Michael Pettis argues that EU debt restructuring should happen soon, before it does even more damage to the euro zone
While most of the debate over Greece centers on this week’s negotiations and payments that need to be made between now and the end of July, but Michael Pettis, finance professor at Guanghua School of Management at Peking University, argues that putting off the inevitable debt restructuring threatens the survival of the European Union.
“I would argue that the biggest constraint to the EU’s survival is debt,” Pettis writes in a recent blog post. “Europe will not grow, the reforms will not ‘work’, and unemployment will not drop until the costs of the excessive debt burdens are addressed.”
Debt is always resolved, even if unofficially
First, Pettis explains that it’s important to remember that debt is always resolved one way or another: someone pays the cost, even if it takes some effort to figure out who that someone is. A country that devalues its own currency to make debt more manageable, for example, effectively passes the buck to people in the middle class who are trying to save money. Governments have plenty of options available to them for servicing their debt, each of which transfers wealth away from some part of the economy, but politics put an upper limit on what’s actually possible (Pettis has used Ceausescu’s austerity measures and subsequent post-revolution execution as an example of those limits).
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The problem is that when sovereign debt levels become excessive it undermines growth by distorting incentives, increasing borrowing costs, and forcing unproductive deleveraging. These financial distress costs have the ironic effect of making countries with greatest need for strong economic growth the least likely to actually have it.
“Historical precedents are pretty clear on this point. Countries suffering from debt crises never regain growth until debt has been partially forgiven — explicitly or implicitly — and the uncertainty associated with its resolution has either been sharply reduced or eliminated,” Pettis writes.
Economists recoil, while hedge fund managers shrug
So a country that has excessive debt and weak growth won’t be able to pay off its debts in the normal course of governing, and Pettis doesn’t believe there is any magic combination of policies that will make it so. Instead, the costs will be levied on various parts of the economy unofficially and without clear plans. The wealthiest and most sophisticated parts of the economy will generally be better able to protect themselves, driving up inequality as well. Pettis doesn’t see debt restructuring as a way of making liabilities vanish, because their resolution always requires a wealth transfer somewhere in the economy, but as a way to allocate costs intentionally and rationally. Doing it sooner than later avoids financial distress costs and can actually increase value for all stakeholders involved in the negotiations.
You can’t kick the can down the road indefinitely either. Right now the ECB is able to credibly stand behind the EU as a whole, but that’s because it can monetize debt, effectively transferring wealth from the lenders to the borrowers, and eventually Germany may not go along. Pettis isn’t worried about the ECB’s credibility today, but if Europe ever gets to the point where people are openly doubting the ECB it will be too late for calm, rational measures. Taking action now ensures that we don’t find out just how far the ECB can stretch, and rewards Europe with stronger growth as well.
“When someone like Yanis Varoufakis proposes that there are ways in which partial debt forgiveness increases overall economic value, instead of merely creating moral hazard, worried economists often recoil in horror, while finance or bankruptcy specialists (and an awful lot of hedge fund managers) shrug their shoulders at such an obvious statement,” Pettis wrote in a previous blog post.
Pettis outlines seven principles for debt restructuring
If the Eurogroup and the Institutions (née Troika) ever decide that they agree with Pettis he recommends following seven principles for effective debt restructuring. First, debt restructuring shouldn’t be delayed. Pettis calls this “the first and most common mistake” because financial distress costs start immediately and the longer you wait the more painful restructuring will be. It also needs to address liquidity concerns, but Pettis says that this isn’t usually a problem.
Next, the goal of restructuring should be to maximize value for everyone – not just reducing value for creditors to benefit borrowers. GDP-linked bonds like the ones that Varoufakis proposed are a good example since it benefits lenders if the borrowers recovers. The restructuring should also be put together in a way that rewards productive investment.
The costs of restructuring (remember, debt is always resolved at someone’s expense) should be meted out to those who can bear it, and it should dampen the effects of volatility (again, Pettis mentions the idea of linking payments to economic growth).
Finally, but most importantly, restructuring should get rid of the uncertainty about how sovereign will be resolved. The four-month extension gives Greece and the rest of the euro zone some breathing room, but it doesn’t tell us anything more about what’s going to happen even a year from now.
“This is the heart of the matter. The point of a debt restructuring is to eliminate or reduce the uncertainty associated with the resolution of the debt so that the total value of the debt increases and future growth is not constrained,” Pettis writes.
In a recent note to clients, Pettis states:
There seems to be very strong support within Europe for an approach to resolving the crisis that embraces flexibility and yet does not result in a breakup of the European Union. This approach is not being offered by the major parties but may become the policy of the Greek government. Any success Syriza might be able to claim in the next few months will have a dramatic impact on the important elections due over the rest of this year.