Will Chancellor Angela Merkel of Germany have to take a call in the near future from Rome only to find out that Italy has followed Greece in defaulting on its sovereign obligations? And would she be so brave as to query, “Et tu, Berlusconi?”

Key countries within Europe had sovereign debt as of the end of 2010 that exceeded 9.3 trillion euros, with 3.1 trillion euros accounted for by the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain), which are currently the focus of all discussions (see table). A few Scandinavian countries have debt that is equivalent to less than 60% of GDP, one of the supposed criteria for joining the euro, but even core countries such as Germany and France have ratios noticeably higher.

Table 1: European Sovereign Debt, 2010

Of course, Greece has not defaulted…yet. Not much time is left to figure out which countries can be fixed, and how. “Kicking the can down the road,” one phrase recently added to the financial lexicon, remains unsatisfactory to investors, and is probably nearing the end of its shelf life for politicians, too.

The alternative preferred by some – blow everything up now and be done with it – is even less satisfactory. The arithmetic of sovereign debt is indeed daunting, but it is not always insuperable. In those cases where the arithmetic works, it makes sense to offer solutions that include government support and forbearance – in other words, when the arithmetic works, no matter how daunting, kick the can down the road. And in those cases where the numbers are insuperable, stop kicking the can and start down a new road.

This paper sets itself two tasks. The first is to construct a simple model that would arithmeticize the dynamics of sovereign debt so as not to get hung up with all of the acronyms and programs designed to save the world. The second is to put this into the context of the European sovereign debt problem and hazard some opinions as to which options can work, and which cannot.

The Conclusions

1. In a world of low growth, it would take a miracle for Greece to escape without negotiating a large cut in the principal of its debt;

2. It is, however, credible that defaults can be limited to a few small countries, and perhaps only to Greece, while the rest can string things along until a somewhat more normal global economic growth pattern resumes later this decade;

3. The probable need to recapitalize commercial banks to cover defaults casts a long shadow on the process; and,

4. The eurozone is likely to need more resources than it has gathered so far, with the European Central Bank (ECB) printing more money probably the easiest way to find those resources.

 

In other words, the arithmetic of Europe’s sovereign debt crisis is daunting, but not insuperable.

Can’t Pay? Won’t Pay?

The model presented below is designed to see if a credible solution to sovereign debt problems can be worked out. The goal here is to separate the daunting from the insuperable. A situation is probably insuperable if, even under favorable assumptions, the debt ratio remains high (say, for the rest of this decade). A situation is daunting but probably superable if the debt ratio gradually comes under control in the midst of tough conditions.

This does not attempt to separate discussions of solvency and liquidity, for they are not always separable. If the market ceases to provide Italy any funding, it will first be illiquid, and then cease to pay. The same would apply to the United States or Japan if the market completely refused to provide any new money today. Neither does the model attempt to address questions of willingness to pay. A look at the cash flow streams available to the most indebted country (Greece, on debt-to-GDP measures) suggests that payments can be made, but that it would involve a sizable transfer of resources outside of Greece compared to the option of default. If Greece simply refuses to go along, that particular game is over.

A few short years ago, the most compelling solution to a difficulty in payments for a developed economy was to print more money, as its debt was usually denominated in the country’s own currency. The United States, Japan, and the United Kingdom, for example, retain that option.

This solution is not available to most European sovereigns, especially the PIIGS countries that have been the center of attention, for they ceded control of their monetary fate to the ECB upon joining the euro. With debt denominated in euros, no PIIGS country can decide on its own to inflate away the debt problem, nor do they have the power as a group to set ECB policy on a more inflationary course. So, they have to persuade markets to hold their debt at a reasonable price for a few more years.

A Stylized Debt Model

Credibility of policy solutions is the focus of this model, which is designed to run on relatively few parameters that capture the bulk of the sovereign debt problem. Those parameters are six: the nominal debt of the country, the interest rate paid on that debt, the nominal GDP of the country, the growth rate of real GDP, the inflation rate, and the primary surplus of the country (the balance of government revenues and expenditures excluding interest payments).

The model is detailed in Appendix 1, and the assumptions for the various scenarios can be found in Appendix 2. It is nothing fancy, but it allows most plausible scenarios to be explored.

Some Test Cases

Does the stylized model work? Let’s review a few test cases.

Inflate the debt away

Almost everyone knows that inflation “solves” debt problems. Exhibit 1 shows just those dynamics. Even in an environment of modest growth and low interest rates (say, 2% interest rates and 1.5% real GDP growth) with a modest primary surplus, higher inflation rates can rapidly lower the debt-to-GDP ratio of a country, as long as investors never catch on (or have loaded up on long duration debt, so that the problem is gone before they can do anything about it). In our scenario, 3% inflation takes the debt ratio down faster than does 1% inflation, and 5% inflation is even better – unless investors catch on quickly. Our last scenario on the exhibit assumes that in the case of 5% inflation, investors would ask for a 6% yield, not 2%, to neutralize the inflation pickup – and all of the advantages of inflation disappear.

Exhibit 1: High interest rates are a killer

High interest rates are a killer

This, too, is hardly a surprise. Suppose one starts at a more manageable debt-to-GDP ratio, say 60%, which would have triggered the Excessive Deficit Procedure in the original Maastricht criteria.1 In that case, even high rates may not push up the debt-to-GDP ratio in a slow-growth environment (Exhibit 2 – assumptions detailed in the appendix). And, if they don’t push the ratio up, then the policy is credible, so there is no reason for market rates to stay high. But at a much less manageable starting point, say 120% (not so different from Italy today), high interest rates are a killer. Thus a credible policy that can restore low interest rates is, not surprisingly, necessary to work out of high debt-to- GDP situations.

Exhibit 2: High Interest Rates Are a Killer

Without austerity things deteriorate rapidly

Another “wow” moment. If one starts at a tough debt-to-GDP ratio, say 100%, in a low-growth, low-inflation environment, it is imperative to get the budget deficit under control. Austerity, as measured by the primary surplus, can bring down the debt-to-GDP ratio noticeably over the course of a decade – noticeably enough that the austerity can be eased, or market interest rates fall, before the decade is over (see Exhibit 3). But without austerity, the debt piles up faster than GDP can grow, so the policy is not credible.

Here the policy questions start to get a little more difficult. In Keynesian models, increased government austerity removes a source of stimulus from the economy. Or, as a recent paper put it, there is a “speed limit” on fiscal

Exhibit 3: Without Austerity Things Deteriorate Rapidly

adjustment – “the pace of tightening after which the corrosive impact on growth starts to undermine the fiscal position itself.”2 This, of course, is why adjustment programs insist on asset sales and various liberalization measures – reduced price supports, freer labor markets – to help offset the negatives of fiscal consolidation. And, in the old days, there was the option of currency depreciation to kick-start demand, an option not directly available to any of the individual members of the eurozone.

To the Real World

Italy’s situation is daunting

Italy is the biggest debtor at risk, for now at least, within the eurozone. The situation is truly daunting, as the country starts with a debt-to-GDP ratio of around 115%, a parliament that is paralyzed as scandal swirls around Prime Minister Berlusconi, and an economy that is slowing toward recession.

If support allows Italy to make it through the current crisis, what might things look like a few years down the road? A policy of support is credible if things can improve enough once we pass through the slow-growth phase of the global economy to get to the point where the markets, not governments, are willing to purchase the full issuance of that government’s debt. A policy of support is probably wasteful if the situation in a few years remains untenable, though there are sometimes advantages perceived in “kicking the can down the road.”

All these scenarios assume real GDP growth of 1.5% per year, in line with the average for Italy in the decade preceding 2008, and inflation of 1% (remember, if the market does not react by bidding up interest rates, then low inflation is “bad” by slowing the decline in the debt to equity ratio). Yields on Italian bonds have fluctuated below 6% in recent weeks, even when fears were great, so that rate was used for the high interest rate scenario, whereas a more moderate 4% was used for the medium rate scenario. The latter figure was derived by adding 2 percentage points of Italian premium to the 10-year bund rate.

Then, the question is how much adjustment does Italy need to enact? With no major fiscal adjustment – a primary balance, which would probably correspond to a permanent deficit of 4% to 5% of GDP – the problem continues gradually to worsen, even at medium interest rates of 4% (Exhibit 4). If Italy runs a primary surplus of 4% – large, but a figure in line with some of the larger adjustment plans undertaken in emerging markets – the debt slowly starts to decline as a share of GDP. One can then hope that growth rates pick up some in the second half of the decade.

Greece is broke

Using this simple model, it is hard to see why anyone still pretends that Greece is fixable without full-fledged default. The best scenario for the medium term involves moderate adjustment and medium interest rates – a 3% primary surplus and interest rates of 5% (Exhibit 5). Those interest rates bear no resemblance to what the market has been asking, and still the debt merely stabilizes for a decade at a very high level. Attaining a 3% primary surplus for Greece would be a major accomplishment, but perhaps not impossible – despite constant protests, Greeks seem gradually to be accommodating themselves to four years of extraordinary real estate taxes (remember, one of the most telling pictures on Greece was a photo of Athens showing private pools everywhere, yet property tax records reported very few), a reduction in the tax-free portion of income, and pension reductions.3

Unfortunately, a 3% primary surplus cannot come anywhere close to stopping the rise in debt if interest rates are high. Perhaps a more realistic outcome of muddling through in Greece would involve interest rates at 7% on the debt and a primary surplus of 5%. In this case, debt keeps rising on a track that isn’t much better than the (implausible) case of no fiscal adjustment with low interest rates. That involves a prolonged transfer of resources from Greece to the rest of the world that probably is politically unacceptable within Greece before the adjustment is completed.

Exhibit 4: Italy's Situation Is Daunting

Exhibit 5: Greece Is Broke

Can Greece get lucky?

Could Greece get lucky and escape the debt crisis without default? Suppose miracles do happen, and that real GDP growth soon recovers to 3% per year for the rest of the decade, that the Greeks manage to run 10% primary surpluses for two years in a row – perhaps from taxing all those pools, perhaps from selling some islands to Germans – and that all these accomplishments lead to market trust, culminating in a rapid return to interest rates of 4% on new Greek sovereign issuance. With all that luck, it takes until 2020 until Greece’s debt-to-GDP ratio falls to where Italy's is today, or where Italy's would be with a sharp adjustment and medium interest rates (see Exhibit 6).

Exhibit 6: Can Greece Get Lucky?

Miracles do happen…this one probably won’t. This leads to the conclusion that there is no credible Greek adjustment package without default and sharp cuts in the debt.

Any lessons from Brazil in 2002?

One might object that if Brazil could recover from its seemingly intractable debt problems in 2002 to become one of the mighty BRICs (the acronym created by Goldman Sachs for Brazil, Russia, India, and China at the forefront of growth in emerging markets), so can Greece.

Brazil’s problems also arose at a time of political difficulty, just before Lula won his first term as president after years in the political wilderness as the Working Party candidate. But Brazil’s debt-to-GDP ratio then was a fraction of that facing Greece (or even Italy), with the real problem coming from always high real interest rates and a substantial dollar-denominated component to its debt. It took four years for Brazil to get going on the growth front, though a recovery of the currency helped lighten the load from the dollar-denominated portion of the debt. Even with the most spectacular recovery, Brazil only shaved 10 percentage points off its debt load as a share of GDP (see Exhibit 7).

One lesson is that a country can work through tough economic conditions to extract itself from a sovereign debt crisis. The second is that Brazil’s task was easier, since the starting conditions involved lower debt (a better starting point) and more outrageous real interest rates (more room for things to improve). The third is a caution that a depreciating currency may not help; Brazil’s situation improved at first because the portion of the debt denominated in foreign currencies became less important as the real appreciated. Solutions hoping for a “new drachma” to ignite rapid GDP growth ignore the problems from debts denominated in euros, and the huge challenges of redefining all contracts if one tries to exit the euro.

It is best to stick to the original conclusion. Miracles do happen…the Greek miracle probably won’t. There is no credible Greek adjustment package without default and sharp cuts in the debt.

Exhibit 7: Any Lessons from Brazil in 2002?

What if Greece restructures?

It appears that banks are becoming resigned to a renegotiation of Greek debt that would involve a haircut close to the 60% the market is currently suggesting, rather than the 20% or so mooted earlier this year.4 Does a restructuring help? The restructuring will not work miracles, but it can indeed help (see Exhibit 8). Using a 60% haircut and medium interest rates at 5%, and assuming that provides a slight uptick to Greek GDP growth rates after a one-year recession from the adjustment package, Greece’s debt-to-GDP ratio can gradually drift down – but only gradually. Using less generous assumptions – if investors have already settled for a 60% haircut, perhaps they would insist on a lessgenerous 8% interest rate – and a GDP growth of only 1.5% per year, the debt-to-GDP ratio starts to drift back up again, but very slowly, even with a primary surplus equal to 3% of GDP.

What about the other bugaboo, allowing Greece to exit the euro? It contributes surprisingly little to a further improvement once Greece were to restructure, but the conclusion is very dependent upon the consequences of an exit from the euro. Presumably if investors are taking a 60% haircut, they don’t plan to take a further 30% haircut on the new securities that are issued in “drachmas” when the drachma devalues post restructuring. But presumably they do require higher interest rates from Greece if the new securities are not denominated in euros. Thus, an “exit the euro” scenario can in fact look worse than the high interest rate restructuring scenario put forward here, if higher drachma rates require yet more fiscal restructuring, depressing growth in Greece.

When bank capital raisings can help

There have also been all sorts of schemes mentioned that would have strong members of the eurozone (Germany, perhaps also France, and a few smaller players) guarantee the debts of problem nations, while other schemes have talked about general purpose capital-raising vehicles to repair bank balance sheets. The last scenario here takes a look at what can go right – and wrong – if the “good” countries are too quick to ladle out the money.

First, it is good to take a look at how a capital raising managed on a domestic basis might work. With French banks’ share prices having been slammed in recent months despite the fact that France had been perceived as a strong country

Exhibit 8: What if Greece Restructures?

within the eurozone, the French sovereign situation seems a good reference point. Suppose France were to provide 125 billion euros of capital support to banks, not just its own, but others, also through cross guarantees; would that make France’s situation worse and threaten the credibility of France? 5

This is addressed in Exhibit 9. France’s sovereign debt jumps when providing the bailout, but because the bailout has preserved a low-inflation, modest-growth environment in Europe in general and France in particular, the debt-to-GDP

Exhibit 9: When Bank Capital Raisings Can Help

ratio begins to decline immediately as long as France is not punished by higher interest rates (bailout but no penalty scenario, where it is assumed French bonds yield the same rate as bunds, 2%). If the bond market penalizes France with higher interest rates (5% in the penalty scenario), France’s own debt to GDP ratio continuously worsens, though at a slow pace. Now, if one supposes that France enjoys the same success with this bailout as the U.S. government did with the TARP plan (stylized as a 100% gain on the bank capital in 2014), France’s debt situation actually improves in the long run – though many countries would, of course, benefit if they could suddenly realize 125 billion euros worth of capital gains. This scenario allocates all those gains to France, where in fact the situation left France exposed to all the potential losses, but it would share the gains with other guarantors.

The less favorable of the above cases has essentially treated France’s investment in the banks as lost money (France’s sovereign debt goes up, but it gets no income from the investments – equivalent to saying the claim on banks is not netted out). The bottom line seems to be that providing capital can work if the market will not penalize you. That suggests, however, that it is wiser for each core country to take care of its own banks, rather than to make the bank capital positions a joint responsibility of all the eurozone members. For if all the capital responsibilities essentially were to collapse on one or a few lenders, the amounts needed are much higher, the probability of penalty interest rates are also higher, and even the debt-to-GDP ratios of core countries such as France and Germany can begin to spiral higher. This runs counter to one of the assumptions of the “American” blueprint for bailing out Europe’s banks.6

From the Stylized to the Current Eurozone Crisis

Reinhart and Rogoff, who have produced many pieces on financial crises in recent years, have provided a good summary of how debt crises happen: “First, external debt surges are a recurring antecedent to debt crises. Second, banking crises (both domestic and those emanating from international financial centers) often precede or accompany sovereign debt crises …Third, public borrowing surges ahead of an external sovereign debt crisis, as governments often have ‘hidden debts’ that far exceed the better documented levels of external debt.”7 And they also emphasize the recurring nature of debt crises once they begin.

We have seen all of those elements in the European sovereign crisis. The work above has concluded that the European debt problem is daunting, but also that it is not insuperable.

If allowed to extrapolate from the stylized calculations presented above, one could attempt to look at individual countries.

For the PIIGS countries, the conclusions are:

Portugal has dug itself a deep hole. It has failed to transform its traditional economy into a globally competitive economy, and it may be too late. Seen more as a source of textiles, shoes, and, of course, wine, Portugal has lost out to China and other emerging markets in the first two categories (heaven forbid that it should lose out in wine!). It has the right language to access one of the world’s more dynamic markets, Brazil, but may not make much of that opportunity. The new government has bravely gone forward with a plan of austerity under which Portugal might be able to pay its debts, though some autonomous regions have provided surprises by finding more debt on their books. If this is not enough, then Portugal is a candidate for a steep haircut. But with debt of 161 billion euros outstanding at the end of 2010, Portugal does not of itself pose a systemic threat.

Ireland, the Celtic Tiger, was until recently a model of success. A low tax rate attracted multi-nationals, and a lovely accent and well-trained work force gave the country access to international service markets. Admittedly, some of that success was fueled by easy credit to the property and construction industries. The good attributes have not disappeared, and a nasty recession has made Irish wages even more attractive, even if based in euros. Ireland’s real problem is that it tried a very large version of the bank scenario outlined above. Ireland forced a small haircut on its

banks and then bailed out the creditors the rest of the way. However, the amounts required were so big that it moved a manageable sovereign debt problem (a debt-to-GDP ratio around 40% pre-crisis, one of the best within the eurozone) into daunting territory. Ireland has been restructuring longer and harder than most other countries, so the problem has to be ruled daunting, but not insuperable. And, in any case, Ireland’s debt is relatively small.

Italy is on the border where daunting can turn into insuperable. It probably is not worth going for a restructuring of the sovereign debt; small haircuts on the debt’s principal accomplish little besides damaging one’s credit rating (this is distinct from the “haircut” on a bank’s Tier I capital that might be imposed during a regulatory review of capital backing those holdings). The political situation does not help; the Berlusconi government might not last long enough to make the hypothetical call to Chancellor Merkel with which this paper started. But the Italian restructuring must start soon, probably bolstered by the sale of some state assets to accelerate the date by which the progress is sufficiently evident so as to restore the market’s full uptake of Italian debt, both new and refinanced.

Greece is broke. Fortunately, Greece is small. It is not clear that leaving the euro would help, because Greece would still be broke. The only question will be the amount by which to write down the debt and the terms for the new debt to be issued. Cutting the debt in half but paying anything resembling market rates probably only sets up Greece for new problems down the road, but if the debt is restructured at very long maturities (for example, 30 years as is commonly suggested) those problems can indeed be postponed.

Spain’s previously exuberant construction sector has become an albatross around the country’s neck, and little improvement can be expected soon on that front. Still, the impact of the real estate collapse on employment and government revenues has already occurred. Labor laws are being eased, the central government has pursued a vigorous and tight fiscal policy, imposing even more constraints on regional governments that had been profligate, and has guided the cajas (saving banks) to a needed restructuring. The ratings agencies have worried about local governments hurting Spain’s adjustment, but the logical conclusion would be for the central government to let a few of the smaller authorities go into bankruptcy while continuing to clean up the central government’s financial mess. As a share of GDP, the debt is under better control than in many other cases, but it is large compared to the eurozone’s resources, so contagion is a risk.

If the problem with the PIIGS can be confined to Greece, Ireland, and Portugal, the amounts are well within European resources. It is even better if only Greece needs to be restructured. But it would be difficult to think of any of the PIIGS countries as much better than a “BBB” investment rating on a casual basis, so it would also not be surprising if there are further downgrades while the solution proceeds.

For the other eurozone countries, we remain cautious on the capital situation of banks, though we have addressed only one aspect of that problem here. Large-scale and amorphous bailouts could worsen the position of core eurozone countries such as France and Germany, especially if they were to take on overly broad responsibility for all debts in the region. The European Financial Stability Fund remains too amorphous a concept to judge on this basis, save to note the risk that it could worsen the sovereign debt position of core countries if they guarantee it. Directly it currently has 440 billion euros of resources, some of which have already been expended; including some other eurozone resources and the IMF plan, the total is a more impressive 750 billion euros, against the 3.1 trillion of general government debt outstanding at the PIIGS at the end of 2010. Overall, though, easier money at the ECB seems an easier solution to the question of resources.

In Closing: Future Reforms

Will there need to be future reforms? Yes, and the following quote from Arthur Salter is a fine summary on that point: “To establish a sounder foundation for foreign lending in future is therefore one of the two or three most important reforms the world needs, if a recurrence of our present troubles is to be avoided.”

Arthur Salter wrote this long before the current crisis broke. Along with a co-author, I used this quote from 1932 in our 1983 publication for the Brookings Institution, “Managing Global Debt,” which dealt with the problems of the early 1980s centered on loans to Latin America. Then, as now, policymakers had grand solutions – longer maturities, reduced interest rates, involvement of multilateral institutions – supposedly able to fix the system for the future while imposing, at most, minimal losses on lenders and borrowers. The only thing somewhat new this time around is the notion of increasing fiscal union in Europe as a way to prevent future problems. Even that is a play on the notion of thirty years ago that some outside source was needed to evaluate the financial position of countries before they could borrow. Grand solutions may yet come, but they probably will not come soon enough. Now is the time to separate the daunting from the insuperable, and to fix both sets of nations.

 

1 Barry Eichengreen et al, “Europe’s Public Debt Challenge,” in “Public Debt: Nuts, Bolts and Worries, International Center for Monetary and Banking Studies, 2011.

2 “The Speed Limit of Fiscal Consolidation,” Global Economics Paper No. 207, Goldman Sachs, August 19, 2011.

3 “Greeks pay for the crisis with their health and wealth,” Financial Times, October 12, 2011.

4 “Greek investors brace for bigger loss to stop rot,” Bloomberg news, October 14, 2011.

5 As of October 24, the press has focused on amounts closer to 100 billion euros of new capital for European banks, perhaps backstopped by the central government, but has not addressed where the funds to expand other mechanisms such as EFSF might come from. So 125 billion euros of support seems a decent place to start.

6 America’s blueprint for bailing out Europe’s banks, Financial Times, October 12, 2011.

7 Carmen M. Reinhart and Kenneth S. Rogoff, “From Financial Crash to Debt Crisis,” The American Economic Review, August 2011, p. 1677.

 

 

 

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