Up Front

Europe’s Fast Track into the Third World

Lex Rieffel

The sovereign debt crisis in Europe has sparked a heated debate about how to finance rescue packages without creating incentives for fiscal misbehavior by EU member governments and how to place some of the bailout burden on private investors who buy the sovereign bonds of countries running unsustainable budget deficits.

While the debate on financing rescue packages seems to be moving in a sensible direction, however, the debate on “bailing in” bond investors could lead to a deeply damaging result.

Starting with the rescue operation for Greece in May, and more recently for the bailout of Ireland, the EU has created a funding mechanism—the European Financial Stability Facility—in a form that has worked well in resolving sovereign debt crises in emerging market countries for 30 years. The EFSF is a pool of official funding with disbursements linked to policy reforms (conditionality) negotiated with the International Monetary Fund and the stricken country’s EU partners. The debate here revolves around the size of the pool, allocating country contributions, and embedding the mechanism in the EU treaty. A workable solution seems well within reach.

The issue with bond investors is reminiscent of the debate a decade ago about “private sector involvement” in emerging market debt crises, such as Argentina’s massive default at the end of 2001. Private investors—not just banks and institutional investors but also many “innocent” households—had been purchasing emerging market bonds because of their high yields. The yields were high because the risks of default were elevated. Thus, when some of these countries defaulted, it made sense for the bondholders to take a “haircut” in the form of a reduction of principal or interest. An important precedent here was the Brady Plan that resolved the 1980s debt crisis by negotiating write-downs on the excessive commercial bank lending that had contributed materially to the defaults.

The problem with using this “bail-in” approach in the EU context is that it would in effect transform the advanced democracies of Europe into Third World countries.

The mess in Europe is not the fault of bond investors. They simply believed the claims of the Eurozone governments that a workable monetary union had been created. The responsibility to make it work lay with the participating governments, not the private investors. The problem arose because the governments let down the investors, not because the investors sabotaged the governments.

Otmar Issing, the distinguished former member of the European Central Bank’s executive board, is one of the leading proponents of haircuts for the investors in bonds of European countries that need to be bailed out of a financial crisis. In a Financial Times op-ed last week, Mr. Issing advocated creating a debt restructuring mechanism—targeting private bond investors in particular—as part of the EU’s new crisis resolution arrangement.

Creating a mechanism to impose haircuts on bondholders is tantamount to saying that the monetary union has failed. It cannot be reconciled with the vision of a sustainable monetary union.

The EU made a terrible mistake. It allowed its own fiscal rules to be breached by too many countries without convincing corrective measures. Now the EU has only two real choices. It can pay the price for affirming the original vision of a zone offering a virtually risk free sovereign bond benchmark for its capital market—because of the firm commitment of its members to maintain sound macropolicies. Or it can abandon the vision in an orderly manner by pushing overly-indebted members out of the Eurozone.

Trying to muddle through this is likely to lead to the breakup of the Eurozone by default, leaving potentially deep and long-lasting scars extending beyond Europe and into the international financial system.