New, dangerous phase for Europe

(The views expressed here are Lawrence Summers’ own)  

By Lawrence Summers  

CAMBRIDGE, Mass.,  (Reuters) – With last week’s  tumult in Italian markets, the European financial crisis has  entered a new and far more dangerous phase. Where the crisis  had been existential for small economies on the periphery of  Europe but not systemically threatening to either the idea of  European monetary union or to the functioning of the global  financial system, it now threatens both European integration and the global recovery.

Lawrence Summers

Last week’s drama surrounding bond auctions in Europe’s  third leading economy should convince even the most hardened  bureaucrat that the world can no longer let policy responses be  shaped by dogma, bureaucratic agenda and expediency. It is to  be hoped that European officials can engineer a decisive change  in direction but if not, the world can no longer afford the  deference that the IMF and non-European G20 officials have  shown toward European policy makers over the last 15 months.

Three realities must be recognized if there is to be a  chance of success.

First, the maintenance of systemic confidence is essential  in a financial crisis. Teaching investors a lesson is a wish,  not a policy. U.S. policymakers were applauded for about 12  hours for their willingness to let Lehman go bankrupt. The  adverse consequences of the shattering effect that had on  confidence are still being felt now. The European Central Bank  (ECB) is right in its concern that punishing creditors for the  sake of  teaching lessons or building political support is  reckless in a system that depends on confidence. Those who let  Lehman go believed because time had passed since the Bear  Stearns bailout that the market had learned lessons and so was  prepared. In fact, the main lessons learned had to do with how  to best find the exits, and so uncontrolled bankruptcies had  systemic consequences that far exceeded their expectations.

Second, no country can be expected to generate huge primary  surpluses for long periods for the benefit of foreign  creditors. Meeting debt burdens at rates currently charged by  the official sector for credit — let alone the private sector  — would involve burdens on Greece, Ireland and Portugal  comparable to the reparations burdens Keynes warned about in  his book “The Economic Consequences of the Peace.”

Third, whether or not a country is solvent depends not just  on its debt burdens and its commitment to strong domestic  policies but on the broader economic context. Liquidity  problems left unattended become confidence problems. Debtors  who are credibly highly solvent at interest rates close to or  below their nominal growth rates become likely insolvent at  higher interest rates, putting further pressure on rates and  exacerbating solvency worries in a vicious cycle. This has  already happened in Greece, Portugal and Ireland and is in  danger of happening in Italy and Spain.

Debtor countries can only reduce their debts by running  surpluses vis-a-vis the rest of the world. If traditional  debtor countries are going to start running surpluses,  traditional surplus countries must be willing to reduce their  surpluses or move toward deficits.

In short, the approach of lending more and more from the  official sector to countries that cannot access the market at  premium rates of interest is unsustainable. The debts incurred  will in large part never be repaid, even as their size  discourages private capital flows and indeed any  growth-creating initiative. Assertions that the most indebted  countries can service their debts in full at current interest  rates only undermine the credibility of policymakers when they  go on to assert that the fundamentals are relatively sound in  Spain and Italy. Further lending at premium interest rates only  increases the scale of the necessary restructuring. It is  reasonable to argue that the recognition of debt  unsustainability in Greece has been excessively deferred. It is  not reasonable to argue that Greek reprofiling or restructuring  taken alone will address a growing general confidence crisis.

A fundamental shift of tack is required toward an approach  that is focused on avoiding systemic risk, restarting growth,  and restoring arithmetic credibility, rather than simply  staving off imminent disaster. The twin realities that Greece,  Italy and Ireland need debt relief and that the creditors have  only limited capacity to take immediate losses means that all  approaches require increased efforts from the European centre.  Fortunately, the likely consequence of doing more up front is  lower cost in the long run.
The precise details are less relevant than having an  appropriate broad approach, and of course will need to be  aligned with European political reality. But the crucial  elements in any viable strategy will include:

European authorities must restate their commitment to  solidarity as embodied in a common currency, and the  recognition that the failure of any European economy marks the  failure of the European economy and is unacceptable. Toward  that end they then should make these further commitments.

First, for program countries. Interest rates on official  sector debt will be reduced to a European borrowing rate  defined as the rate at which common European entities backed  with joint and several liability by all the countries of Europe  can borrow. A default to the official sector will not be  tolerated, so there is no reason to charge a risk premium,  since charging a risk premium needlessly puts the success of  the whole enterprise at risk.

Second, countries whose borrowing rate exceeds some  threshold — perhaps 200 basis points over the lowest national  borrowing rate in the Euro system — should be exempted from  contribution requirements for bailout funds. The last thing the  marginal need is to be pulled down by the weak.

Third, there must be a clear and unambiguous commitment  that whatever else happens, the failure of major financial  institutions in any country will not be permitted. The most  serious financial breakdowns-in Indonesia in 1997, Russia in  1998, and the United States in 2008 — come when authorities  allow there to be doubt about the basic functioning of the  financial system. This responsibility should rest with the ECB  with the requisite political support and cover provided.

Fourth, countries judged to be pursuing sound policies will  be permitted to buy EU guarantees on new debt issuances at a  reasonable price payable on a deferred basis.

These measures would do much to contain the storm. They  would lead to a reduction in payments for debtor nations,  protect states at risk from participation in rescue efforts or  from shortfalls in market confidence, and assure that the ECB  is able to continue backstopping the stability of European  banks.

This leaves the question of what is to be done with  sovereign private debt. Creditors gain nothing from breakdown.  They have signalled that they will support an approach based on  a menu of options. Some will want to sell out of their  exposures at prices marginally above their current market  value. Others who still regard sovereign European debts as  worth par should be provided with appropriate reduced interest  rate, longer-maturity options. Debt repurchases are a  possibility if the private sector accepts sufficiently large  present value debt reductions. The key standard by which any  approach should be judged is the genuine sustainability of  program country debt repayments on realistic assumptions.

Much of this will seem unrealistic given the terms of  Europe’s debate. It seemed highly unrealistic even 10 days ago  that Italy’s solvency would come into substantial doubt. If the  political will can be found, the technical economics are not  that difficult. But it will require a shift from politically  driven arithmetic to arithmetically driven politics. The  alternative to forthright action today is much more expensive  action — to much less benefit — in the not-too-distant  future. The next few weeks may well be among the most  consequential in the history of the European Union.

(Lawrence H. Summers is the Charles W. Eliot University  Professor at Harvard University and a former U.S. Treasury  secretary. He speaks and consults widely on economic and  financial issues.) 

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