis, Europe’s leaders have started a process that could backfire on them. Here’s Mohamed El-Erian, chief executive of PIMCO, on this issue:
It took time for Europe to recognize the severity of the peripheral debt crisis. Now it is also recognizing that liquidity support (while necessary) may not be enough. Instead Europe is embarking on a gradual transition to a medium-term mix of liquidity and solvency solutions. Understandably, Europe wants this transition to be orderly, and relatively long. But it is walking a difficult line. Any slippage on this most recent deal will quickly see European officials facing a transition that is quicker and less orderly than they would like.
Europe might be facing a conundrum that is almost impossible to resolve. The Eurozone’s leaders rightly want the private sector to share in the costs of its debt crisis. Why should taxpayers in Germany, France and elsewhere in Europe have to suffer for errors in judgment and policy made in Dublin, Athens and the boardrooms of banks and investment houses around the world? But investors are in effect holding the governments of Europe hostage – any talk of including them in the losses will only make them flee European sovereign bonds more quickly, spreading contagion and making more bailouts even more likely. That’s not fair, but it’s reality. And it’s reality that Europe has to stop dodging and start addressing. Perhaps the only way out of this trap is to get ahead of the game – introducing proactive debt restructurings for Greece, Ireland, probably Portugal and maybe even Spain. In that way, bondholders will at least know where they stand, while the taxpayers and unemployed of Europe might get slightly better economic prospects.
