In November 2008, Barak Obama was elected under the inspirational motif "Yes We Can," a call to Americans to shed the pessimism and fear that haunted the U.S. in the days following the collapse of Lehman Brothers.
Now, a new political party in Spain is capitalizing on the President's message of hope. The party, Podemos ("we can" in Spanish), has lept to prominence since its formation a year or so ago and currently polls about 8% of the national vote. Political commentators speculate that the next elections could result in a coalition government with Podemos holding the balance of power.
So, say you, what does this have to do with sovereign debt restructuring?
Well, one of the policy planks of the party platform is a proposal to default on "illegitimate" debt. Although the offending debt hasn't been defined, I wouldn't be surprised if it includes claims incurred under the IMF-supported adjustment program. Why? The argument might go something like this: “Creditors accumulated claims believing that, as long as the IMF was providing support, they faced a deal too good to pass up — higher returns with risk underwritten by the IMF; absent the patina of IMF support, and the potential for bailouts, creditors would have been forced to write down their claims.” The problem, Podemos might argue, is that the program required an insufferable adjustment burden: in effect, that the program entailed too much adjustment (in terms of squeezing domestic consumption and investment) in order to generate the resources needed to service debt. What was needed but wasn't forthcoming was more "adjustment" in terms of the claims on the sovereign borrower.
The spectacular rise of Podemos and its threat of default underscore the fact that, six years after the Lehman shock, unemployment in Spain remains at Great Depressions levels, while debt-to-GDP ratios around most of the globe, including the Eurozone, have continued to rise as documented in a recent Geneva Report on the global economy (PDF). In part, this increase in the debt/GDP reflects the dismal growth performance of the region over the past six years, which means that the denominator hasn't grown as quickly as the numerator. And, if the trend continues, it could lead to a growing chorus of “yes we can.” Needless to say, a strategy of persevering with debt servicing is politically easier if nominal income growth brings down the debt/GDP ratio. But, with tepid growth (at best) combined with low inflation and the looming risk of deflation in the Eurozone, which increases the real debt burden, this strategy may become increasingly difficult to sustain over the medium term.
In fact, there may be a growing appreciation that the status quo is fragile and that alternative approaches — including debt restructuring — may be required. Adair Turner argues (here, in the Financial Times) that the surest route out of the current morass is to explicitly recognize that government bonds held by central banks will remain in the central banks. Some fear the risk associated with a “helicopter drop” of money — moving from inflation that is too low (or deflation) to inflation that is too high. Regardless of its merits and risks, this proposal is tantamount to money-financed deficit spending, which is an anathema in Germany and thus not an option for the ECB. My friend Robert Kahn at the Council for Foreign Relations, meanwhile, recently proposed a “rules-based approach to official-sector debt relief, in which countries meeting firm conditionality would be assured of adequate (and predictable) relief.” Rob’s proposal strikes me as a sensible approach; one that aligns with my own musings two and a half years ago (see an earlier blog post, here). A potential problem with a Paris Club approach for the countries of the periphery, however, is ringing-fencing access. If such treatment is provided to one member of the Eurozone, how is it denied to another member? Access to all might be too big a pill for creditors to swallow.
This led to the suggestion made by Pierre Pâris and Charles Wyplosz to “bury the debt forever.” Under their proposal the ECB would buy the bonds of member countries with severe debt problems and exchange these bonds with a perpetual, interest-free loan in the same amount. The loan remains an asset of the ECB, which implies a very large increase in the size of the balance sheet. But, as recent events have demonstrated, under current conditions this need not lead to a run-away increase in inflation. Moreover, the ECB could sterilize the impact of the transaction by issuing its own debt instruments. Although the interest paid on sterilization bonds would reduce ECB profits distributed among its member countries, the scheme promotes burden sharing among all countries that use and benefit from the use of the Euro, arguably, supporting the stability of the currency union.
Considerable uncertainty about the prospects for European growth remains. High debt burdens and the need to repair public and private balance sheets represent a drag on growth. Absent an unexpected resurgence of growth, attention can be focused on alternates to dealing with the debt overhang; the specter of sovereign debt restructuring will hang over region. In this context, efforts to improve the framework for sovereign debt restructuring, such as the Sovereign Debt Forum, merit serious consideration.