Europe's ugly truth needs an ECB fig leaf

Lowy Interpreter

While financial markets and politicians applauded the outcome of Europe's 0.3 growth in the second quarter of 2013 – the first positive growth for the past six quarters – there is not much joy to be had in this figure. Not only is it a tiny uptick, but the prospects for a sustained recovery in Europe remains unremittingly bleak. Unemployment in the euro area is close to 12 per cent, and more than twice this figure in the peripheral countries.

Germany is the only European country where GDP is higher than it was prior to the 2008 crisis. France has yet to come to terms with excessive government spending. The Netherlands spent too much in rescuing its banks and its housing price bubble has burst. The sharp exchange rate depreciation in the UK should have helped, but it is still hobbled by unrelenting budget austerity.

Over the whole of Europe, commercial banks are obsessed with repairing their capital base rather than with lending.

Meanwhile, three years after Greece's debt disaster was revealed, there is still no resolution in sight, and Germany is now talking about another bailout for the country. The drip-feed rescue continues. Rather than definitively fixing this relatively small problem in 2010 with a debt rescheduling, contagion spread. Now financial markets not only question the debt sustainability of Greece, Ireland, Portugal, Spain and Italy, but France as well.

The attempts to grind down budget deficits (with some success in Greece but little in Spain) are simply incompatible with growth. However necessary the austerity, it has made the debt position worse rather than better.

The only answer is a substantial restructure to remove a good part of the debt overhang.

This was obvious in 2010, but even now, key players will not allow this topic to be discussed – let alone implemented. 

The quandary is this: even if budget deficits are ground down to achieve surpluses (still a huge and unfinished task), the debt ratio will come down so slowly that sustainable debt levels are a generation away. In the meantime, unemployed youths never gain work experience, skills atrophy, and the best of the next generation move overseas. Investors look at the budget reforms – more tax, less assistance for industry – and shift both their capital and their entrepreneurship elsewhere.

History suggests that, without dramatic restructuring, the only way of getting debt/GDP ratios down is to increase nominal GDP, either through real growth or inflation. Germany's inflation-phobia ensures that the answer will not be found in the latter. And real growth cannot occur with these debt burdens.

An explicit rescheduling seems as distant as ever, for political reasons. Non-bank private debt holders managed to unload their bond holdings over the past three years. The debt burden is left in official hands, either held directly, indirectly through the European Central Bank or in the balance sheets of banks which would have to be rescued if the debt were to be written down.

In the face of this impasse, the key may be to find a fig leaf behind which a rescheduling could be achieved, perhaps obscuring the key elements from the public gaze.

In an article for VoxEU, authors Pierre Paris and Charles Wyplosz propose such a fig leaf. Their starting point is to reduce the official debt of those countries with unsustainable debt burdens by one quarter. They include not only the peripheral countries, but Italy and France as well.

The amounts are huge. Even if France were to be excluded, the restructuring would be equal to around a quarter of the GDP of the 'forgiving' countries, which is enough to put their own debt into the danger zone.

The answer to this latter problem is to use the European Central Bank balance sheet. The ECB would take over this debt, selling it back to the issuing government in exchange for an interest-free loan from the ECB. The net outcome is that the debt would be written off, the issuing government has an interest-free debt to the ECB which need never be repaid, and the ECB has issued more base money which finds its way into the balance sheets of the euro area banks, held in the form of deposits with the ECB.

Like all fig leaves, this does not alter the essentials.

The shareholders of the ECB (the euro countries) are bearing the interest cost of the extinguished debt, in the form of the interest payments which the ECB makes to the banks on their deposits at the ECB. The total amount of official debt has not been reduced, as the ECB's increased holdings of bank deposits has to be counted as part of official debt. But the burden has been redistributed, largely lifting it from the 'forgiven' countries, giving them a chance to get their debt ratios down further through growth. The fig leaf may obscure the nature of the transaction enough to make this scheme politically acceptable. 

Those who can see past the fig leaf may not like what they see, but the current strategy is a dead end. It bought time, but at the cost of making the underlying situation worse. It offers no hope of sustained growth in the peripheral countries, while the debt overhang makes chronic recession the 'new normal'. The strategy is held together only by ECB president Mario Draghi's promise to do 'whatever it takes' to keep the eurozone together. This keeps the interest rates on peripheral bonds at a tolerable level, but it is a promise yet to be tested, with uncertain outcomes if it is.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.