Debt Reckoning for Europe

Country-by-country and bank-by-bank, the good must be disentangled from the bad

By Amar Bhidé

Saving the euro, say the sages of the global economy, requires radical steps.& The OECD recently called for a large European firewall – a mega-bailout fund for troubled governments and banks. Others argue for integrating taxes and borrowing in the eurozone and shedding weak members, like Greece, that struggle with a strong currency.

But tall firewalls, fiscal union, or homogeneity of membership are neither necessary nor desirable. What is needed are mechanisms that recognize and accommodate differences, rather than new top-down efforts to impose uniformity.

All governments, even Germany’s, tend to spend more than they tax, and to hide shortfalls using accounting sleight-of-hand. Treaties alone do not induce fiscal virtue. The expectation that all eurozone countries would obey rules aimed at capping their budget deficits was the common currency’s foundational fantasy.

Countries cannot get overly indebted on their own: excessive borrowing by European governments required lenders who overlooked the fact that sovereign debt is in many ways similar to, and in some cases worse than, unsecured private debt or junk bonds. Governments provide no collateral and offer no covenants to restrain profligacy. As the Greek debacle has shown, governments do not pay penalties for fraudulent accounting. There is neither a legal process for forcing a state to pay off creditors, nor a legal venue for debt renegotiation.

Purchasers of sovereign debt, therefore, should be extremely careful – either shunning spendthrifts or demanding higher interest rates to offset greater risk. Making excessive borrowing expensive or impossible would cap deficits, treaty or no treaty.

Unfortunately, banks enabled excessive borrowing by reckless governments by accepting interest rates that were only a bit higher than the rates that more cautious governments had to pay. The 2008 debacle should have served as a sharp reminder of credit risk. Instead, banks increased indiscriminate purchases of government debt, and regulators unwittingly encouraged it by permitting banks to hold sovereign debt without capital reserves that properly reflected the risk. In fact, holding government debt helped banks to meet their liquidity requirements. Not surprisingly, they loaded up on the highest-yielding bonds, ignoring whether the extra interest justified the risks.

This indiscriminate lending now jeopardizes the solvency of banks worldwide. Yet the official response has been more willful blindness to differences between dodgy and sound debt. The European Central Bank has been lending to banks without regard to the creditworthiness of their government-bond holdings, thereby accumulating debt that threatens its own solvency.

Bailout funds have been created to buy troubled debt. But, while their purchases have temporarily boosted asset prices, they won’t change the reality of over-indebtedness.

The “more integration” camp wants European governments to guarantee each other’s debts explicitly. Such schemes could eliminate risk and interest-rate differentials; however, while some governments, like Germany, are in relatively good shape, their resources are not infinite.

Straining these governments’ finances in the hope of restoring market confidence is a bad bet. Moreover, any meaningful fiscal union is a non-starter. Handing revenues over to a single fiscal authority is unappealing to many Europeans. Indeed, regional parties in Spain, Italy, and Belgium are already pushing for greater devolution. And, even if fiscal integration were feasible, the examples of the United States and Japan do not inspire confidence that integrated European finances would exhibit German thrift rather than Greek profligacy.

According to French President Nikolas Sarkozy, “There cannot be a single currency without economic convergence.” Yet the dollar has served the US as a medium of exchange for nearly 150 years, despite huge regional differences between, say, Silicon Valley, the Rust Belt, and the Oil Patch. And dollars are widely used in domestic transactions in places far outside the US, such as Russia and Israel.

Differences in the circumstances of individuals and businesses within and across countries are unavoidable. It behooves all, whether they are struggling or soaring, and whether they are near or far, to use a common medium of exchange to trade with each other. Like standardized weights, currencies are supposed to calibrate and bridge, not eliminate, differences. The Greek economy was not “unfit” to join the euro in 1999, just as no one is too heavy to be weighed in kilograms.

That is why shrinking the eurozone to exclude weak members reflects another unwarranted predilection for uniformity. Governments, after all, can rarely overborrow without access to international credit. Indiscriminate lending – not the end of the drachma – saddled Greeks with unbearable debt. And exiting the euro will neither reduce the burden nor erase German and French bank losses.

The least awful solution requires an honest reckoning: writing down debts that cannot be repaid and recapitalizing insolvent banks. Country-by-country and bank-by-bank, the good must be disentangled from the bad.