Saturday, September 8, 2012

Why early sovereign default could save the euro

by Harald Hau and Ulrich Hege


September 8, 2012

The recent announcement by the ECB that it will start to buy Spanish and Italian sovereign debt has been warmly welcomed throughout Europe. But this column argues that by doing so the ECB is digging the euro’s grave. It says the solution is default, either through inflation or debt restructuring – and that debt restructuring has many advantages if it is done early enough.

The crisis in the Eurozone is primarily a debt crisis. Debt overhang, whether public or private (as it originally was in Ireland and Spain), impedes investment and growth (Reinhart and Rogoff 2010). And it diminishes incentives for fiscal rigor if the benefits accrue mainly to creditors, and aggravates the macroeconomic effects of austerity if much of the additional saving that deleveraging requires is transferred to creditors abroad. Low growth and capital flight reinforce the debt problem and create a downward spiral, from which belated budgetary austerity provides no exit.

Any strategy of dealing with the Eurozone crisis therefore must be evaluated in light of its effectiveness in dealing with the debt overhang problem. Two solutions are possible.
  • Inflation reduces the real value of nominal debt, lowering the debt burden both on the sovereign and all other debtors.
An unanticipated inflation increase of three percentage points amounts to a 34% (compounded) debt relief on a ten-year bond; little of the government debt in question is inflation-indexed (less than 8% in Italy and none in Spain). But such relief hits all investors alike, independent of the solvency of their respective debtors.
  • Or sovereign default writedowns of the face value and interest payments or reprofiling of such payments. These can take various forms.
For example, exchanges of short-run debt for long-run debt and adjustments of the interest payments can help restore sustainability to debt dynamics.


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