Partial Debt Restructuring Will Not Work

Changing horses midstream is generally a risky proposition. Trying to do so in the midst of the eurozone debt crisis, where the economic and political stakes could not be higher, could prove especially hazardous. It will be even more so if careful thought is not given to the ramifications of the partial debt restructuring proposals that are now being happily bandied about.

The IMF's virtual admission that its €110bn Greek bail-out programme is badly off track has sent European policymakers scrambling to explore alternatives. So have persistently high market interest rates for European peripheral debt, which underline the market's growing conviction that large sovereign debt writedowns for the European periphery are only a matter of time.

It has now become clear that, with two-year government debt yields now about 25 per cent, the Greek government has virtually no chance of re-accessing the market, as it had previously planned, for its large public sector financing needs in 2012.

Until very recently, policymakers joined the European Central Bank in setting a taboo on talk of debt restructuring or exiting the euro as a solution to the problems confronting Europe's periphery. However, given the prospect of Greece needing yet another large bail-out package to survive 2012, European policymakers have begun a discordant debate on whether a Greek debt restructuring is now inevitable.

Among the more vocal proponents of a Greek debt restructuring has been Jean-Claude Juncker, the Luxembourg prime minister, who also chairs the meetings of European finance ministers. To the ECB's consternation, he is now advocating a re-profiling, or a soft restructuring, of Greece's sovereign debt.

Mr Juncker is hardly alone. Otmar Issing, a former ECB chief economist, now warns that Greece is unlikely ever to repay its debts. And even Angela Merkel is insisting that post-2013 private burden-sharing must be built into the European stability mechanism soon to be established. The German chancellor also insists that post-2013 sovereign bond issuance by countries in the periphery include collective action clauses making such bonds more susceptible to debt restructuring.

Understandably, Jean-Claude Trichet is apoplectic at the loose talk of debt restructuring. The ECB's president fully appreciates the real risks of contagion from a Greek debt restructuring to the rest of the periphery. He also knows that all too much of the cumulative $1,000bn in sovereign debt of Greece, Ireland, and Portugal sits on the French and German banks' balance sheets.

Mr Trichet correctly perceives that, if European policymakers now abandon their previous commitment to do "whatever it takes" to prevent a Greek debt restructuring, markets will question the credibility of their repeated assurances that none of the peripheral countries will default. If Greece were allowed to default, why should markets believe that Ireland and Portugal would not follow suit?

An equally compelling justification for Mr Trichet's antipathy to any form of soft Greek debt restructuring is how little this would improve Greece's fundamental fiscal policy challenge. Stuck in the straitjacket of euro membership, Greece is having to make a Herculean effort to restore fiscal sustainability, without the ability to resort to exchange rate devaluation and so boost exports as a much-needed offset to the adverse effects of fiscal consolidation.

Even if Greece's public debt were written down by 20 per cent, this would only spare Greece the need to make an extra fiscal adjustment of about 1 percentage point of gross domestic product to stabilise its public debt to GDP ratio. Greece would still have to make a fiscal adjustment of at least a further 8 percentage points of GDP to restore long-run fiscal sustainability. Such a large fiscal adjustment, within a fixed exchange rate system, is almost certain to add considerably to the decline of more than 9 per cent in real GDP that Greece has already experienced over the past 18 months.

Proposing half-baked policy nostrums in the middle of a serious debt crisis will do little to restore market confidence. Before continuing to advocate partial Greek debt restructuring, Mr Juncker and his colleagues should ask themselves whether they really want to bring forward the day when Greece is forced into a major debt restructuring and a possible exit from the euro. For that would seem the only real policy alternative to the ECB's preferred course of having Greece stick to the "no default and no devaluation" policy line.

Desmond Lachman is a resident fellow at AEI

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