Sunday 24 September 2017

Delaying day of reckoning on default a recipe for major disaster

Mario Blejer

One of the undeniable features of the European debt crisis is the tendency to obscure, verbally and politically, the real issues. Euphemisms, statistical gimmicks, undecipherable acronyms and double talk proliferate as part of the debate.

In my experience as central-bank governor in Argentina during the worst financial crisis in our history at the start of this century, I learnt how useful it is to cut through the fog in order to rebuild credibility and to allow a more lucid evaluation of the outlook.

While there are few similarities between Greece's debt situation and Argentina's in 2002, it is possible to reduce the talk of a default to four basic issues and make some predictions.

The nature of the debt problem in peripheral Europe is structural. Since it doesn't reflect a temporary liquidity squeeze, the approach adopted so far can't resolve it.

The strategy in progress has been to pile new debt upon the existing stock. New loans are used to pay old debt, in addition to financing remaining fiscal gaps. This is why the Ponzi scheme analogy is appropriate.

And while the pyramid is growing, the share of peripheral debt held by state-owned institutions also keeps getting bigger. This means that when it all finally collapses, it is the taxpayers of Europe, and the world, that will bear the full cost.

The IMF has performed badly in this crisis. Its programmes are bound to fail because their design is profoundly flawed.

They contain two basic blunders. First, they have wrongly assumed that peripheral countries could return to the voluntary capital market next year. Today we know that Greece's ability to borrow €30bn in 2012 is nothing but a fantasy.

The programmes, therefore, remain unfinanced. And the situation promises to be even more difficult in 2013 if the permanent-bailout mechanism being designed is adopted.

Second, the programmes have been based on dreamy debt sustainability scenarios in which countries outgrow their debt under severe fiscal tightening. But since these austerity plans cause deep recessions, the debt/gross-domestic-product ratios increase over time in all peripheral nations. How this squares with sustainability, and how the macroeconomics add up, is hard to comprehend.

Imbalance

One proposed solution has been the sale of state assets. But this would result, at best, in fire sales. The Latin American experience is that privatisation never resolved a fiscal structural imbalance.

All this should not detract from the need for fiscal and structural adjustments as part of a long-term solution. But there is no long-term stable solution without debt relief, which, in plain English, means default. There are many ways of defaulting, but it is evident that without a significant haircut for bond investors there is no way out. The real question isn't whether, but when and how.

The institutional crisis-management setting is in disarray: The EU wouldn't oppose a default (if it could use a different word); the IMF demands financial assurances for next year; and the European Central Bank (ECB) is ardently opposed to any form of debt relief. The most likely scenario is that the ECB will make a U-turn before reaching the abyss.

The ECB threats to cut Greek banks from access to liquidity in case of default are dangerous, and ultimately not credible, because it could trigger an accelerated bank run and detonate a banking crisis, including the possibility of a deposit freeze similar to Argentina. This would have more potential to damage the euro than any credit event.

As for the Argentine experience, it is important to remark that, while without the default the economy wouldn't have been able to recover, the experiences aren't directly comparable. Argentina was able to devalue its currency and was also helped by a significant fiscal adjustment.

But there is an important lesson. Postponing inevitable actions increase the cost of eventual adjustment. At the time of the default, Argentina's output had already declined by more than 10pc. A timely and friendlier negotiation aimed at obtaining debt relief would have saved the country years of pain.

The European strategy, if there is one, seems to be to delay the day of reckoning. It could, however, be useful, if the time gained is utilised to prepare for the inevitable default.

Just muddling through, in the mist of a cacophony of contradictory statements that further erode the credibility of the crisis-management framework, only creates uncertainty and is a recipe for major disaster.

Mario Blejer is a former governor of Argentina's central bank, was a senior adviser to the IMF and is vice-chairman of Banco Hipotecario.

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