Tuesday 20 February 2018

Slow learners on debt dynamics spread pain and confusion

European politics today cannot be understood without understanding the basic mechanics of debt

'I SHALL WEAR THEIR LOATHING WITH PRIDE': Greece's former finance minister Yanis Varoufakis tries to engage with Ireland's Michael Noonan during a meeting of EU finance ministers last February. Photo: Geert Vanden Wijngaert
'I SHALL WEAR THEIR LOATHING WITH PRIDE': Greece's former finance minister Yanis Varoufakis tries to engage with Ireland's Michael Noonan during a meeting of EU finance ministers last February. Photo: Geert Vanden Wijngaert
Dan O'Brien

Dan O'Brien

It is truly amazing the amount of ill-informed nonsense that is spoken and written about debt - in the Irish context, in the Greek context and in Europe more widely.

After so many years of crisis, and with so many people suffering the problems related to personal indebtedness, you might think that politicians and commentators in this country and across the continent would understand the basic mechanics of debt. But no.

Worse still, even people who should know better still use terms such as 'debt relief', 'debt restructuring', 'debt write-off' and other debt-related terms interchangeably, as if they all meant exactly the same thing. They do not.

Before discussing the specifics of Irish, Greek and European debt issues, let's just start with some clarifications.

'Debt relief' is the broadest possible term when one discusses changing the terms between a creditor and a debtor. In other words, debt relief is an umbrella term, and there are many ways a debtor can be relieved.

At one extreme on the debt relief spectrum is a write-off. In this case, both parties just tear up the IOU they have previously agreed to.

No more interest payments exchange hands. The debtor removes it from the liability side of his balance sheet and the creditor removes it from the asset side of her balance sheet (hence the term "write -off").

Debtors and creditors can also agree to write off a portion of the money. This is also known as a "haircut", as happened in 2012 when private lenders wrote off €100bn of Greek government debt.

Other forms of debt relief can be almost as effective for debtors and as costly for creditors, but they are not as intuitively comprehensible as a write-off.

Understanding all this is absolutely central to understanding European politics now, so even if sums are not your thing, please bear with me for just a couple of paragraphs because this really does matter.

To see why relief that doesn't involve a write-off can be very effective, imagine you had borrowed €1m from a friend - on terms just a little better than you can get from the banks. But later you fall on hard times, losing your job or your business.

Your pal - let's call her Frieda - takes pity. But she doesn't want to go the whole hog and tear up the IOU because her balance sheet would be messed up if she wrote off the €1m - it could affect her own credit rating or her bankers might start thinking she was insolvent after a €1m hole was suddenly blown in her balance sheet.

So instead of writing off the entire debt, she "restructures" it.

If Frieda was a very generous friend, she might ask you to pay just €100 a month in interest and, instead of paying back the principle (the €1m itself), she might say that there is no need to worry about doing so for 10 years (a change in the timeframe of repayments is sometimes called 're-profiling').

This restructuring would be great for you, and your debt would become very manageable. But it would be bad for Frieda.

She would be making a big loss because the amount she eventually gets back will be worth much less than the sum she lent in today's terms. While it is not as direct and final as a write-off, it amounts to a loss for the creditor and a gain for the debtor.

As thinking about sums on a Sunday morning can make heads hurt - if they are not hurting already - let's end the explainer there (but if you want to understand a bit more about how debt mechanics work, pop "net present value" into an Internet search engine and in no time you will be more expert than many supposed experts).

Now consider the more political aspects of it all. Iron law #1 of the euro debt crisis is: No write-offs of public money.

That is because many of the countries who contributed to the loans do not want holes in their balance sheets. But a much more important reason is political.

Some leaders promised their voters when they lent to Greece originally that they would get their money back. Conceding to a write-off would amount to a clear breach of that promise.

Although some of the money has already been lost due to other forms of debt relief, the opacity of measuring the cost (in "net present value" terms) means that they can fudge the matter.

And they will fudge it again for Greece if it stays in the eurozone. That is likely to happen in stages, after Greece has delivered on commitments, not upfront, as Athens had wanted.

Before looking at Greek debt relief in more depth, consider Ireland's debt relief thus far. It has come in two forms. The first was on the bailout funds it got from EU sources in late 2010.

The original interest rate on these loans, which was the same as Greece had got six months earlier, was not generous.

But over the course of the following years, both the interest rates on the various EU loans were cut sharply and the timeframe for repayments pushed out over decades.

A second form of debt relief that Ireland has received was the restructuring of the promissory note, used mostly to pay off depositors and, to a lesser extent, bondholders in Anglo Irish Bank.

That restructuring was very like the deal with Frieda discussed above. It amounted to very significant debt relief on one slice of the Irish State's debt pie.

These two changes can be seen in the decoupling of the growth of public debt in Ireland and the cost of servicing it.

That, in turn, has made interest payments considerably lower than they would otherwise have been, and much lower relative to GDP or tax revenues than in the 1980s, when public debt was similarly high.

It is also worth considering the commitment made back in June 2012 by eurozone leaders to break the link between banks and sovereigns and the specific mention made of Ireland. That raised the prospect of another strand of debt relief.

That commitment was made when the Irish economy was still contracting, the risk of even more bank losses was real, the euro crisis was at its peak and contagion had spread to Spain.

If this perfect storm had intensified, Ireland would have moved towards default. To prevent that, the rest of the eurozone would have given Ireland further debt relief for reasons of self-interest, enlightened or otherwise depending on your view.

That relief would probably have come via the European bailout mechanism buying the Government's stakes in the banks; the cash received would have cut debt and the change of ownership would have ended the Irish sovereign's exposure to more bank losses.

But it would have taken a worsening of Ireland's economic fortunes and/or a deterioration of the euro crisis for that to happen.

Thankfully, neither happened. When the other countries saw that Ireland's debt burden was becoming more manageable they had less interest in offering further relief.

A cold hard look at the interests of eurozone countries also explains what is happening with regards to Greece.

Many people are perplexed as to why the other countries which have been bailed out - Ireland, Cyprus, Spain and Portugal - don't back Greece in the hope of having their own bailout loans restructured.

In Ireland's case the head- scratching is made worse by the dog's breakfast the Government has made of communicating its position.

The politics of not giving the fellow travellers of Syriza in their own countries electoral ammunition is clearly one reason, but it is underpinned by the knowledge that the creditor countries would have refused mass, multi-country restructuring.

Just as Greece was never going to win the argument with its creditors, nor would a bigger group of debtor countries. If a periphery-core clash had erupted, the entire euro project might have come apart.

Given that the cost of such an eventuality for countries like Ireland would be far greater than the gain of any relief, it was a battle the peripherals wisely chose not to fight.

At the time of writing this piece on Saturday, it appears that a deal has been reached to avoid Grexit as the slow learners in Athens have finally accepted that they fought a battle they could never win. Faced with the catastrophe of exit, they have backed down.

But don't expect this to be the end of the saga. Even in a best-case scenario there will be plenty more dramas and crises along the way.

Sunday Independent

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