Markets Insight

May 8, 2013 9:11 am

Markets Insight: Eurozone crisis demands swift debt restructuring

Early resolution is less costly than delay, says Willem Buiter

Balance sheet obstacles to sustained demand growth mean the EU faces two or three more years of recession and tepid cyclical recovery, even if EU policy makers enact the right measures as fast as their glacial decision-making process allows.

The balance sheet recession is caused by excessive leverage: zombie banks throughout the EU, excessive sovereign debt and deficits in the periphery, and excessive household indebtedness in many countries.


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Unfortunately we cannot be sure that, even when the deleveraging process is complete and domestic demand expands again, there will be more than a cyclical recovery. For the growth rate of potential output to rise, deep structural supply-side reforms are needed.

The deleveraging will not come through growth, as growth will not return until deleveraging is completed. It will not come through inflation because the European Central Bank will not inflate. The debate between Spendarians and Austerians has little relevance as only Germany is in a position to provide a significant discretionary fiscal stimulus.

If countries under pressure to reduce their deficits wish to spread the pain of austerity over a longer period, they will either have to convince the markets to fund them or ask the troika of international lenders for additional concessional funding. For most countries, the level of austerity will be higher this year than last, but less than it would have been without the retreat by the European Commission and International Monetary Fund from their past support of excessively pro-cyclical austerity.

Another positive development is the elimination of Cyprus as a tax haven and the contribution this is making to the rapid elimination of bank secrecy in tax havens in or near the EU and in UK overseas territories. This creates new, less demand-destroying revenue opportunities through wealth levies, including tax amnesties that may prove valuable to such countries as Italy.

The main instruments of deleveraging will be debt mutualisation and restructuring. Euro bonds will not be used, either to deal with the problem of legacy excessive sovereign debt or with the flow problem of funding future deficits in the periphery. This would require significant additional fiscal union, and there is little political support for this. Instead, there will be some limited ex-post mutualisation, as the outstanding debt of troika programme countries to their sovereign creditors is gradually converted into a zero-coupon perpetuity, promising to pay nothing forever.

There will also be some more mutualisation of sovereign debt and of bank losses when the ECB takes losses on its exposure to probable insolvent sovereigns and to probable insolvent banks that have offered substandard collateral. But this will not suffice to deleverage quickly.

In line with the agreement reached to manage the Cyprus crisis, the new template for bank resolution bails in the existing shareholders followed by all unsecured creditors, including if necessary the non-insured depositors. Domestic taxpayers are no longer subordinated to senior unsecured bank creditors. Once the single supervisory mechanism for eurozone banks comes into force, the European Stability Mechanism will be able to recapitalise banks directly. German proposals to delay this and to forbid it recapitalising banks with “legacy” capital needs are likely to be shelved after the German elections.

A directive for national bank recovery and resolution mechanisms for EU member states could be transposed into national laws by the time of the German elections. Although this falls short of a single European bank resolution regime, it will accelerate the recovery or resolution of EU zombie banks.

The ECB will soon start a euro-area Asset Quality Review that is likely to be conducted by independent experts, without excessive interference by captured national supervisors. By the end of this year, the informational and institutional toolkit to dezombify the euro area banking system could be in place.

Sovereign debt restructuring by bailing in private creditors will not remain confined to Greece. Cyprus, Portugal and Spain are also at risk. Even Italy’s sovereign creditors are threatened because of the seeming inability of its political institutions to deliver growth-enhancing structural reforms.

Early resolution is preferable to economically costly and politically unsustainable additional austerity and pointless concessional funding. The inherent disruption is minimised through early, co-ordinated and simultaneous debt restructuring of banks, households and sovereigns, of sufficient size to convince markets there will not be an early repeat of the exercise. Losses would be less than those created by further delay. Easy, really.

Willem Buiter is chief economist at Citigroup

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