Facing Down a Half a Trillion Dollar Hole
European leaders swear a Greek default isn’t in the cards. Their parliaments debate whether to bolster an inadequate rescue facility. The International Monetary Fund sends delegates to Athens to make sure it deserves its next tiny tranche of bailout aid. German Chancellor Angela Merkel regularly declares fealty to the euro.
They’re all in denial. Almost no one believes Greece is solvent, not with an economy shrinking and debt ballooning to 180 percent of gross domestic product, a burden that no amount of belt-tightening will make bearable. Europe ultimately needs radical change, including a fiscal union and the ability to issue bonds, much like U.S. Treasuries, that all 17 euro-zone countries collectively would stand behind. But that would require amending treaties, which each country’s parliament must approve. Europe’s voters deserve a say, too. All that could take years.
No reliable road map exists for managing a sovereign bankruptcy involving $500 billion. Argentina defaulted in 2001 on debts of a mere $80 billion. An orderly default would require immediate restructuring of Greece’s debts, and possibly those of several other countries. That would have to be accompanied by the three S’s: stopping the contagion, saving the euro, and stabilizing the banks—all at once, euro-zone wide, and preferably over a single weekend.
A controlled default first must answer the question of whether Greece can stay in the euro zone. The answer should be a resounding “stay.” Expelling Greece from the euro would cause more economic, political, and social chaos than the world can handle. The possibilities range from runs on European banks to rioting in the streets of Athens—or even civil war. True, leaving the euro would allow Greece to devalue its currency and be more competitive. But it would also paralyze a drachma-tized economy. One big reason is that companies with euro debts would be hard-pressed to pay them back with a deeply devalued drachma, and would face bankruptcy.
Greece would need debt forgiveness, in which creditors accept haircuts of at least 50 percent to bring the debt-to-gross domestic product ratio below 100 percent. If bank and other investor losses are tax-deductible, the hit to profits would be somewhat softened. Greece would also need to issue new bonds, which the European Central Bank, the IMF, and possibly the European Bank for Reconstruction and Development (a public-private financing source) could jointly back to attract buyers and present an overpowering, united front to skeptical markets.
Instead of imposing a tough-love austerity plan on Greece, this troika should peg any new securities to an economic recovery, so that payments increase with GDP growth and decline in a recession. A similar arrangement worked for Latin American countries issuing Brady Bonds in the late 1980s.
To stop the contagion, the ECB must pledge to provide liquidity for as long as it’s needed. But the central bank must do much more by erecting a financial firewall around the rest of the euro bloc. Any new bonds issued by Portugal, Ireland, Spain, Italy, Belgium, and France would also need guarantees to attract investors at reasonable rates.
This part of the plan will not go down easily in Germany. The ECB’s charter directs it to control inflation, and doesn’t allow it to monetize sovereign debts, which is the label some German officials will give such guarantees. But Germany may have little choice: If it left the euro, its exchange rate would skyrocket, exporters’ profits would plummet, and its economy would shrink.
Preventing contagion also means stopping bank runs. The default road map must include a plan to reassure all Europeans that their savings and retirement plans are safe. It may be necessary to impose temporary capital controls in Greece and possibly other countries to stop bank runs before they start. Euro-zone governments should also guarantee deposits, much the way the U.S. swiftly raised the guarantee on American deposits to $250,000 from $100,000 (now made permanent by Congress) after Lehman Brothers collapsed.
Saving the banks would require recapitalizing dozens of European banks holding Greek and other sovereign debt. Once Greece defaults, its bonds and those of a half-dozen euro-zone countries suddenly will be worth a fraction of the value at which they are carried on banks’ books. The amount of bank capital needed—estimates range between the IMF’s $410 billion and Merrill Lynch’s $550 billion—must be based on realistic stress tests that take sovereign defaults into account.
Many banks will be able to raise private capital. For those that can’t, governments must be ready to inject capital in return for equity, as the U.S. did with its Troubled Asset Relief Program.
Who will pay? The European Financial Stability Facility could be the source of capital for a euro-TARP and the ECB sovereign-debt backstop. The bailout fund may soon have €440 billion ($600 billion), assuming government approvals of a July replenishment plan take place by mid-October. Those funds could be leveraged with the help of the ECB, to build a two- or three-trillion euro facility. But there’s no getting around the fact that Europe’s taxpayers will be on the hook.
Economists and analysts disagree on the details for each of the steps involved, but they agree that a prepackaged, well-managed bankruptcy, not unlike the ones arranged by the Obama Administration for General Motors and Chrysler in 2009, would be better than letting the chips fall where they may.
None of this is to say that an off-the-shelf blueprint will make a default easy. It won’t. The distress will be felt worldwide. But it will be far less traumatic this way. Carpe diem, Europe.