After the elections that took place in Greece over the weekend, many European leaders breathed a sigh of relief…for a couple of hours. With the narrow defeat of the anti-austerity, anti-bailout opposition party, the results lessened the possibility that Greece would backtrack on commitments recently assumed as part of its second aid package, and decreased the chances of a chaotic exit from the Euro zone. However, the election results did not buoy markets for long.
Likewise, the announcement of Spain’s bank bailout last week did not rally markets for more than a few hours. The lack of enthusiasm reflected the view that this most recent bailout is yet another in a series of half-measures, which have become the norm throughout the Euro crisis. It is not only the fact that Spanish banks need equity (rather than further debt funding that will not directly address fears about their solvency), but also the intermediary role played by the Spanish government that aggravated the concerns of private creditors about the subordinated position of their assets.
Both events illustrate the limits—and decreasing results—of the series of policy responses adopted in the crisis heretofore. By doing just enough to address each urgent problem as it arises—instead of moving ahead of events and directly implementing their ultimate solutions—problems have become increasingly deeper and harder to solve. Take for instance the recent Greek sovereign debt restructuring, the biggest in history. Had it come, say, one year ago, when Greece’s insolvency was already beyond a doubt to everyone, chances are that the negative feedback loop between national banks and public debt in Portugal, Spain and Italy since then would have been less intense. Such a negative feedback loop would have at least not been aggravated by contagion from the lack of response to Greece’s unsustainable path. Procrastination did not help avoid facing the eventual insolvency problem—in the end, inaction made things worse, not better.
But haven’t we been down this road before? Haven’t similar experiences in the debt crises of the 1980’s, Russia in 1998, and Argentina in 2001 taught us that waiting too long to restructure in situations of clear insolvency can be more costly in the end? Indeed, as I argue with coauthors Brian Pinto and Mona Prasad in a recent World Bank Working Paper, “Orderly Sovereign Debt Restructuring: Missing in Action!,” procrastination becomes increasingly costly in such cases. Not only does the ratio of debt-to-GDP keep rising until a default or debt restructuring becomes unavoidable, but also investments and growth remain subdued while the debt overhang remains and everyone waits for the inevitable outcome.
Based on previous experiences, we argue that in situations where countries face solvency problems, official intervention that includes debt restructuring may be necessary—even if it is a bitter political pill to swallow. Although the record of official intervention in sovereign debt crises is not a flattering one, such interventions are more likely to succeed if official money is lent at the risk-free rate reflecting its seniority and private creditors receive an upfront haircut. Such an approach would limit the costs associated with procrastination and increase the chances of success by enabling a more realistic fiscal program to restore solvency. While the ship has sailed on such an outcome for Greece, let’s hope countries faced with sovereign and/or bank debt problems in the future realize the virtue of decisive policy action and the danger of procrastination.
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