Last week, at a panel on emerging markets at the Luxembourg Financial Forum, I was asked what lessons for the European debt crisis could be drawn from the rich and diverse experiences of emerging markets. It was not the obvious comparison with the Argentine economic crisis that came to mind, but rather the Latin American debt crisis of the early 1980s.
The Latin American debt crisis originated from excess liquidity caused by a surge in oil prices in the 1970s and abundant savings by oil exporters, which were channeled to developing economies. Seduced by the easy money, the economies of Argentina, Brazil, Mexico and Peru, among others built up important stocks of hard currency debt that proved to be lethal once interest rates normalized, capital flows retreated, and inflated developing country currencies faced depreciation pressures that pushed debt ratios to unsustainable levels.
The first approach to the Latin American debt problem was denial. Supposedly, all that was needed was time to implement a drastic fiscal adjustment, for which the International Monetary Fund, sponsored by the United States, would provide the needed refinancing. In 1985, the Baker Plan elaborated on this approach by introducing private sector involvement through the voluntary rescheduling of bank loans, so as to lengthen the fiscal adjustment period. The result was a massive debt overhang that discouraged investment and triggered frequent spells of capital flight and disappointing growth that was reflected in growing debt ratios. This became known as the lost decade for Latin America.
Only in the 1990s did the players involved in the debt rescheduling recognize that an insolvent country requires some genuine debt relief, in the form of a reduction in the nominal value of its debt, or a “haircut”. This new understanding took the form of the Brady Plan, which exchanged unrecoverable, unmarketable bank loans for discount marketable Brady bonds – bonds that would be the seed of the emerging markets asset class.
What about Europe? It appears that today’s consensus is halfway between denial (restructuring of any kind “is not on the cards”, as stated by European Central Bank President Jean-Claude Trichet) and a Baker-style solution (a unilateral offer by creditor banks to lengthen the repayment time frame – a view shared by French Finance Minister Christine Lagarde and Eurogoup Chairman Jean-Claude Juncker).
It is tempting to see these positions as an ECB versus eurozone governments debate on collective fiscal responsibility. After all, if we accept that there is a limit to how much adjustment could be realistically expected from Greece’s asset sales and belt tightening without stifling growth or undermining local political support, then there are only two other groups to foot the remaining bill: private creditors and euro member states.
This is the key difference between peripheral Europe now and Latin America in the 1980s. It may have taken almost a decade to reach consensus, but it was clear from the beginning that Latin American creditors would not be able to recoup loans in full and therefore they should take a hit. In contrast, Greece has Europe, which many argue should move closer to a fiscal union if it wants the euro to succeed.
This, and not who pays for Greece’s 2012 financing gap, appears to be the dividing question. On one side, Bank of France Governor Christian Noyer argues that “you can’t ask the European taxpayer to pay for Greece’s bailout and then restructure the debt.” So, should Europe explicitly guarantee the sovereign debt of Greece and other member states? According to German Finance Minister Wolfgang Schäuble, “strong member states will not provide an automatic safety net for weak member states.” Schäuble asserts that “if debt sustainability cannot be confirmed,[…] private sector involvement becomes compulsory.”
Once we see the current division in this light, it becomes even more obvious that a Baker-style rescheduling would not do the trick. For starters, it would do nothing to mitigate Greece’s debt overhang, its exclusion from capital markets, or the lingering risk over other heavily indebted European states and Europe in general. Moreover, it would dodge the critical question about the loss sharing scheme – a question that, as the Latin American history illustrates, could takes ages to be addressed.
Would a Brady-style solution work? Yes. It would not solve Greece’s lack of competitiveness or unbalanced fiscal accounts, but it would offer a clean start and a strong political incentive for Greece to adjust. It would also provide a market disciplining mechanism for Europe, as the market digests the revelation that eurozone sovereign risk is not one but many (which would entail the inevitable contagion to other indebted members states and possibly another restructuring) and scrutinize individual countries accordingly.
Would a fiscal union work? Yes. It would require stronger European rules and enforcement at the expense of fiscal sovereignty, as it would move opposite to the Brady solution, eliminating country differences from a market perspective and, if unchecked, opening the door to fiscal policy free-riding.
A re-scheduling may borrow some time to reduce the exposure of the European banking sector and other indebted peripheral European countries to a Greek default. But, by the same token, it conspires against a Brady-style solution as the current European support— both through the European Financial Stability Facility and through the ECB’s collateralized liquidity assistance— gradually bails out the private creditors that are expected to share in the losses in a restructuring scenario.
Ultimately, which of these two solutions is best for the eurozone is for eurozone member states to decide. However, the Latin American experience suggests against a Baker-style rescheduling of an unsustainable debt, which would only perpetuate the agony by pushing forward the day of reckoning. Rescheduling would be an ineffective solution halfway between fiscal autonomy and fiscal union, which is the longstanding and unresolved tradeoff that is perhaps the key pending assignment for European.